Blockchain Technology and Islamic Capital Markets In Iran

Transcription

1. Utilizing Blockchain Technology for Post-Trade Securities Settlement : A Framework for Islamic Capital Markets in Iran LEISAN SAFINA UMAR OSENI
2. Islamic Republic of Iran • The second largest economy in the MENA region • An estimated GDP in 2016 was USD 412.2 bln • The second largest in the world in natural gas reserves • The Fourth in proven crude oil reserves • The oldest Stock Exchange in the Middle East with market capitalization of about USD 104 bln
3. Timeline : • 1936 - the concept of official capital market in Iran was introduced • 1967 - the Tehran Stock Exchange was officially launched • 1979 – the major restructuring of banking system in Iran • 1989 – the first post-war Budget Act; the number of listed companies increased up to 249 • 2005 – the Parliament of Iran ratified New Securities Market Act; establishment of “The Securities and Exchange Organization” • 2009 – the Law for Development of New Financial Institutions was ratified; new entities – advisory companies, investment banks and mutual funds • 2010 – new clearing system – NETClear; a special system for data exchange – CSDIDATA • 2011 – Futures Post-Trade System - FPTS • 2012 – Energy exchange registry system – Regex • 2015 – Test launch of New Post Trade System – IRPT • ???? Structure of Capital Market in Iran
4. Central Securities Depository of Iran ◦ Established due to the segregation of trade activities from post-trade activities at Tehran Stock Exchange in September 2005 ◦ The depository is the sole central custodian, registrar and clearing house for the Iranian financial market including all four exchanges ◦ It adopted the hybrid registry system with a fully dematerialized book entry system. ◦ Settlement Guarantee Fund provides guarantee for investors against counter party risk ◦ Settlement period: participation certificates - T+1, equities - T+3 ◦ The transfer of ownership over securities from the seller’s ownership code to the buyer’s ownership code occurs automatically ◦ The financial and non-financial rights on securities such as dividends, preemption rights arising from the capital increase, stock dividends and voting rights are transferred only after the finalization of transaction ◦ Transfer of funds: until the end of each trading day the Depository calculates the net amount for the settlement day to be paid to or received from each broker’s bank settlement account.
5. General Issues in the securities settlement 1 . The system can’t operate 24 hours per a day, 7 days a week and 365 days per a year 2. Lack of the integration 3. Manual processes 4. The speed of trading outpaces the process of completing such a transaction which increases counterparty risk 5. During the time between trade and settlement, a purchaser has purely contractual rights and only after the full settlement it becomes proprietary 6. The cost of the process is substantial for market end-users (Benos et al., 2017; DTCC, 2016). Industry’s expenditure solely for securities post-trade settlement and related functions ranging from USD12 - 17 bln yearly in the world 7. Large post-trade fees make traders post more aggressive quotations with a small probability of execution 8. Shari’ah issue - the practice of contra trading (Kasri & Lukman, 2017) .
6. Issues in the securities settlement in Iran 1 . The System can’t operate 24 hours per day 7 days per a week. Exchanges are open from Saturday to Wednesday from 9 a.m. to 12.30 p.m. except public holidays 2. Lack of integration: The rights and obligations of the securities buyer and seller and other stakeholders connected with the transaction is established simultaneously with the execution of the deal. But the settlement day for shares – 3 days after the execution of the trade (T+3) and for participation certificates – 1 day (T+1) 3. Manual processes: at the end of each day, the related stock exchange send the electronic message of execution or non-execution of the transactions to the Central Depository company through trading system. The Depository calculates the net amount for the settlement day be paid to or received from each broker’s bank settlement account 4. The speed of trading outpaces the process of completing such a transaction which increases counterparty risk: the central depository established the services of Settlement Guarantee Fund to mitigate this risk 5. During the time between trade and settlement, a purchaser has purely contractual rights and only after the full settlement it becomes proprietary: the financial and non-financial rights on securities such as dividends, preemption rights arising from the capital increase, stock dividends and voting rights belong to the buyer upon finalization of transaction. 6. Shari’ah issue - the practice of contra trading
7. Blockchain Technology Blockchain is a distributed ledger where transactions are grouped in the blocks and the chain of these blocks represents the accepted history of transactions since the initiation of the blockchain . Block 102 Block 103 Block 104 Block Hash: 0000654ehd87 Block Hash: 425262kkoer871 Block Hash: uetbdj08642bj Previous Block Hash: 88762hjsy635nk Previous Block Hash: 0000654ehd87 Previous Block Hash: 425262kkoer871 Transaction Hash: hsgr286nbg5vsf Transaction Hash: 912japl934hdn Transaction Hash: jhdn0927hskk9754
