Northern Trust is Going Beyond Efficiency

As featured in Capital Pioneer, a new Rhotic media title. Read article here.

 

A changing man

Unpicking centuries of work and repositioning almost everything you’ve built takes time, effort and resources. The first step is finding – and proving – the reason to do it, writes Elizabeth Pfeuti.

Justin Chapman, Group Head of Strategic Partnerships, Digital Assets and Financial Markets at Northern Trust, first presented to the US bank’s board on “Bitcoin versus Blockchain” in 2015. In the intervening decade, a lot has changed says Chapman, but, interestingly, some things haven’t.

As one of the world’s largest custody and asset servicing banks – which also operates a significant asset management arm – Bitcoin, as a concept, was a bit “out there”, he says.

“Given the regulatory environment and the challenges associated with the ecosystem, we looked at the hypotheses around blockchain. Was there a real use case to operate within it?”

The industry instantly claimed “efficiency”, says Chapman. For a sector so focused on shortening settlement times, reducing failed trades and improving access to accurate client data, the idea of a technology promising to all this and more sounded revolutionary – but there was one issue.

“We started to see, particularly in the mid-20-teens, a lot of projects trying to prove the value hypothesis from an operating efficiency standpoint,” says Chapman. “The answers to most of our questions were yes, but only if everybody deployed the same thing.”

With a large part of his career spent in change management, the re-engineering and creation of new products and a focus on standards since the 90s, Chapman understood the alchemy of a “whoosh moment”, and it didn’t seem to be there – yet.

“You need a lot of things to come together across multiple organisations and jurisdictions to get efficiencies,” he says. “It feels to me that the efficiency play was probably difficult to prove given you need a whole industry to move together to get it.”

As the initial excitement died down, companies asked dedicated teams to start to develop the tech, trying to understand it and how it could be deployed to create efficiency.

Soon enough, the crypto market kicked back in, taking centre stage by producing outsized investment returns and building momentum for the whole digitalisation movement as a whole.

The impact of FTX

But, almost as soon as the buzz took hold, the party was cancelled – or at least the lights came on for a moment. The collapse of trading platform FTX, along with the murkiness of the fall out, gave pause for an industry that prided itself on security of assets and client confidence.

“The FTX scandal created a significant regulatory focus – and it certainly focused the industry’s mind,” says Chapman.

“Pressure came back on blockchain and crypto, asking that if it was unregulated and difficult, and if the use cases weren’t there for efficiency, what were we doing?”

If FTX had shown the world how not to operate in the digital assets space, it did offer an opportunity for the traditional banks and other institutions to both grapple with how to do it themselves – and to prove it could be done safely and with the end client in mind.

“We tried to bring the cryptography, technology and blockchain into more of a traditional structure, which allowed other organisations to coalesce around it,” says Chapman. “Off the back of the FTX crisis, we looked at the regulation and where regulated entities could operate in the crypto and public chain environment.”

Having run projects and uses since 2017, Northern Trust believed in the underlying technology, which enabled the bank to see past the industry’s initial thoughts on efficiency being the only and ultimate goal.

“Stopping reconciliation issues or improving a process is great, but margins aren’t going to move on that alone,” he says. “The technology has to offer more. We believe you get true value when you have natively digital issued activity.”

Not just efficiency

If the promise of efficiency was the amuse bouche, what digital transformation offered the industry on the rest of the menu looked even more appetising.

“It’s not just about efficiency – it’s the value it adds around data and information. Being able to trust and capture data at source and make it available across multiple participants – from the end investor to regulators – to create one source of truth is really powerful.”

Data is key in most industries, but particularly investment management. All along the chain — investors, servicers or traders – data is imperative. The key is to receive data from the source without any friction and trust it, according to Chapman.

“The industry coined the phrase tokenisation and began to rally around it, which was quite useful because, tokenisation is the first stage of a DLT transaction – the first stage of an issuance,” says Chapman.

In taking this step, it allowed the industry to understand a bit more about natively issued assets.

