updated on 16 October 2018
QuestionHow are fintech developments being deployed in capital markets, and how might this affect the role of lawyers?
In recent years the potential of fintech to disrupt the status quo and usher in the next wave of technological revolution has been widely broadcast. The term ‘fintech’ can be used to cover a variety of technologies, from the much-vaunted poster-child blockchain (or distributed ledger technology in general) to artificial intelligence and robotic process automation.
The capital markets space is well suited to electronification and as such, has been a particular focus for fintech companies wishing to improve efficiency in existing capital markets infrastructure and processes. A report published by the Boston Consulting Group in March 2018 calculated that capital markets fintech companies had raised $4,401 million in equity funding between 2013 and 2017.
As the market continues to develop to incorporate these advances in technology, so too will the role of a capital markets lawyer: from understanding the changing processes and accurately reflecting them in capital markets documentation to advising on familiar legal issues like enforceability and jurisdiction in novel contexts.
Although there are countless ideas for innovation in the capital markets sphere, the following article discusses a few examples and examines some of the legal and practical issues surrounding each one.
One area of particular interest in the capital markets context is distributed ledger technology (DLT), of which blockchain is one example. At its core, DLT is a database (ledger) which is distributed across multiple computers (nodes), which each maintain an identical copy of the ledger. Any update to the ledger can be verified using a consensus algorithm. This creates a decentralised, consistent and immutable system using consensus-based authentication to achieve continuing synchronisation between multiple ‘authors’. The ledger can be public (a permissionless system), for example, like the Bitcoin or Ethereum blockchain, or alternatively, authors can be restricted to certain ‘trusted users’ to maintain the integrity of the network (a permissioned system). Cryptographic hashing protection would be employed to protect data and ensure the immutability of the ledger.
For capital markets, the most immediate applications of DLT are in the ‘post-trade’ phase of a transaction, which covers collateral management, securities lending, cash equity settlement, and clearing. Indeed, over 75% of capital market fintech companies working with DLT operate within the post-trade space.
In part, this arguably reflects the limitations of the existing infrastructure rather than inherently novel solutions offered by DLT. Post-trade infrastructure has grown organically in line with the growth of modern securities trading. While generally efficient, this has still resulted in an amalgamation of imperfectly-integrated, overlapping systems lacking in standardisation, and at some points still reliant on manual data entry. Significant resources are dedicated to communicating and reconciling information between systems and their antiquated nature puts such systems at risk of cyber-attack. Indeed, a white paper published by the Depositary Trust and Clearing Corporation (DTCC), the major post-trade service provider in the United States, concluded that they were “not equipped for 24/7/365 processing” required by the modern securities marketplace.
Nevertheless, DLT offers certain potential benefits over existing systems.
In a permissionless system, authentication via the majority removes the need for post-trade intermediaries such as DTCC altogether. Rather than requiring a party to maintain a ledger of securities-holders and effect any subsequent trades, this would be done on a peer-to-peer basis, with funds and title moving between the parties via the ledger. A permissioned system would instead lower the cost to employ such intermediaries as they achieve cost-savings from standardising technology, removing the need to reconcile between systems and eliminating manual data processing. However, this would need to be weighed against the increased power consumption, data transfer and storage and verification costs of a decentralised system compared to their centralised counterparts.
As well as the efficiency improvements outlined above, DLT systems would provide for faster post-trade interactions by reducing communication costs. For example, all parties would have access to necessary approvals or confirmations as soon as they are received, allowing more workstreams to be run simultaneously and expediting the settlement process.
DLT systems would increase market liquidity due to the speed at which transactions can be processed. In addition, the transactions using DLT may attract interest from a wider investor base.
That entries to the ledger automatically form part of an un-editable record of all transactions could provide significant benefits for verification and audit purposes. In the case of debt securities, issuers could also leverage this to gain greater sight of the holders of their securities. Similarly, regulatory bodies, if given access to the ledger, could provide more responsive oversight with access to real-time market information.
However, immutability is not without potential problems. As the multiple hacks of various crypto-currency wallets have shown, even without a single point of entry, DLT can still be vulnerable to exploitation. Even if such systems were secure in themselves, vulnerabilities would remain – via theft of the investors’ cryptographic keys used to authorise transactions, or even simple human error in entering transaction details. If such unwanted transactions are unable to be unwound then investors and regulators may well resist DLT-based systems until acceptable solutions are presented.
Indeed, the potential benefits have attracted interest from a number of exchanges. In December 2017, the ASX announced that it is planning to replace its existing clearing and settlement system architecture for equity transactions with a new system utilising DLT. The new system is expected to be operational by the end of 2020 or early 2021, and would represent one of the first practical implementations of DLT by a major bourse (NASDAQ integrated DLT in its private market for the trading of pre-IPO-shares in 2015). Several other major exchanges, including the LSE, the Deutsche Boerse and the Moscow Stock Exchange, have also announced they are examining ways to utilise the technology.
Of greater interest to capital markets lawyers is the platform that DLT provides for the utilisation of ‘smart contracts’. Working on the basis of ‘if X then Y’ logic, smart contracts are self-executing pieces of computer code. Able to monitor the conditions of an agreement, if certain circumstances are met then execution of certain clauses occurs automatically, with no input required from any party. While such programming has been utilised since even the earliest of computers, the revolutionary aspect lies in leveraging the inter-connectivity of assets represented on DLT.
