JANUARY 2016 EMBRACING DISRUPTION TAPPING THE POTENTIAL OF DISTRIBUTED LEDGERS TO IMPROVE THE POST-TRADE LANDSCAPE A WHITE PAPER TO THE INDUSTRY TABLE OF CONTENTS Introduction . 1 cutive Summary 2 The Evolution of Today’s Financial Markets 4 Limitations of the Current Financial Market Infrastructures 5 Key Features of Blockchain and Distributed Ledgers Explained . 6 The State of Distributed Ledger Technology Today 8 Building Blocks for Leveraging Distributed Ledgers in Financial Services . 10 Leveraging Distributed Ledgers . 12 Conclusion . 181 INTRODUCTION DTCC is an industry-owned and governed financial market utility with more than 40 years of experience mitigating risk and driving operations and cost efficiencies for the financial industry. We believe that realizing the promise of distributed ledgers lies in aligning the technology with these core principles to leverage new opportunities and simplify or replace legacy systems. The emergence of the Bitcoin payment network 1and its associated ecosystem of blockchains, sidechains and altchains have been described as a generational disruptive force in the financial services industry. While some of the concepts of distributed electronic currencies have existed since at least the 1990s 2 , the implementation of Bitcoin and the white paper that described it were the watershed moment in use, adoption and popularization of a decentralized crypto-currency. While Bitcoin as a payment mechanism is being discussed and researched in many other forums, the Bitcoin technology plat, commonly referred to as the blockchain or distributed ledger, is considered in this paper for application to post-trade processing and other functions that are managed by financial market infrastructures. The premise of the Bitcoin plat – a decentralized, trustless, replicated ledger of transactions – is the virtual opposite of the centralized, trusted, guarded, model of modern securities processing, which has long relied upon DTCC, among others, as a central authority. The trust model, along with the economies of scale of centralizing common back-office processes and the strict controls and regulatory oversight of DTCC, has ensured the safety and soundness of securities trade processing through periods of extreme volumes and systemic market shocks. It has also created the most cost efficient post-trade processing infrastructure in the world. DTCC has a long history of driving innovation to strengthen the post-trade process. In this same spirit, DTCC embraces the potential application of distributed ledger technologies across a range of processing to further lower risk and costs for the industry. The purpose of this paper is to cut through the hype and provide DTCC’s insights on opportunities for leveraging distributed ledger technologies to improve existing business models and legacy systems. As always, the core DTCC mission of protecting the markets infers that safety, soundness, integrity, resiliency and reliability, and the trust that DTCC has earned across more than 40 years of uninterrupted service to the global markets, will be a central element of those thoughts. 1 Bitcoin A Peer to Peer Electronic Cash System https//bitcoin.org/bitcoin.pdf 2 E.g., ecash proposed by D. Chaum 1983, hashcash proposed by A. Back, E-Gold launched in 19962 CUTIVE SUMMARY Today’s global financial markets are underpinned by a complex network of internal systems and service providers that support the processing of hundreds of millions of financial transactions each day. This amalgamation of internal and external systems may appear disorderly, but as a result of painstaking efforts over the years, they have been integrated to enable the seamless and efficient flow of assets, ination and data across markets and regions. While the current system was not created through intentional architecture and design, it provides the necessary stability, reliability and certainty that ensure global markets are efficient, transparent and cost effective. DTCC believes that distributed ledger technologies have the potential to address certain limitations of the current post-trade process by modernizing, streamlining and simplifying the siloed design of the financial industry infra- structure with a shared fabric of common ination. There are several key features that make this technology a potentially attractive option to improve existing processes, including the fact that standard rules exist for securities transaction validation and replication; immutable linkage to transaction history and auditability. While distributed ledger technology has captured the imagination of the industry, key challenges with the plat will need to be overcome before it can be widely adopted or considered enterprise-ready. In addition, the industry itself needs to determine whether using the plat is more cost effective than improving existing technology and whether it can overcome its inherent scale and perance challenges. Furthermore, there needs to be indus- try-wide discussion, including regulatory and policymaker engagement, and consensus on developing requirements and determining whether trusted third parties are best positioned to develop them. The industry hype and research into this new plat has been unprecedented but also generally uncoordinated up to this point. As a result, the industry is at risk of repeating the past and creating countless new siloed solutions based on different standards and with significant reconciliation challenges – essentially a new system with the same challenges we face today. To avoid this, the industry should engage in a collaborative rearchitecture of core processes and practices to ensure standardization. DTCC believes it is best positioned to support and coordinate the uation and standardization of the distributed ledger plat, help address industry challenges and determine whether it is a better solution than existing technology. In addition, as an industry-owned and governed financial market utility with more than 40 years of experience mitigating risk and driving operations and cost efficiencies, DTCC is uniquely positioned to per this role with absolute focus on the best interests of post-trade processing in a manner that serves the industry, regulators and the investing public. In uating opportunities to leverage distributed ledgers to improve upon existing infrastructure, DTCC has identified several areas and processes for further review. Based on its research and analysis, DTCC recommends exploring distributed ledger initiatives in Master data management Asset/securities issuance and servicing Confirmed asset trades Trade/contract validation, recording and matching for the more complex asset types that currently do not have strong, existent solutions Netting and clearing Collateral management Settlement3 Importantly, while there has been a great deal of discussion around implementing real-time settlement using distributed ledger technology, the current U.S. equity market convention of T3 is based on laws and market structures. Modernizing current practices and laws to enable real-time settlement are not dependent on the use of blockchain technologies. DTCC strongly believes that the financial services industry has a once-in-a-generation opportunity to reimagine and modernize its infrastructure to address long-standing operational challenges. DTCC has the experience