Blockchain - Could Real Time Trade Settlement Become a Reality?
A principal reason for moving to real time trade settlement would be to enable better cash management within funds, removing the constant questioning from fund managers as to how much cash they have to use. A great deal of effort and manual work is involved when compiling cash data in order to get an accurate picture of the cash position at any point in time. When making a purchase on our personal accounts, monies are debited either instantaneously or at least same day, so why does it take 2 days to settle a trade in a fund?
The latest innovations being driven within the 'fintech' sector could generate the required speed of information sharing necessary to create payments for security trading activity to be completed at the point of execution. The early adoption of blockchain, as a means of transmitting a single message to all interested parties involved in a trade, is being promoted at industry events which are in turn leading to the formation of working groups to advance these ideas further. Banks involved in the movement of payments are engaging in various activities in an attempt to keep up with, or get ahead of the game as the technology advances.
Technology has acted as an enabler of industry change in the recent past, such as CCP OTC trading and Continuous Linked Settlement (CLS). This latest development although not specific to the security trading industry as it has uses in many other industries, is however driving its evolution. That said, there is excitement within the Investment Management industry that this could solve many long term challenges, with an added appreciation for the magnitude of change involved. To help understand the issues, challenges and possibilities this article will firstly re-visit the past.History
When announcing a move to T+1 towards the end of the last millennium, US Regulators recognised there were barriers to shorter settlement periods. The industry responded by forming the Global Straight Through Processing Association (GSTPA), with the participants (the main global banks), providing investment to create the technology. GSTPA became the industry focus following the launch of the Euro in 1999 and the Y2K impact on systems. Every industry event had speakers and presentations covering how this would need to operate through the trading lifecycle, as depicted in this diagram.
In contrast to the GSTPA was Thomson, the owner of 2 global electronic trade confirmation messaging systems (Oasys and Oasys Global). Thomson formed an alliance with Depository Trust & Clearing Corporation (DTCC) to create Omgeo, with both owning 50%. Omgeo developed Central Trade Manager (CTM) as a matching utility allowing firms to migrate from the 2 Oasys platforms by building a bridge. In October 2002, both GSTPA and Omgeo presented their offerings at that year's Geneva based SIBOS (SWIFT's [annual] International Banking Operations Seminar) and within a month of this Swiss beauty pageant, GSTPA were formally announced as bankrupt leaving Omgeo as the only viable option. While some put this failure down to economic conditions, many highlight the fact that the primary motivation for GSTPA was to develop a piece of software and limited consideration was given regarding selling it. CTM on the other hand was profit driven and therefore more tailored to meet client need.
Unfortunately, without any competition, the industry-wide changes necessary lost momentum and it took a further 12 years for the full retirement of the 2 Oasys platforms. In that corresponding period, shorter settlement cycles were achieved in Forex, OTCs and finally equities through Target 2 Securities. History may well repeat itself, with the requisite changes taking a long time to gain enough traction for blockchain to be accepted as a robust and viable technology that could be used to enhance the settlement process.What it Blockchain and how does it work?
Blockchain is a secure transaction ledger database that is shared by all parties participating in an established, distributed network of computers. It securely records and stores every transaction that occurs in the network, essentially eliminating the need for "trusted" third parties such as payment processors. Blockchain enables the anonymous exchange of digital assets, such as Bitcoin, but it is not technically dependent on Bitcoin's approach. The elegance of blockchain is that it obviates the need for a central authority to verify trust and the transfer of value. As transactions occur in a blockchain ecosystem, a public record of all transactions is automatically created. The distributed ledger is available to all interested parties at the point of trade execution, with secure authentication to receive the message and recognise the transaction.
For a more detailed explanation of how blockchain and distributed ledger technology works, please kindly refer to our other article; Blockchain - A Beginner's Guide.
The benefits of blockchain extend beyond the realms of financial services with take up already established in Diamond Trading, Voting Systems and Benefits Payments. These examples show the strength and versatility of blockchain as being adaptable and able to meet the need for secure authentication where processes are at risk of error or abuse. While these risks exist for investment trading, they are relatively small and therefore the untrusted model of Bitcoin (i.e. no central trusted authority) and its immutability protocols, would not be seen as critical drivers for the financial services industry. That being said, blockchain technology can be adapted to work with a central trusted party and an early example of adoption can be seen in Australia where the latest update to the Australian Securities Exchange (ASX) legacy settlements platform, CHESS, is currently being designed to be blockchain enabled.Benefits
So what is it that real time, or near real time settlement (as confirmation within a few seconds is the most realistic goal here) will help achieve?