From a client’s perspective, smart contracts offer a variety of potential benefits.
Primarily, self-execution removes costs associated with the monitoring and enforcement of contractual provisions. Furthermore, once appropriate code has been written for a specific provision, it can be easily re-used, thus lowering or even removing the input needed from lawyers and other intermediaries, particularly for simple or repeat transactions.
However, the benefits to early adopting firms are limited, creating first-mover disadvantages which may slow the uptake of smart contracts. For smart contracts to be economically viable, sufficient market participants and their assets and information must already be connected via DLT to provide potential benefits outweighing the cost to a firm of migrating their own systems onto a ledger.
Minimising human input and utilising data stored on DLT removes unnecessary duplication, allowing transactions to be conducted faster by systems that can function 24/7.
For a smart contract to function, it must be recorded in a logic-compatible format, with no room for ambiguity. While further certainty of outcomes is a significant benefit to the contractual parties, all eventualities must be contemplated in advance (and no mistakes made in the contract’s formulation); the pitfalls of unintended coding can be seen in the hack of the blockchain-based venture capital fund ‘The DAO’, where the coding of a smart contract was exploited to obtain approximately $70 million of investors’ funds. If the outcome of a contract increasingly relies on the quality of the code underpinning it, where liability lies if things go wrong will undoubtedly be a topic of debate within the legal industry.
In addition, traditionally useful legal ambiguities – qualitative measures such as ‘reasonableness’ or ‘best endeavours’ – will no longer be available to those drafting smart contracts.
In a self-executing world where transactions are recorded on an immutable public ledger, the gap between the dual meanings of ‘enforceability of contract’ is widened. On the one hand, the traditional legal meaning that an agreement is capable of being upheld by a court; on the other, the practical meaning that all variables are such that, if certain circumstances arise, a transaction will occur with no further human input required. While there has always been a certain divide between de jure and de facto enforceability, smart contracts raise new issues. Widespread adoption would require not only the reconciliation of various formalities (for example, execution of deeds), but also between the ‘immutable proof’ of ownership on the face of a ledger and the court’s interpretation of the legal rules in the context of the facts of the matter. It is unlikely - and arguably undesirable - that the court would cede its position as the ultimate arbiter of legal standing and so the regulation of such self-effecting contracts will need to be carefully considered.
As such, it is likely that smart contracts will have a limited impact on the legal profession in the short-term. Given the issues outlined above, it is likely that initial implementation will be for repeat transactions with few negotiated elements, or restricted to certain sections of an agreement, both contained within a wider, traditional-form legal contract.
While blockchain and its associated technologies have attracted a substantial amount of attention and funding within the fintech space, they are not the only technologies being used to develop novel capital markets practices.
A prime example of this is the ‘mobile’ bond, dubbed the ‘M-Akiba’ bond, which was launched by the Republic of Kenya in April 2017. The key difference between this and traditional government securities was that investors subscribed for the securities exclusively via their mobile phones. Seeking to broaden the investor base, which had typically been limited to high-net worth individuals with easy access to Kenya’s main financial centres, the M-Akiba bond utilised Kenya’s high proportion of mobile phone coverage - roughly 90% of the population is estimated to have access to a mobile phone. The entire process, from completion of KYC requirements and initial subscriptions to buy-and-sell orders in the secondary market, were processed in real-time entirely via investors’ mobile phones. Payments for the bonds utilised Kenya’s existing mobile-banking infrastructure and were processed through investors’ ‘mobile wallets’.
The three-year bond, which was listed on the Nairobi Securities Exchange, targeted retail investors with a minimum denomination of the equivalent of €25. The initial tranche proved successful, raising the target of Ks150 million, equivalent to roughly €1.25 million, two days ahead of schedule. However, the launch was not without difficulties as the subsequent main offering raised only roughly 25% of the targeted Ks1 billion. Several technological factors are cited as possible causes: many of the target investors were using mobile phones that were unable to download the disclosure documentation and a subsequent study by the development programme FSD Africa found many investors felt the instructions given in the purchase process were unclear. In addition to technological teething troubles, the main offering coincided with general elections in Kenya, which may have led to the marketing of the bond being overshadowed by the election campaigns.
Ultimately, however, the success of the initial tranche highlights the potential for such technologies to transform the capital markets space, particularly in emerging markets where widespread engagement with formalised banking institutions is limited. Such a transformation would necessarily impact on the legal structuring and documentation of transactions; not only will consideration need to be given to incorporating greater flexibility in payment channels, but also, as indicated by the M-Akiba bond, as to how best to structure and format disclosure documentation to reach investors across a range of platforms.
Given the speed at which technology is progressing, adapting existing processes and infrastructure in capital markets transactions is no longer an option, and more a necessity. As market practice develops and evolves, lawyers will also be required to adapt to the changing technology and processes and ensure that they are viable from a legal perspective.
Felix Aspin and Nikita Thakrar are, respectively, a trainee solicitor and associate at White & Case LLP.