“That helped us think about what we can capture at source and what benefit downstream it could deliver,” he says. “It was about changing the mindset about what was possible, which enabled a change of focus. The automation element may be a consequence of getting digital issuance correct in the first place. It’s a supplementary benefit.”

Latest developments

For Northern Trust, with a large number of institutional investor clients who are mandated with various sustainability reporting requirements, this area of development seemed a natural choice.

Its latest delivery, the Northern Trust Carbon Ecosystem powered by its digital assets platform, Northern Trust Matrix Zenith, shows the importance of digital issuance capability to meet the needs of its clients with remarkable efficiency.

“If an asset manager or corporation wants to offset its carbon, they need to be confident they are getting a carbon credit that shows they have actually reduced the carbon dioxide going into the atmosphere,” says Chapman.

The best way to get confidence is to trust how that particular asset is issued.

“Imagine an IoT device is linked to North Sea oil well where captured carbon dioxide from a scientifically measured carbon reduction project can record and trigger the creation of a carbon reduction credit as the CO2 is actually stored and removed from the environment in real time,” he explains.

“I have no issue then taking that credit the moment the CO2 is removed and using it to offset my emissions because, at issuance, it has all of the attributes and behaviours it needs for me to trust what I have purchased, and report what has happened.”

Greater visibility

For an institution raising debt or equity, or creating a structured investment, if all the fundamentals of the company are baked into that potential issuance and it can be evidenced, it’s very attractive to an investor wanting clarity from the outset.

“You can offer visibility into the dynamics of the company, even dynamics of its performance, so you start to have a greater ability to understand the fundamentals of the company you’re investing into or the product you’re buying, or the carbon credit,” says Chapman.

This understanding and creating use cases to demonstrate the potential offered by DLT has moved the discussion on from an efficiency play to realising true value. From the outset, an issuer that that wants to raise capital can evidence credentials and demonstrate the value of its company.

Rather than just improving efficiency, developing this area could really change the game in capital markets.

“Linking everything to the actual asset can demonstrate to the investor what it is, how it performs, its ethics, its outcomes – and it actually makes it more investable,” says Chapman.

“That’s a bigger deal than efficiency. This is the real exciting bit for us and we’re starting to see a lot of interest in how we can introduce this added value across different asset classes.”

Northern Trust is working with National University of Singapore, which is rebuilding its campus.

The bank has developed the technology to take readings off its new buildings and compare them to the old ones, enabling the university to demonstrate outcomes to the investors in the green bond that are aligned to both the issuance and investor objectives.

The project was announced in January and will run for 36 months.

Since 2020, Northern Trust has also provided digital bond custodian services to Singapore-based Bond eValue, a company that fractionalises investments to enable a broader cohort of investors to access securities that had been unavailable to them due to high minimum investment hurdles.

Step two…

Elsewhere in Asia, the Hong Kong Monetary Authority issued a green bond in traditional and digital formats. In Europe, projects with the regional central bank have proved the concept works, but the market remains fragmented – which is the next issue to tackle.

“The digital market is not fully connected to the traditional market so we’re not seeing flows in the same way,” says Chapman.

“For the moment, institutions have issued large, short-term debt, with large buyers tending to take the issuances for the duration. We need to see secondary market capabilities emerging for any digital asset to properly take off.”

This is where one of the biggest obstacles for further adoption lies, and it has become the biggest focus area for the industry.

“Technically the solution is not difficult,” says Chapman. “We can have interoperability. Our platform Matrix Zenith allows connection from one digital realm to another, or digital to traditional. Potentially you can come in and out of any of those ecosystems and record tokens on, off, or in escrow, and that can work across multiple platforms.”

Northern Trust has backed up its real-world test drives with an academic study focusing on bridging across public chains too.

“We think the technology is there,” says Chapman, “but it will require a big lift to connect digital to traditional ecosystems, so the market has access to liquidity no matter how an asset is issued.”

For the moment, this leads to the absence of a rather large piece of the puzzle, and it needs finding before any widespread adoption will take hold and push towards the digital transformation of capital markets.

