An Overdue Revolution: Blockchain and Syndicated Loans

Banks and technology firms working with blockchain consortium R3 seem to be taking a leaf out of the Steve Jobs playbook for their latest product rollout, shrouding the research project in secrecy so they can unveil the finished article in a theatrical stage show.

“We are expecting to showcase in mid-March,” says Emmanuel Aidoo, head of blockchain technology at Credit Suisse in New York, which is working closely with R3 on the project. “We will show the market everything we’ve built.”

What R3 and some of its members are working on—utilizing technology from vendor Synaps—is a distributed ledger for syndicated loans, a $4.5 trillion industry, but one where transactions are still conducted via fax, and where the majority of trades take longer than a week to settle (see box: Faxes and Fedwires). The project could help transform the market, participants hope, dramatically speeding up settlement times and bringing in new players and fresh investment capital.

 “There were roughly 25 million faxes floating around Wall Street at quarter end,” says Bob Berk, COO for capital markets at US Bank in Minneapolis. “With blockchain, investors would have direct access to systems of record for syndicated loan data. This would yield immediate savings by reducing the manual reviews, data re-entry, faxes and reconciliations that occur during the course of a loan’s lifecycle, and which ties up a lot of capital banks need to hold against unsettled positions.”

Syndicated lending allows banks to share the credit risk of financing large clients, such as multinational corporations and private equity sponsors. These loans offer floating rates, as well as the ability to prepay without incurring penalties, making them popular with borrowers. 

“In 2018, we are confident blockchain can take over for a small subset of loans. The existing systems will still be considered primary, but in parallel we will have blockchain.” Emmanuel Aidoo, Credit Suisse

The floating rates are also appealing to investors—especially during central bank tightening cycles. According to the Loan Syndications and Trading Association (LSTA), around $650 billion of syndicated loans—consisting almost entirely of non-investment grade debt—are traded annually on the secondary market.

Attractive Features

Many of the features that make syndicated loans attractive to borrowers also make it difficult to settle transactions expeditiously, however. For instance, most loan agreements give the borrower the right to block a sale of the debt, even in the secondary market. The variable rates and prepayment options also mean loans must be continuously repriced as interest rates change and principal is paid down. 

As a result, the market is plagued by outmoded technology and workflows, with trade settlement times of as long as 30 days, a perpetual bugbear for fund managers drawn to the asset class, such as ’40 Act funds, which raise money from retail investors.

“If you’re a ’40 Act fund, and the end-investor wants to transfer from one fund to another, by law, that ’40 Act fund has two days to complete that transfer,” says Aidoo. “Since loans have long settlement times, that can be unattractive to fund managers, because they need to hold extra capital on their balance sheet to guard against redemptions.”

Despite efforts to improve settlement times, as of 2015, only 20 percent of par trades were settling within seven days, according to the LSTA, while 45 percent took from eight to 20 days, 16 percent took from 21 to 30 days and 19 percent took more than 30 days. “Loans are unique in that they settle over-the-counter, from desk-to-desk,” says Bram Smith, executive director at the LSTA in New York. “That doesn’t lend itself easily to technological solutions.”

The variable rates on offer also create an incentive for some buyers and sellers to deliberately delay settlement when interest rate changes are imminent. “Because of their variable rate nature, many shops freeze settlement for a day or two, any time there’s an interest rate roll,” says an industry source. “That could be as often as once a month.”

The industry has tried various approaches to curb these practices—including so-called “delayed compensation” provisions in loan contracts, which indemnify buyers against settlement delays longer than seven days—but to no avail. “This is an extremely complex problem, involving elements of legal, operations, behavior and technology,” says Smith at the LSTA.

The headaches are magnified by a lack of central utilities such as a clearinghouse to process transactions. Lenders, borrowers and secondary market participants rely on a network of agent banks to collect and process interest and principal payments—often using faxes and Fedwire, the Federal Reserve banks’ real-time gross settlement funds transfer system—and handle the ongoing record-keeping and administration associated with syndicated loans.

This is where distributed-ledger solutions come in. On paper, the applicability of the technology to the market’s inefficiencies is obvious and the potential benefits enormous. Converting the terms in a standardized loan document—the details of buyers, sellers and critical payments dates, for instance—into code would allow them to be turned into so-called smart contracts, which are tradable on a distributed ledger, where payments are processed in real-time and transactions records are instantly available to all users on the network. “When I first read about blockchain, I thought, ‘this would be great for loans,’” says Aidoo at Credit Suisse.

