A Future Leaders Programme Project
Over the past several years, the business world has seen the assumptions around blockchain technology shift from being a platform solely for Bitcoin and Crypto-assets, to its functionality as a scalable and highly secure database solution with a large amount of use cases across industries. At this time, no industry has invested more heavily in blockchain technology than Financial Services. While projects for facilitating financial transactions on a blockchain are moving from the Proof of Concept stage and into production, more and more use cases continue to be identified. One such use case is within the Syndicated Lending market.
This paper explores the feasibility, opportunities, and potential roadblocks of deploying a blockchain solution to make Syndicated Lending processes more secure and efficient for Financial Service providers.
Authored by our Future Leaders Eric Bergersen & Anna Dumrauf; led by Nick Siconolfi, Prospect 33 Head of FinTech Change; with contributions from Subject Matter Experts: Ben Green, Program Manager CRO Change, Credit Suisse & Tom Spouse, CEO, Prospect 33
Background: Distributed Ledger Technology
To understand how blockchain applies to Syndicated Lending, we must first lay a base understanding of blockchain technology and its capabilities and limitations. There are four primary benefits of implementing a blockchain solution that are critical to understanding any blockchain use case: Security, Immutability, Decentralization, and Automation.
Fundamentally, a blockchain is a single ledger where transactions (‘blocks’) are verified across multiple computers (‘nodes’) using cryptography. Because transactions on a blockchain are stored across multiple nodes, there is greater security against an attack on a single node (i.e. there is no single point of failure). Additionally, once transactions are verified on a blockchain they are immutable, so cannot be altered by any one party. The nature of this distributed ledger is such that it defines a “single source of truth” stored across all nodes in the blockchain. Because of this, no central intermediary is required to verify transactions.
Finally, blockchains allow for the execution of what is known as ‘smart contracts,’ a computer protocol that allows for the automated execution of terms of a contract. For example, if the terms of a loan indicate that a certain amount of interest is due on a given date, a smart contract could automate the payment of that interest and store the resulting transactions on the blockchain.
Background: Syndicated Lending
Syndicated Lending involves a consortium of banks coming together to share the risk in providing high value loans, typically to fund mergers, acquisitions, restructuring, or large capital intensive projects such as construction initiatives. The advantage of a borrower using a syndicate is that they are more likely to gain access to the required capital, while avoiding higher interest rates. The repayments are unique to each loan, and are agreed upon before the loan is disbursed.
In providing a syndicated loan, one bank, known as the arranger or book-runner, will typically act as the central point of contact for servicing the loan throughout its life-cycle. It is responsible for collecting and distributing repayment of principal, interest, and fees among the syndicate, providing underwriting and advisory services, and ensuring quality of reporting across the syndicate and to Regulators, among other commitments. While these responsibilities fall heavily on the book-runner, each party must still maintain their own books and records. Problems can arise while trying to reconcile payments between members of the syndicate. A small error in principal, interest rate, or dates can cause a break in which each party must research and reconcile.
This manual process which relies heavily on investigation by and communication between multiple parties can lead to inefficiencies and delayed payments. The resulting manual processes for servicing a syndicated loan over its life-cycle are costly to maintain, and therefore in need of more automated solutions.
Evaluating a Blockchain Solution to Syndicated Lending Processes
Prospect 33, in collaboration with several of our Tier 1 banking clients, have proposed that a blockchain-based solution is ideal for the Syndicated Lending marketplace. The benefits of a blockchain for the syndicated loan market are evident in the nature of the business. In any instance where highly manual processes are required, there is an opportunity for smart contracts to facilitate automation.
In this case, repayment of principal, interest and fees between the borrower and book-runner, and distribution of funds across the syndicate can be fully self-executing without the need for manual processing. This simplifies the role of the book-runner, reducing costs and improving speed and efficiency. Effectively, the book-runner’s role is primarily taken over by the blockchain itself.
Since all parties in the syndicate would have access to the same single source of truth (agreed via consensus prior to being stored on the ledger), there would be less need for manual interaction among members of the syndicate to verify details or chase payments. Rather than each member of the syndicate maintaining their books and records separately, there would be a single blockchain database, alleviating the need for each member to utilize their own platform, which could potentially store inconsistent information or provide varied functionality across the different members.
Not only would a Distributed Ledger Solution benefit the loan issuers, but the borrowers would also reap the benefits from reduced transaction costs which may drive down interest rates and improve the security of their data. A single blockchain platform, utilized by all members, including the borrower, would ensure complete security and transparency.
While the opportunities for utilizing a distributed ledger in Syndicated Lending are clear, there are also barriers to implementing any solution at scale, and questions still remain about the true benefits of a blockchain. While smart contracts can definitely help to automate more manual processes involved in providing a syndicated loan, it is important to note that in order to do so, the input data going into the blockchain must itself be clean and accurate first. A distributed ledger can only act on the data and protocols it is given. If these are not valid to begin with, then a blockchain has no hope of improving efficiency down the line.
More so, any blockchain solution would require consistency and cooperation among all members of the syndicate to utilize the same solution. If a single member of the syndicate is not a participant on the blockchain then that member would fail to reap any benefits and would require more attention from the book-runner.
A big question for many blockchain service providers will be how they can get multiple parties to agree to abandon their own platforms/software, and adopt a new technology. This is especially true in large financial service institutions that have been historically resistant to change.
Another hurdle is managing the regulatory environment, which is still not yet clearly defined for distributed ledger technology. While regulation does not appear to be stifling innovation (yet), it may be forcing organizations – particularly the highly regulated Financial Service providers – to be cautious in moving into production with this new technology. Making sure the solution abides by all regulation is key to success, as reporting and transparency will be needed to the regulating bodies. Additionally, a distributed ledger is inherently difficult to regulate, in the sense that data can exist in multiple jurisdictions.
A final challenge worth noting is a single distributed ledger application for syndicated lending will not necessarily improve any of the supporting processes, such as know-your-customer checks which need to be performed prior to issuing a loan. While these may also be improved via another blockchain solution, it is likely that this will not be done at the same time or utilize the same application. Therefore, an organization's IT strategy must be aligned across departments in order to fully realize the benefits of a distributed ledger.
As use cases for Distributed Ledger Technology continue to expand, Syndicated Lending will surely be one area where a solution will be further explored. Already, a group of seven global banks, including BNP Paribas, BNY Mellon, HSBC, ING, and State Street, have piloted Fusion LenderComm, a blockchain-based syndicated lending platform developed by Finastra and R3 (Corda). As further pilots are validated and benefits are realized, more and more use cases will continue to emerge.
However, Financial Institutions must also be careful in how they validate and build upon those benefits. While distributed ledger technology has many advantages, it is not a silver bullet that can solve every issue. Any blockchain solution to a single process must be viewed in tandem with an organization’s overall IT strategy in order to align the technology with its business needs.