In the vast majority of cases, investors buying an asset want to know they can sell it too. Today, while technically possible through an OTC transaction if the asset is native digital, the prospect is likely to offset much of the initial efficiency benefits at least, while adding new investor headaches along the way.

For Chapman, who has worked with and brought about institutional change for much of his career, there is no sense in rushing to solve this issue.

Build the network

“At the moment, it’s about bringing fragmented liquidity pools together rather than coming up with a final answer,” he says.

“There’s a lack of the core layer one network. Some governments are working on layer ones, cross regulatory, but I am not expecting we’ll end up with a design where there is one layer, one distributed network where everybody can play. Instead, I think we will settle on the architecture of a distributed networks that link together.”

Chapman believes existing players that already provide core system infrastructures will begin to allow bridging capabilities between them.

“We already had bridges between a number of the banks where a client can custody a record on somebody else’s tech platform,” he says. “A lot of this is about how you show and demonstrate control; how you manage risk; how you manage liability.”

These are – and remain, even in a digital environment – the basic elements of custody and asset servicing.

“You don’t need one network for everybody. You need to be able to join things together and work in a framework that identifies where accountability is and who is responsible,” he says. “It’s actually more of a legal fiduciary construct than a technical solution.”

Fungibility is also key.

“There will be several regulatory layers that sit over the top and there will be several infrastructures,” says Chapman, noting that many of them will be the traditional infrastructures that will create environments within which anyone can all operate rather than talking to a crypto native on the other side.

“This is what we do at the moment and it’s not optimal,” he says. “I want to be able to get data from issuance to an investor in a real-time and trusted way. I don’t care so much about what the platform is, what the infrastructure is, or what the subscription is.”

Chapman points to the current push to explore that cross-organisation type of infrastructure, with products already emerging around risk and liquidity management, and innovation coming in money market funds too.

“The question we are all looking at is whether they will be private permission, public permission or public networks,” he says, noting how regulation will be key to the answer.

“Private permission networks are very easy because they’re basically just operating like we do now but with better tech,” he says.

“Public permissioned offer both benefits and challenges too. It’s very difficult to be in a public, non-permission network and meet all regulatory requirements. Specific assets, yes, but not across the full trading and fund activities. The broad regulatory environment hasn’t crystallised yet.”

Watching, waiting, working

But a lack of regulatory visibility is no reason to hold off on developing either the technology that is going to be required or the links needed to deploy them, and, for the banks operating in the custody and asset servicing world, collaboration is business as usual.

“The largest custodians already work together because that’s how our markets operate,” says Chapman, who is responsible for strategic engagement on the market side at Northern Trust and oversees its strategic financial and vendor relationships across its network. He has access to all the banks it works with, along with all the infrastructure and depositories that it accesses across 100 markets.

But stepping into digital transformation requires more than the current day-to-day working relationships.

“We are collaborating because we can’t afford to not be ready when this landscape begins to move,” says Chapman. “We also can’t afford to be investing fully on our own and taking the wrong option.

“To bring something of value to our clients, we need to be able to work in the real world, so chances are I’m going to be on somebody else’s network, or they’re going to be on mine – at some point we’ll start to rationalise the networks, but we’re still looking at user standards,” he says.

Expect announcements

While these conversations are not obvious in the market, Chapman believes announcements where three or four organisations have all worked together on the issuance and custody will soon start to trickle through.

Software entities will also be working within a large banking infrastructure, according to Chapman, but he believes it is unlikely they will be an operator in this space due to capital requirements, regulatory risk and fiducial responsibilities.

“Before FTX, there were lots of non-financial-based companies within those particular spaces, but today most of the companies I work with are regulated financial institutions,” he says. “We might be working with a provider, but the license or the function is still with the bank.”

After the sugar rush of fintech proliferation of the 2010s, tech development has become more measured, with hybrid models of build, buy, develop illustrating how the sector has matured.

“I don’t think you’re going to see a disruptive fintech startup offering digital custody on a traditional asset any time soon, as you just can’t just uproot and plug into the regime,” he says.