- Absolute transparency of cash positions would enhance portfolio liquidity, potentially leading to more efficient portfolio management by facilitating the maximum utilisation of assets available for investment.
- Reduced cost of settlement processing and related reconciliation. While it is acknowledged that short term costs of development and implementation will be high this will be far outweighed by the long term savings. Settlement processing would become redundant and with a distributed ledger, reconciliation activities would also become unnecessary.
- Settlement risk would practically be eliminated as it becomes almost instantaneous. There would be very little need for a central party to take the burden of this risk which will remove exposure to parties involved in the trade such as those that are still being unravelled after the demise of Lehman Brothers.
The list below details some of the issues that will need to be addressed. This list is far from exhaustive and further challenges will become apparent as proposed solutions emerge.
- Data integrity and continuous reconciliation - This could be addressed through the utilisation of distributed ledger technology as the golden copy will be shared amongst all participants. Reconciliation is obviated although interfacing to internal systems (and further allocation to accounts) would still be necessary but this is conceivable.
- Complexities of the current fragmented settlement process where standardisation is scarce - as there are no set standards or agreed rules within the settlement and clearing process, this seems to be one of the biggest hurdles to overcome. While blockchain could facilitate such rules through what is known as the deployment of smart contracts, the issue is solution agnostic.
- Outdated and 'silo-ed' technologies and related security concerns - The DTCC claims in its white paper on blockchain and real time settlement that technology is not the issue and that it is market structures, current practices and regulations that are holding back the movement to real time settlement. Distributed ledger technology, they say, would therefore not resolve this.
- Netting of transactions - would netting have a place in a world of real time settlement? There would be an argument that netting would no longer be necessary as the resources required to settle each trade gross would be minimal and netting, by its nature would actually impede STP and real time settlement. It currently exists to ease the effort and costs related to the complexities of the current settlement process (it is easier to net than settle every trade gross). However, as the journey to real time settlement will be relatively long (how long depends on the will of the industry and the collaboration of all stakeholders), it is acknowledged that an intermediate step might see distributed ledger technology employed to facilitate netting while it still remains a valid part of the overall settlement process.
- The scalability of current blockchain technology - the technology as it currently stands, does have some challenges around scalability. The volume of Bitcoin transactions, while increasing, pales in comparison to the daily volume of trading activity on certain exchanges. To record and process all transactions on every computer or server within the distributed network, would as a result become problematic. The same is already being seen in blockchain where the sheer processing power required to validate each transaction means that full participation will be limited to the few (thus undermining the Bitcoin philosophy of no central trusted party). While processing power is not necessarily an issue for banks, as time goes by and the size of the ledger increases, a solution for this will need to be found.
- Potential for abuse and fraudulent activity that could materialise with the advent of real time settlement. The established nature of the current settlement process and parties involved would need to be carried through to any real time distributed ledger solution. This implies that a non-trusted approach would not be embraced and a trusted model with some form of central authorising and controlling party would remain. The exact type of security risks would only become apparent as any solution materialises.
- Transition from 'as is' to the 'to be' model. Whether this is big bang or (more realistically) phased, each presents its own challenges. In the latter, some securities or exchanges would be settling real time, while others are not. While this is apparent in certain markets today, more wholesale changes within asset classes could lead to complications. Additionally, if distributed ledger technology is embraced, the boundary between this technology and existing, physical assets will need much attention and oversight to mitigate 'double spending'.
- Future roles of existing parties - conceivably, should distributed ledger technology be used, the existing roles of clearing houses and custodians could change or be dramatically reduced. While it is felt that the untrusted Bitcoin model (where no central trusted party exists) would most likely not be the chosen solution, as the settlement process is simplified and therefore related costs reduced, the current business models of these parties will have to change accordingly. Therefore, the enthusiasm shown by such parties to embrace these disruptive technologies might be dampened somewhat. Other parties will also be keen to protect their own interests and with collaboration key, this could affect the speed at which this progresses.
While the benefits of real time settlement are clear, questions remain as to whether this is enough to drive forward the changes needed and a number of planets would need to be aligned to make real time or even same day settlement a possibility.
Although blockchain technology could be the trigger that eventually helps realise this long held goal, the steps needed to achieve this seem vast and not entirely technology related. More realistically, in the short to medium term, blockchain will likely play a role in simplifying and automating some of the stages within the existing settlement process. The more the technology is employed within the financial services industry, assuming that these are successful and therefore increase the level of confidence around blockchain, the more this will drive the assessment of where further benefits like that of real time settlement can be realised. In other industries, such resistance to embrace new technologies can lead new entrants to the market (the so-called 'disruption factor'). It remains to be seen how this scenario will be played out in the financial services industry and whether any such disruption would occur.