8. Attributes of blockchain : 1. Distributed and sustainable 2. Secure, private and indelible 3. Auditable and transparent 4. Transactional and consensus-based 5. Orchestrated and flexible
9. Basics of Blockchain Public key encryption infrastructure is used to securely communicate in a network . Every participant has the public and private keys pair generated by the blockchain. Public key is published on the system publicly, while the corresponding private key is kept securely by the software. Hash Function - any function that can be used to map data of arbitrary size to data of fixed size (page 4, Peters & Panayi, 2016). Hash function mathematically glues or ‘chain’ a new block of transactions into the existing chain of blocks by using the data from the previous blocks. It creates a one-way function which is almost impossible to be decrypted. Digital time stamp records the temporal existence of a particular blockchain ledger item at a given instant of time. Additionally, a digital time stamp might contain the data related to the hash. This secures the privacy of the data recorded on the blockchain ledger (Peters & Panayi, 2015). Source: Smart Contracts Alliance & Deloitte (2016)
10. Types of blockchain : 1. Permissioned Participation is pre-selected or subject to the fulfillment of certain requirements or by approval of an administrator. The current state of a ledger might be determined by the consensus protocol, an administrator or some group of participants. It might be fully private where permissions are granted only by an organization or it might be a consortium blockchain where preselected nodes control consensus process. Examples, Hyperledger, Ripple, Eris and others. 2. Permissionless Open to public so that anyone can send messages to the network and take part in reaching consensus. Verifiers are crucial to the operation of the network and their participation is encouraged and incentivized by issuing new currencies to be paid for the verification of a new block of transactions. These algorithms provide security of the network but extremely costly. Users are anonymous or pseudonymous. Example, bitcoin. 3. Public - open for everyone to submit and read transactions. 4. Private - restricted to participants within an organization or number of organizations.
11. Smart Contract ◦ Smart contract is computerized transaction protocol that self-executes the stipulations of an agreement when predetermined conditions have been fulfilled (Institute of International Finance, 2016; Korpela, Hallikas, & Dahlberg, 2017) ◦ The concept was described by Nick Szabo in 1996 ◦ The process of uploading a smart contract to the Ethereum blockchain is similar with the Bitcoin transactions. Nodes on the network recognize the smart contract code and create a special address for it. The contract can be later triggered if parties send a transaction request to the address which fulfills predetermined conditions necessary for the smart contract’s execution. This may result into the chain of reactions which may theoretically be infinite number of times.
12. Blockchain solution for post-trade securities settlement in Iran 1 . Type of blockchain proposed – private permissioned 2. Smart contract automatizes the execution of agreements. Contract including contractual terms such as confidential agreements, payment terms and conditions will be written as code into the blockchain. A triggering event like a transfer of payment triggers the transfer of securities ownership to the respective party. 3. The cash leg can be linked to the securities leg through the issuance of cryptocurrency available on a distributed ledger. 4. Verification – an administrator or any other authorized participants.
13. Security of the network : 1. Encryption identifiers are used to secure the information including the balance of cash and assets held on accounts may be provided by using of encryption identifiers instead of names. Most participants will not know the exact identity of counterparty of a transaction. 2. The assets could be cryptographically secured by the pair of public and private keys. A public key represents so called address of the asset, while a private key gives the access to the asset allocated at the address represented by the corresponding public key. 3. Once the transaction is recorded in the blockchain it is almost impossible to remove it from there. This feature of the blockchain facilitate creating unique reference database of all securities with provided ownership information. It could record the ownership of securities and safekeep the assets. Each asset will have a unique security identifier embedded in the system and shared among all participants of the network. 4. “Accenture” has developed a prototype enabling permissioned blockchain to be edited in abnormal situations to solve human errors, accommodate regulatory and legal requirements and other issues while preserving key cryptographic features (Accenture, n.d.).