“Yet, I’m not being complacent. I think there’s a huge speed advantage to develop and attack. But we have to build back into the traditional rails and existing ecosystems. It all has to work together.”

Northern Trust has kept close to innovation, working with several emerging companies. Most notably, it invested in Zodia, which was one of the first approved crypto custodians, in 2020, alongside Standard Chartered.

Northern Trust has also worked in partnership with its investment, offering fund accountancy services on a Bitcoin ETP, launched in Europe by Invesco, with the custody supported by Zodia.

Getting there

And it’s these types of forays that enable progress by allowing the client and the regulator to feel comfortable. In the US, the largest asset managers have launched these products, which have instantly got scale. Thanks to offering the same information in the same documentation, investors understand what they are getting into and sign up.

“If you look at the fund structure success, whether crypto or liquidity assets, the regulator has been involved every step of the way,” says Chapman.

“From a client’s perspective, it gives them a safer environment to invest into some of these asset classes, particularly if they’re buying into an ETF or something similar. They’re now facing off against a large ETF manager rather than a bilateral transaction on an exchange or network.”

Being able to sell products by presenting them digitally to the consumer means retail will move a lot quicker than institutional, according to Chapman. Large pension funds or other major entities just don’t access products in the same way. But that doesn’t mean the market serving these gargantuan capital allocators won’t move, it’ll just be driven by different factors.

“They will want fundamentals,” says Chapman. “They will want things like investment information, to know how companies are performing from a governance perspective. The behaviours will start to differentiate issuers by the ability to make their information available and consumable through digital channels.”

The underlying operations will all need to work together too.

“The retail products also need to be serviced. You can’t have a real time investment on the retail side with a T+2 settlement,” he says. “Eventually the institutional flows that support those retail flows will come and will have operate within the same digital environment.”

The next challenge is to make sure that they have enough platforms to demonstrate that value on.

The whoosh moment

In 2020, Chapman anticipated take-up to be between 5-10% by 2030. For a variety of reasons, he feels it is likely to be closer to 5% than the 10%, although new types of assets may provide a boost.

“I still believe it’s not going to be wholesale, across all the markets, rather it will be around the ability to democratise certain classes, add value with data or bring them into play to manage risk and liquidity,” he says. “The focus will be on alternatives, money market funds, tokenisation of commodities, RWA and liquidity funds. These all show potential to offer a lot of value.”

These options would give investors safe ways of accruing value outside equities or fixed income, offering diversification that can also offset risk.

“They’re like cash funds, so they become a lot more fungible and that will enable a lot more activity,” he says. “I’m still positive that we’re going to get a build up over the next five years and we will definitely see cross-market capability.”

By this time, the market will have found the missing piece to solve the secondary markets puzzle too, according to Chapman – but it’ll be evolution, rather than revolution.

“It’s going to be traditional exchange players offering venues where assets can be aggregated and marketed,” he says. “This is just integrating technology and bringing data, which we’re already getting better at. It shouldn’t matter where a data/liquidity pool is, I should be able to transfer an asset, its record and its provenance over to where it is needed.”

The changes, while transformational are also likely to remain rooted in traditional asset theories, too.

“Our current policy is to work on private networks – it’s no different from the traditional system,” he says.

“You have a network with capabilities that look public, but they’re actually within a set of rules and boundaries and are only operated on or within by firms that have the appropriate rights to do so. You can do that also in public networks, with permissions.”

There are similar challenges with data access, privacy and usage, but that, according to Chapman, is an issue that extends way beyond digital assets and banking, so the industry just needs to solve what it can.

“The logic is that if you know where the data is, you can trace it and it’s immutable, in theory it should be easier to control. Systemically you can create the appropriate gates which is the logic around digital permission to the network, but this just has to be at a lower, more granular level than it is currently.”

So, while plenty has changed since 2015, and challenges lie ahead, enough players see the potential to push for transformation.

“You still hear the narrative around efficiency but there are a significant number of firms that have started to realise it’s about more than that,” says Chapman, “and once they start to demonstrate the true value, we’ll see real industry movement.”