Innovation in asset management

Originally published in the issue

Blockchain, the underlying technology of bitcoin, is now drawing significant focus as well as investments from many financial institutions, including asset managers. Given the technology’s potential to both disrupt and enhance processes and systems, many firms are dedicating the resources necessary for understanding blockchain and integrating it into their business.

This article will explore why asset management firms are seeking out opportunities to harness the benefits of blockchain and the key challenges for adopting this technology. Furthermore, it will highlight near-term practical applications of and approaches to blockchain innovation.

Benefits of blockchain
Blockchain technology, which functions as a shared record or distributed ledger, is highly flexible and has a number of potential use cases within the asset management lifecycle (see Fig.1). Once implemented, it can be used to streamline management of portfolios, speed clearing and settlement of trades, and ease compliance burdens associated with anti-money laundering (AML) and know your customer (KYC). It can eliminate redundant functions, reduce operational expenses and increase opportunities to enhance the client experience. While hedge fund managers may not use blockchain technology to replace current systems, they will find it can be leveraged to reconcile information across existing platforms or enable new infrastructure for new markets and products. (See Fig.1).

Challenges of blockchain
Asset managers are still in the early stages of exploring blockchain and its applications to the business. In fact, many practitioners are not yet familiar with the way blockchain works or how to reap its benefits.

A few key challengesinclude:

  • Many critics claim that blockchain technology is “looking for a business problem to solve.” We agree that business cases should drive technology solutions, not the other way around.
  • Fig.2, based on 2016 EY research, indicates that, for many organizations, scalability is expected to be a hurdle to industry-wide adoption. To date, blockchain has seen limited deployment in situations requiring large volumes of data; the linear nature of technology calls into questions its ability to handle such a volume.
  • Firms face limitations due to their own product complexity. After complex products are rolled out, parameters can be difficult to change later using a distributed ledger.
  • Significant unknowns related to regulatory and legal hurdles exist in asset management. For example, stakeholders have custodial requirements if assets are held on a blockchain network at any point.

Other barriers to widespread adoption include data privacy and the high cost of replacing legal infrastructures.

Potential blockchain applications for hedge funds
Blockchain is no doubt a difficult topic to understand, and determining a good business strategy for its applications is even more challenging. Despite the challenges, EY believes that blockchain technology can be applied to solve business needs for asset management firms’ middle- and back-office internal processes first, and eventually as a widespread client solution.

For hedge funds specifically, blockchain will likely start out as an internal solution to track investors and ownership without relying on a fund administrator. Rather than stacks of paperwork and manual mechanisms for monitoring complex ownership structures and subsequent changes, portfolio managers can use a distributed ledger to manage ownership of complex assets and investment vehicles in real-time. Investors can securely check their holdings and investment allocations whenever they want, and hedge fund managers can drastically reduce the time required to assemble complex statements or performance reports. And as more and more firms originate their assets on distributed ledger technology, the easier and safer it will be to invest in these assets.

LendingRobot is an example of a firm leveraging this technology. It developed what is possibly the first blockchain-based investment vehicle targeting the hedge fund space called the LendingRobot Series – a “robo” fund for alternative lending. The firm offers four distinct “series” comprised of numerous loans from various originators; each one targets a specific risk-return profile and maturity. Because it uses distributed ledger technology, LendingRobot can have each series hold thousands of notes from multiple origination platforms. To ensure the data is tamper-proof, users also include a hash code signature in the blockchain. With this technology, fees are lower than traditional hedge funds and, in most cases, investors can withdraw funds within two weeks of their request.

Steps to implementing blockchain strategy in your organization
While many technologists can grasp blockchain’s concepts and underlying algorithms, many leaders are unsure of how it can benefit their business in a meaningful way or where it can disrupt current models. To accomplish this, EY recommends breaking strategy development (see Fig.3) into three key phases:

Phase 1: Identify the opportunity for technology
The first step in developing a strategy is creating a framework to identify where emerging benefits might exist and which areas of the business are most vulnerable to disruption. As hedge fund managers examine opportunities, it’s important to look internally first because it is much easier to develop and gain adoption within your own firm. When smaller internal solutions begin to gain traction, managers should look to expand the solution internally across functional groups and then across business lines – to demonstrate efficacy and gain support and momentum. Once you obtain internal support, you should examine business cases and development for altering existing revenue-generation business models.

With so many potential blockchain opportunities, establishing an effective framework to identify real business value is critical. Firms should focus on use cases that have the greatest opportunities with minimal risk, and use a framework to allocate time and resources properly. In additional to creating specific use cases, managers can consider blockchain as an enabling technology for general business operations. Hedge funds can expect blockchain disruptors to emerge where operational overhead and data management issues exist or where there are potential revenue-generating opportunities.

An opportunity assessment strategy should contain the following components at a minimum:

  • An establishment of a framework for identifying the areas of opportunity and threats, as well as defining relevant use cases for analysis
  • A team structure that includes stakeholders, along with select subject-matter experts in the areas of concern (e.g. operations, product management, technology, strategy)
  • A communications plan for socializing findings and decision-making
  • A prioritization matrix or framework for identifying key use cases for the execution road map

Phase 2: Focus on developing innovative solutions to capitalize on the opportunities
The next logical step is to focus on developing solutions — first on a small scale internally, but gradually ramping up to larger, more impactful internal and client-facing solutions. Several firms have adopted this approach through an innovation strategy. This is usually defined as the process for: 1) assessing opportunities previously identified in your analysis; 2) determining the impacts to current business models and strategies; and 3) creating solutions to take advantage of those opportunities and impacts.

In several cases, firms have implemented an innovation strategy through an “innovation lab,” where teams can focus on evaluating the opportunities and developing proofs of concept and working prototypes to explore the possibilities of blockchain. While some of these innovation labs start as individual, stand-alone groups, many firms develop them with the idea that they will eventually integrate the output into the organization’s business lines.

Phase 3: Work with your technology partners to implement solutions successfully
Most hedge funds now realize that working in a vacuum can delay implementation or even result in significant rework to integrate new solutions into existing systems and business processes. The most successful firms define the frameworks for innovation up front and work within the prioritization set early on to develop solutions. They also take into consideration that they might not need to develop the technology solution in-house. There are currently dozens of blockchain technology providers, with more launching on a regular basis.

After you detail all the concepts during the innovation phase, it’s important to align the solution to your technology strategy and competencies. Many firms — even some of the largest players in the asset management space — are collaborating to implement blockchain solutions.

With so much confusionregarding FinTech and blockchain, many firms are unsure of where to turn next and how to spend their very limited strategic dollars. Given that the success of a blockchain solution rests in its distributed nature and the willingness of the participants in the chain to work together, many firms are shying away from an initial aggressive approach. To be successful, however, a firm or set of firms must take the lead and begin the innovation process. Ultimately, these are the firms that will stand to benefit the most and reap the rewards of the technology – along with their investors.