Cutting Delays 

Blockchain technology has already inspired a number of projects aimed at cutting settlement delays in the secondary market for syndicated loans. The R3 project is being led by Credit Suisse and US Bank. Other members of the R3 consortium—BBVA, Danske Bank, Royal Bank of Scotland, Scotiabank, Societe Generale, State Street and Wells Fargo—are also involved, along with several major fund managers, including Eaton Vance Management, KKR and Oak Hill Advisers. “Distributed ledgers could cut down on the settlement delays and document processing that goes into loan processing,” says Michael Herskovitz, senior vice-president of fixed-income risk operations and technology at Alliance Bernstein in New York, which is among the firms involved in the R3 effort.

Credit Suisse says it developed a proof-of-concept for the technology’s potential application to the market, in conjunction with vendors Ipreo—which itself launched a system designed to reduce loan settlement times in September 2015—and Symbiont in the spring of 2016, and began pushing it to other members of the R3 consortium.

At around the same time, US Bank was exploring potential use-cases for distributed-ledger technology in the lifecycle of a syndicated loan transaction—from origination to administration and custodial arrangements for secondary market participants. After sharing its research with other R3 members, US Bank decided to join forces with Credit Suisse on the project.

Few doubt the immense potential for blockchain to bring greater efficiencies to markets with lengthy settlement cycles and other cumbersome post-trade processes. But after years of hype, few projects in flight at either of R3 or Digital Asset Holdings—the other large industry consortium—are close to fruition, and cracks are starting to emerge over which use-cases to prioritize.

Credit Suisse and US Bank, however, insist the R3 effort is producing tangible results. “We’re at a point where we think we have demonstrated it can do what it says it can do,” says Chris Swanson, vice-president of innovation research and development US Bank. “The protocols work. The code as written performs as we expected it to. The next steps will be continuing to build the technology out.”

Credit Suisse’s Aidoo says the plan is to unveil the technology this month, and have it implemented by year-end. “In 2018, we are confident blockchain can take over for a small subset of loans. The existing systems will still be considered primary, but in parallel we will have blockchain,” he says.

Other Players

R3’s effort is not the only one aimed at applying blockchain technology to syndicated loans. Digital Asset Holdings (DAH) and JPMorgan began testing the use of a private distributed ledger to settle bank loans at the end of 2015. It is unclear whether those tests—first reported by the Financial Times—have yielded any positive results. Three separate sources tell Waters’ sibling Risk.net that they believe the project has stalled or has been discontinued. “My understanding is that JPMorgan had other things it wanted to focus on,” says a source familiar with the matter. A spokesperson for JPMorgan denied that was the case, but declined to provide a delivery timeframe for the project, while DAH declined to comment. 

In the absence of any updates from DAH and JPMorgan, the industry is anticipating the mid-March announcement from R3, although some warn against expecting too much. “Blockchain isn’t this magical thing,” says Hu Liang, head of the emerging technology center at State Street in San Francisco. “In the short term, we are still going to have an operator and participant model. The real value proposition is that you can use a whole new technology that’s somewhat future-proof, rather than 30-year-old technologies, and you have all these components—such as native security, message delivery and distributed-business logic—in blockchain. But you still need to have trust.”

State Street is one of several agent banks that facilitate interest and principal repayments for syndicated loans, and provides ongoing record-keeping and administration services for the industry. It has already deployed blockchain technology internally to handle the reconciliation of data between it and its clients, but Liang says this technology might take some time before it is ready for widespread adoption. “I don’t think anyone would want to put a mission-critical application on it yet without technologists understanding what the cost is to actually run blockchain in a production environment,” he says. “What will happen, which is what we’re doing, is building blockchain into some of our internal architecture, that doesn’t need to involve the market yet. We’re aiming to have that implemented in 2017. But for the industry, it will be a year or two before things start taking shape externally.”

Hub and Spoke  

Market participants also stress that distributed ledgers will not do away with the need for traditional intermediaries in the syndicated loan markets, such as agent banks. Lee Braine, a member of Barclays’ chief technology office, who works on the bank’s smart contract effort, says unlike the true peer-to-peer networks that characterize bitcoin, a distributed-ledger system for syndicated loans will look more like a hub-and-spoke model, with an agent bank or a financial market intermediary (FMI) sitting in the middle.

“The idea is that banks’ distributed-ledger nodes could start by being hosted centrally by FMIs, but at some later point those nodes could potentially be re-deployed to individual banks to host themselves,” he says. “For syndicated loans, the topologies are typically not as centralized.”

Although Barclays is not participating in the R3 project, it sees syndicated loans as one of its top 10 use-cases for distributed ledgers, Braine adds.

Whatever form distributed-ledger systems for the syndicated loan market ultimately take, market participants say the technology could help eliminate bottlenecks in the market and spur more investor interest in the asset class. “If the technology is able to make it easier to invest in the asset class, it would be easier for issuers to borrow and for investors to invest,” says Herskovitz at Alliance Bernstein. “It could be a means to grow the actual market for syndicated loans.” 

This feature first appeared on Risk.net, Risk magazine’s website.