and capabil- ities to enable the integration of a financial industry distributed ledger ecosystem with the existing financial market infrastructures in a manner that is consistent with its mission and that further lowers risks and costs for all market participants.4 THE EVOLUTION OF TODAY’S FINANCIAL MARKETS At its most basic level, trading is simple. An investor exchanges an asset of value and receives payment in return. Peer-to-peer. No intermediaries. And ideally, the exchange takes place at the same time. That is how trading occurred in the early days of the stock exchanges, with the trade agreement and settlement typically completed bilaterally. However, as exchanges matured and became more complex, and as more people accumulated assets and authorized trusted third parties to hold and manage those assets on their behalf, various service providers became trusted to manage the processing. Over time, periodic financial crises, oftentimes spawned from abuse of investor assets by those same trusted service providers, caused investor losses, prompting the addition of governance and utility infrastructures to oversee processing and to mitigate these and other risks. The result is the complex layers of interactions that exist today and is depicted in the image below, which illustrates the currently planned move to shorten the settlement cycle in the U.S. to two business days after a trade is cuted, known as T2. Buy Side Broker Dealer Omgeo Custodian Exchange NSCC DTC Clearing Prime Broker Trades SSI Enrichment Clearing Netting Matching Afrmation Order Placement Settlement Order cution Order Management Trade Detail Allocation Instruction Trade Detail Allocation Capture Trade Detail Allocation Conrmation Institutional TradesT0 T1 T2 T1 12PM ID Net Processing CNS Processing PROJECTION REPORT PROJECTION REPORT PROJECTION REPORT This picture greatly simplifies the processing that occurs in each firm. In reality, buy-side and broker-dealer institutions have an amalgamation of systems that have been developed over the past 40 years through automation initiatives, regulatory mandates and the proliferation of marketplaces. Today, different internal systems and/or service providers address different aspects of trade order management, post-trade processing, asset account services and data management. Despite multiple layers of orchestrated interactions, reconciliations and workflows, modern global markets are highly efficiently, transparent and relatively low cost.5 LIMITATIONS OF THE CURRENT FINANCIAL MARKET INFRASTRUCTURES Today’s financial market infrastructures have a proven track record of providing stability, reliability and certainty – all key ingredients to ensuring the efficient operation of the markets, especially during periods of extreme volatil- ity. The collapse of Lehman Brothers and MF Global, as well as the 2012 “electronic trading glitch” and 2010 flash crash incident, are just a few recent examples that reinforce the critical role of central counterparties and market infrastructure in protecting the integrity of the global financial system when a systemic shock occurs. However, the current system also has certain limitations that distributed ledger technology has the potential to address Multiple Versions of the Truth The layers of financial market systems are siloed and contain multiple versions of truth. There is minimal transparency into each system, and every bank maintains large, costly libraries of application code existing only to reconcile different versions of the truth. Vulnerable to Technology Threats The legacy systems currently employed were not architected to protect against today’s technological threats, including the potential for cyberattacks. As a result, the potential for data compromises due to system vulnerabilities exists. Unnecessarily Complex Today’s systems are very complex due to their evolution over the course of decades. Trading activities, along with clearing, settlement and collateral/capital/asset management systems, were built at different times and intended to serve different needs. Today, there are minimal widely used standards, systems are not well integrated and many manual processing steps still exist. Not Equipped for 24/7/365 Processing Today’s systems were mostly architected prior to the globalization of the industry and the resulting need for markets to operate 24 hours a day, 7 days a week, 365 days a year. 6 KEY FEATURES OF BLOCKCHAIN AND DISTRIBUTED LEDGERS EXPLAINED In assessing opportunities to leverage distributed ledgers to improve the current system for processing securities transactions, it is helpful to have an understanding of the Bitcoin payment network and the individual components that its underlying technology plat. The Bitcoin payment network was built as a peer-to-peer, distributed and decentralized plat to validate and track transactions without any central authority. Eight key capabilities that combined to create this innovative plat are described below The Asset Is Built-In The asset called Bitcoin BTC is produced and managed completely within the Bitcoin network. Therefore, the history and quantity of every movement of Bitcoins is mathematically verifiable by the recorded history in the distributed ledger of the Bitcoin network. Party Identity Abstraction Security by obscurity is built in to the plat, meaning individual parties are never identified. Instead, security keys public and private key pairs are required to gain access to transaction output. Only the holder of the private key can send Bitcoins or get access to received Bitcoins. Only the private key owners know their total aggregated amount of Bitcoins. Transaction Linkage Every transaction record ledger entry is linked to previous transactions and is standardized for every participating node. Every ledger entry is retraceable across its full history and can be reconstructed. Transaction Scripts These are the standardized rules and conditions applied to a transaction. Every node applies the same rules. In the simple Bitcoin model, a Bitcoin is moved from one party to another according to rules. Newer versions of the blockchain have expanded the scope and capabilities of those rules, which the basis of what is called “smart contracts.” Transaction Distribution There is a standard network protocol that allows every participating node to receive every transaction and apply the same validation rules. Blockchain This is the single standard for how every node stores the transaction data ledger data. Every node adheres to that standard and can have a full copy of the data. This is sometimes called the “distributed ledger.” Records, or blocks of transactions, are added to the blockchain and include a link to the previously added block. This is the official point of immutable recording of a transaction. Decentralized Consensus This consists of the standards and rules for how every node exchanges the block- chain ination, the mathematical rules for all nodes to agree on the integrity of that data sometimes called “proof of work” and the payment incentive to support the consensus model. A key point of the model and this entire plat is a to ensure all transactions are validated and all valid transactions are added once and only once. No valid transactions can be omitted sometimes referred to as censorship and, in the case of the Bitcoin network, a Bitco