Private equity record keeping has entered the realm of blockchain, or distributed ledger technology, with Northern Trust leading the way. And as Northern Trust’s Justin Chapman (pictured), suggests, as the technology matures, the ability to digitise the operations of larger traditional asset classes is a case of ‘when’ not ‘if’.
As announced earlier this year, the administration group has partnered with IBM Corporation to build a private blockchain ecosystem exclusively for its private equity business, bringing what has traditionally been a manually intensive exercise firmly into the digital realm. “As an organisation, we are looking to explore all innovative technologies and how to deploy them,” says Justin Chapman, Global Head of Market Advocacy Innovation and Research at Northern Trust. “We’ve been looking at blockchain for the last five years to change business models and drive efficiencies. We made a decision last year to move away from proof of concept and deliver a product. We considered which business area was ripe for innovation and decided upon private equity.”
“There are a couple of key areas where blockchain can add value; firstly in creating a single view and an immutable record and secondly in creating a trusted environment in which participants can collaborate with each other. If one looks at the current private equity environment and how it works between all the different participants, it is still very opaque. There are lots of legal agreements and precious little transparency on transactions.” As such, says Chapman, it was an ideal opportunity “to see if we could work with a number of partners – issuers, GP, LPs, regulators – to reinvent the model using blockchain”.
To construct the blockchain record keeping solution, Northern Trust selected IBM to provide the cloud infrastructure. Blockchain can run on either the public or private cloud but as Chapman confirms, because of the security required around this asset class, “We decided to go with a private blockchain solution. We also worked with Hyperledger, whose blockchain code is now open source. We developed the code internally and we own it. But what we needed was to have the most secure private cloud infrastructure on which to build it.”
Northern Trust ultimately became the first client with whom IBM launched the High Security Business Network, which is hardware encrypted as well as software encrypted. “It was this combination of using HSBN with our blockchain code that helped us to create a secure environment within which to issue a live fund,” adds Chapman.
Included within the blockchain ecosystem are investment managers, limited partners, fund administrators, regulators and auditors. Each has a node, and a capability, within the blockchain environment. It has been specifically designed so that everybody is sharing the same unique, immutable record. “It’s important to build the solution with everyone in mind, not just the ones we work with on a day-to-day basis,” says Chapman, adding that the aim was to develop the most secure blockchain environment possible, with existing technology.
The logic is that by using a private ecosystem, security and data consistency can be optimised as any information recorded on the ledger is shared with all participants. If one wanted to change data on an LP versus a GP, that couldn’t happen because everything on the ledger has to be in lockstep with the contractual arrangement; data cannot be altered or compromised using blockchain technology. This immutability is part of its appeal to the marketplace.
Having that hardware and software encryption should add another layer of defence because we will be encrypting data at the data level not just erecting a wall around the data, which is standard practice,” explains Chapman. He says that private equity was the ideal business to push this innovation with, given that it is, by nature, more of a closed network of participants.
“When you start looking at large group innovation, such as equity and fixed income markets, blockchain technology could do with being more robust, in terms of its volume processing. The number of counterparties is substantial and they would all need to be established nodes within the ecosystem, in order for the blockchain to work properly and add value. The larger the asset class, the larger the ecosystem and the more difficult it is to migrate people.”
In Chapman’s view, there will be additional markets and additional functionality for blockchain over the next three to five years. Significant markets, such as Australia’s cash equity market, are planning to make a decision in November to move their equities business onto blockchain. Other catalysts will undoubtedly help to drive the adoption forward.“We are very positive on the technology itself,” asserts Chapman. “The challenge, for the industry, is bringing people to the technology to understand the potential value proposition of such an ecosystem.”
Primarily, what Northern Trust is attempting with this first iteration of its blockchain solution is to automate the administrative and legal processes that support private equity.“We will look to automate the full end-to-end lifecycle once a fund is issued and up and running. The ecosystem will use digitised private equity agreements so that there’s one version of the truth that is negotiated with all the lawyers. Once these are signed, downstream processes can execute from those smart contracts. The capital call process, the distribution waterfall process, is very much linked to the terms contained within those contracts.”
“Once the fund is issued into that digital environment there will be a full register, full transparency, and the ability to negotiate all legal terms and contracts in one place, between lawyers, GPs and LPs, as well as the ability to capture GP board meetings and governance requirements in real time,” explains Chapman. This would allow an auditor to have real-time audit information on private equity funds, which is pretty unique. Moreover, by using a network of computers, each of which holds a copy of the ledger, rather than a centralised authority, it could empower regulators to monitor funds – private equity or otherwise – rather than require them to file regulatory reports.
“We have worked directly with the Guernsey regulator to make sure that the data points in the product satisfy the requirements they are going to need for reporting. They have an access point and a node but if they needed to get into the node there is still a legal process they have to follow; that is, they would have to confirm that they wish to access information. I don’t, however, think that regulators are yet in a position where they want to be doing real time surveillance. But it does allow them to access true, immutable information very quickly, after acquiring legal approval to access it. I think this will mature with regulators as they start to get more comfortable with blockchain,” explains Chapman.
Unigestion were the first client selected to trial Northern Trust’s blockchain solution. One of the key criteria, says Chapman, was that they were willing to bring one of their funds live into the product, “to demonstrate our blockchain capability from start to finish. With any new technology, we wanted to ensure we could protect our client’s assets. We built a live production environment, we went through a capital call process for the fund. Now, we will look for opportunities to move the solution forward and work to bring more funds onto the platform,” he says.
Aside from volume processing capabilities, which still need to improve to make blockchain truly scalable across the funds industry, one of the biggest risks, or challenges, to building such a solution is the sheer legal and regulatory complexity. Chapman confirms that the legal budget was nearly three times the cost of the technology implementation. “We had to get 48 different legal opinions from different jurisdictions because you’re dealing with different data protection laws. You have to make sure you’re not breaching the tax laws of jurisdictions. Deploying this technology in the lab, versus deploying it in the field, is completely different.”
“You’ve got to consider the bigger picture. That helped with our design principals, to ensure the solution could work in a live environment, taking cross-border legal and regulatory issues into consideration,” says Chapman.
