Why the Buy-Side Should Get Off the Blockchain Sidelines

Sid Kalla
Jul 24, 2016 at 15:50 UTC
OPINION

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Blockchains have attracted significant interest in the financial sector, a rare occurrence for a new technology in an industry not known for being at the forefront of technological innovation.

However, dig a little deeper into where the interest is coming from, and you’ll see a host of sell-side financial institutions and back-office groups working on prototypes. Most of the R3 consortium members, for example, are sell-side banks. Notably absent is the buy-side, made up of pension funds, mutual funds, hedge funds, private equity and other money management firms.

The buy-side has different structures and mandates, but at the end of the day, investor risk-adjusted returns are a primary concern, and the blockchain can help with that.

The back-office is interested in blockchains because of the ability to simplify settlements, and provide reconciliation of data among different parties without explicitly moving and verifying data across organizational borders. This saves a check on data validity at each entry and exit point, as a consensus mechanism is accessed collectively by a group of participants.

But while interest from the buy-side has been generally muted, it would be a mistake for these firms to ignore blockchains.

Cost reductions

The obvious win for the buy-side is the possible efficiency gains that could be achieved by using a blockchain-based solution at the back-office for custody and settlement.

Asset custodians charge a few basis points for assets held by clients, which can quickly add up. By improving efficiency, the total cost of servicing assets by a buy-side firm should fall.

The other longer term benefit could be regulatory costs.

Buy-side firms today spend a significant amount of money on compliance and following regulations. Markets that adopt the blockchain could potentially encode a lot of these rules into the blockchain as smart contracts, thus reducing the need for human intervention and oversight.

The CFTC is especially interested in such efficiencies for the futures markets. Such moves would arguably make the markets safer for investors, while providing better market transparency.

Access to different markets

The benefits of global diversification on enhanced risk-adjusted returns are well known in the industry.

However, many fund managers and buy-side firms struggle to invest in a truly globally diversified portfolio because of friction in managing the process. Global ETFs solve the problem to some extent, but managers looking at specific securities have a hard time investing economically.

The current model of global custodians and expensive asset custody fees could be a thing of the past if blockchains are widely adopted on a global scale. Such a move would benefit smaller investors the most, but would make the process of cross-border investments much simpler for all buy-side firms.

There is little manual intervention required in such a system – issues like corporate actions, for example, could one day be automated in smart contracts, removing financial intermediaries.

'Digital Assets'

One of the more exciting trends in the blockchain space is around the use of public blockchains not as a settlement layer, but simply as both asset and settlement layer. Bitcoin was created as a peer-to-peer electronic currency system, but is also being used as an asset.

Large market players like the CME Group already see promise in this area. Further, investment manager Ark Invest and blockchain startup Coinbase published a recent report arguing the same.

Digital assets provide a whole new investment class to the buy-side, with potential to improve risk-adjusted returns for existing portfolios. Some companies are already taking the lead on this.

Hedgeable, a robo-adviser based in New York, has been advising clients to invest money in bitcoin as an asset class. Last year, the average bitcoin return at the firm was over 60%, contributing 0.96% of the yearly returns, even though bitcoin made up less than 2% of the firm assets.

Matthew Kane, the co-founder of Hedgeable, told CoinDesk that 30% of its clients have opened a bitcoin wallet through Coinbase to invest in bitcoin.

The average investor at Hedgeable owns 1 BTC. Kane further said that his company views bitcoin as a long-term asset class that helps enhance risk-adjusted returns.

Looking to the future, with two bitcoin ETFs now pending approval from the SEC, it appears to be only a matter of time before bitcoin and other digital assets become available to common investors as an investment option.

Sideline image via Shutterstock

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