14. Level of access to the network :
15. Legal consideration The principal legislation governing the Iranian capital market is Iranian Securities Market Act , 2005. The law was ratified by the Consultative Assembly on 22 November 2005. The legislation allows for the establishment of the Securities and Exchange High Council whose powers include the issuance, suspension and cancellation of the activity permit/license of the Central Securities Depository among others. In Iran, just like other jurisdictions, the clearing and settlement of securities is handled by the Central Securities Depository. One of the key objectives of CSDI is the development of information technology infrastructure to facilitate transfer of ownership of securities in a seamless manner. This will definitely be attractive to investors who are becoming more advanced and exposed to current technological developments. Therefore, as blockchain technology is new and promising, one would believe CSDI must have started working on the adoption of such seamless innovative solution for securities settlement. Even though Article 16 of the Regulations provides T+3 in respect of shares trading generally and T+1 for trades in participation certificates (Musharakah Sukuk), the blockchain solution would make settlement instantaneous. In addition, with blockchain technology, issues of non-compliance with the Regulations contemplated under Article 29, which will lead to disputes, will be drastically reduced, as smart contract introduces self-executing clauses which are triggered immediately upon a breach. With this, the number of disputes currently being handled by the Arbitration Board will be drastically reduced. Therefore, in order to ensure settlement is done on the same day of trading via blockchain, the Regulations may be amended in accordance with Article 35. Such initiatives must come from CSDI.
16. Shari ’ah perspective The Sharī‘ah Committee is domiciled in the the Department of Research, Development and Islamic Studies under the Chairman’s office. The blockchain solution would be considered to be more Sharī‘ah compliant as it is not only cost-efficient but also saves time and avoid risks associated with delays between the trading day and the settlement day. In a way, blockchain enhances the Sharī‘ah compliance of securities settlement by converting a debt-based settlement framework (i.e. T+1, T+2, T+3) to aqd al-muawadah (non-deferred commutative contract in form of spot transaction) (i.e. T+0) which is encouraged and preferred in Islamic commercial law. Therefore, one would realize that some of the challenges identified in securities settlement today may be better addressed and finally resolved through the blockchain solution. In addition, the idea of cost-efficiency through the blockchain solution is in accordance with the maqasid alSharī‘ah with particular reference to preservation of wealth. This will enhance the objective of ensuring endto-end Sharī‘ah compliance post-trade and settlement process.
17. Blockchain Solution for Securities Settlement The issues in securities settlement in Iran The solution provided by blockchain 1 . The System can’t operate 24 hours per day 7 days per a week. Some developers claim that blockchain for settlement could be constantly active, i.e. in operation 24 hours a day, seven days a week 2. Lack of integration Blockchain has the potential to allow trading and settlement of securities to take place at almost the same time even potentially with instantaneous settlement. Where trading platforms are connected to a distributed ledger, it is possible to make the posting of orders to the trading venue or over the counter by buyers and sellers dependent on the integrated blockchain system having ascertained the availability of securities in the account of the seller and cash in that of the buyer. 3 Manual processes Integrated blockchain system automatically updates all copies of the database 4 The speed of trading outpaces the process of completing such a transaction Where settlement is not instantaneous, smart contract encoded in the ledger enables margin calls automatically executable in the accounts of its clearing members 5. Purely contractual rights between the time of trade and settlement Real-time or quasi-instantaneous post trade securities settlement eliminates this issue 6 The practice of contra trading Instantaneous settlement of cash leg and securities leg through introducing cryptocurrency of the central bank removes this Shari’ah issue
18. Conclusion The technology will bring not only the automation of a process but rather it has the potential for entire paradigm shift in the securities market by developing new business models and new practices (Financial Industry Regulatory Authority, 2017). Real-time or quasi-instantaneous post trade securities settlement will almost eliminate the counterparty risk (Caytas, 2016). Blockchain might reduce reconciliation costs, streamline the post-trade value chain and increase the efficiency of regulatory capital and collateral (Pinna & Ruttenberg, 2016).