May 3, 2016
Most of the previous decade in the capital markets space has been spent on optimizing the efficiency and speed of the pre-trade processing. Pretty much all of today’s stock exchanges are extremely efficient centralized electronic marketplaces running fully computerized order-matching engines, with ability to receive and process tens of thousands of buy/sell orders per second. As a result, they generate hundreds of millions of trades per day. The underlying order processing latencies are already measured in nanoseconds. Highly computerized algorithmic trading was the main driver for this type of technological innovation.
Despite the fact that buy and sell orders can be rapidly processed, booked and matched on a stock exchange, the actual clearing and settlement—including delivery of the underlying security asset (to the buyer) and actual payment (to the seller)—are still measured in days. The current post-trade processes are perceived as highly complex, slow, expensive and inefficient—and as such, in dire need of optimization and streamlining that is ripe for technology disruption.
It is important to understand the reasons for making the clearing and settlement processes faster and more efficient. More efficient and faster post-trade processing could enable faster recirculation of the capital back to the markets (otherwise tied up in the T+3 post-trade cycles today) and could reduce counterparty risks and thus, also reduce margin/collateral requirements. All these processing efficiency gains could further enable reduction of overall trading fees and enable increased order flow and liquidity.
These benefits seem attractive enough that many capital market players are taking a serious look at the potential for using promising blockchain distributed ledger platforms as the potential base for the next generation of post-trade processing. Fully dematerialized security markets as Singapore, Canada and Australia may be best positioned to emerge as clear leaders in this space and establish the first foundation for the future standard.
Can applying the blockchain distributed ledger technology to post-trade processing completely eliminate the need for operating the Central Counter Party (CCP)? It is an interesting question, but it is hard for me to make a firm conclusion at this point (with still immature blockchain frameworks in place). Based on my own capital markets and payment industry experience—in combination with extensive research into the matter—I feel that the most likely outcome would be some kind of hybrid framework that will most likely emerge in this space.
The mainstream industry will likely continue to recognize that CCPs still have extremely important roles to play in ensuring ultra-efficient multilateral netting, novation and risk management processes. CCPs reduce (if not completely eliminate) counterparty, operational/transfer and market risks, including the collateral management requirements. The fully decentralized blockchain-based solution simply may not be able to make these important processes more efficient nor reduce these inherent risks – so why not simply reuse already efficient components of the existing centralized solution and instead focus on addressing main pain points?
The industry’s consensus seems to be that the main limitation of the today post-trade processing is the existence of the multiple versions of the truth. The costly libraries of application code exist in every of the participant systems dedicated just to reconciliation of these different versions of the truth at the end of the trading day.
The blockchain’s immutable nature of the distributed ledger (due to the clever usage of cryptographic hash pointers for block linking and digital signatures for block content signing) can ensure that all participants have the exact same verified and final copies of the daily ledgers, each containing all of the daily trades for an individual stock. Such solution can clearly eliminate the need for regular costly and inefficient daily reconciliation processing (including labor-intensive manual interventions and exception handling procedures). I expect that blockchain would play a major role here by its ability to enforce the single version of the truth. That’s why I believe that this blockchain use case is the main focus of the most current PoC efforts and will eventually deliver an initial production deployable framework.
There are obvious benefits to the issuers of securities, and to the owners of those securities, if the consistent, publicly distributed and widely known source of truth concerning the full ownership of a security exists. Any changes to the ownership, stock splits/reverse stock splits, etc., need to be accurately recorded and managed. Using a distributed ledger platform to manage security issuance and track current ownership and state of each security asset could greatly simplify servicing in a manner that is already difficult to achieve with legacy, centralized technology. I therefore expect that blockchain-based solutions can certainly play significant role in making this domain more efficient and simplified.
It is important to realize that blockchain adoption isn’t necessary requirement for achieving the T+0 settlements. The primary reason for current multi-day settlement periods are mainly regulatory, legal rules and market practices, tailored to enable transparent participation by very important retail investors. Delays are not caused by any limitations of current technology.
The current CCP based and centralized post-trade technology platforms could easily be modified for T+0 settlements only if regulatory and legal environment allowed for it. Therefore, the reality is: the industry doesn't need blockchain to deliver T+0. In addition to that, the markets with T+0 settlement windows may not even be desirable, since in a T+0 settlement environment, there may not be opportunities anymore for short selling, which would negatively impact (reduce) liquidity by eliminating the whole segment of very sophisticated traders.
My conclusion here is that I definitely expect that settlement windows will further shrink, with or without the blockchain, but will likely never fall down to T+0—and certainly, blockchain technology may not be the main enabler here (although it could be used as well).
Blockchain technology, as-is, may be inferior in several aspects to the existing traditional state of the art mechanisms for data retrieval, inquiry, reporting or analytics, deployed in enterprises today:
This is clearly an area where startups and value-added service providers could innovate, bring a lot of value and make the blockchain platforms enterprise ready.
As with any early-stage and complex technology, which brings promise of significant disruption, as blockchain currently is, I think it is too early for me (or anyone else for that matter) to make any bold predictions about its potential and future adoption.
That being said, I am continuing to stay very interested, focused and dedicated to following blockchain technology developments very closely and participating in the evaluation/PoC efforts of its technology potential. It is definitely a very exciting technology space for all of the segments of the financial business: capital markets, payments and even insurance.
Despite all the hype and according to many analyst projections, twe may still be another five to ten years before seeing the real enterprise-grade distributed ledger platforms starting to replace the current CCP-based centralized post-trade facilities. The same analysts also seem to agree that the 2016–2018 period would be the period of many small scale, but very important experimental proof-of-concept (PoC) initiatives. Those PoC initiatives are a great opportunity for learning by experimentation in an agile environment and rapidly move forward.