Disclaimer: this posting is my own and does not represent my employer’s positions or opinions.
The largest risk in securities markets is settlement risk, which is the risk that the transfer of a security between parties fails. Two examples of a failed delivery is when the buyer of the security receives the asset but does not transfer payment to who they purchased it from, or where the seller of the security receives payment for the security and does not transfer the security to the purchaser.
To mitigate this type of risk, security settlement systems have been put in place which are implemented by a third-party such as a central bank or other specialized entities. One of the world’s largest third parties which oversees security settlement is the Depository Trust Company, or DTC. DTC was founded in 1973, and emerged in a time when stock exchanges were trading hundreds of thousands of shares per day and traders had to keep track of physical certificates. DTC’s main function is to act as a clearinghouse to process and settle trades by maintaining a centralized digital ledger. The goal of DTC was to lower costs and settlement risk as well as increase settlement and trading efficiency. In order to take advantage of DTC’s services, one must become a DTC participant and pay fees which are ultimately passed onto the clients of the DTC participants.
Even with the implementation of trusted third parties to oversee security settlement the whole process can be slow, costly, and inefficient. Security settlement can take anywhere from 1-3 days for ‘normal’ securities such as equities and bonds, but in some cases can take several weeks. The services these third parties offer are definitely a step up from running around with paper certificates, however not much has changed with them since.
Over the past decade new technology has been created which, if applied to the security settlement process, could greatly reduce settlement times and processing costs. Blockchain, a system which utilizes distributed ledger technology, should be adopted and applied to security settlement.
Blockchain has been a buzzword since 2017 when Bitcoin and other cryptocurrenices were constantly making news headlines. Many people in the world of finance know about these coins/tokens that use blockchain technology, but only a small percentage actually understand the underlying technology. Applying blockchain technology to the security settlement process is an example of using blockchain that the masses can understand more so than how cryptos and blockchain based applications work.
In order to understand how blockchain technology can be applied to the security settlement process, one must first understand what blockchain is and how it works. In its simplest form, blockchain is a decentralized ledger which is distributed to all network participants. The blockchain contains the entire history of past transactions, and each new block, or transaction, is built upon the previous one. To change a past block all the previous blocks that have been created since that particular block would need to be changed.
A blockchain participant is a user who has a computer that participates in the blockchain network. A node is the term used to describe the device that is connected to the network. These users solve computationally difficult problems using cryptography to verify all transactions on the network. The first user to verify the transaction gets rewarded for doing so, which is called mining. Once a transaction has been verified, another block is added to the rest of the blockchain. In order to mine additional blocks, all blockchain versions which have been distributed to each participant must match.
The reason that blockchain technology is so attractive is because distributing the blockchain among participants provides a decentralized dataset. In order to hack into the blockchain to change something, one would have to update all blocks occurring after the change, and also update all of the versions of the distributed ledger and make sure they match.
If implemented, blockchain technology could increase efficiency within the security settlement process and reduce settlement time. However, these advantages are outweighed by some issues that would need to be addressed.
First off, mining costs money. Nodes are expensive to buy and maintain, and the energy expense that would be needed to keep the network up and running would be substantial. Because there are costs associated with mining, network participants will need to be incentivized. An example of an incentive could be monetary, such as a portion of the trading fee going to the first transaction verifier. The incentive could either be a type of fiat money, such as a credit into a bank account, or it could be in the form of a cryptocurrency, either an already established one such as Bitcoin or a new coin that would be created specifically for the security settlement blockchain.
Another issue would be network security. A user of the blockchain might find it in their best interest to change previous blocks if they made an asset trade that did not end in their favor. There are also risks of external security threats from cyberterrorists. Hacking into the security settlement network could be beneficial for many crime groups and could create market instability which could temporarily halt any type of security transfers. In order for this blockchain system to work, a strong defense mechanism must be in place.
Because of all of the operational procedures that must be enacted, the possibility of a completely decentralized security settlement network might not be feasible, which does not mean that the technology could not be used. The use of a third-party may still be needed to administer the network. The administrator could be a company, like DTC, a regulatory entity such as the SEC, or a government, who could contract out a tech company to create the network for them instead of developing it themselves. Many large institutions are trying to get involved in the blockchain space, such as IBM, LeewayHertz, and Intellectsoft. Additionally, if the administrator was a global entity, then cross border blockchain based security settlement could be possible.
There are several blockchain networks that currently exist that could be used for the security settlement network. Ethereum is a decentralized software platform which enables the use of SmartContracts – self-executing contracts with built-in terms of agreement between all parties involved written into lines of code which can be used to transfer property. Decentralized applications, also referred to as DApps, could be created to run on the network.
Examples of such applications include crowdfunding, online gambling, and securitized token transfers (which is where Ethereum’s digital token Ether comes into play). A security settlement application could be created to run on the Ethereum network however because of the scale of the security transfer process it could bog down the Ethereum network substantially, which is why it might be in the best interest of all parties involved to have a separate blockchain specifically developed for security settlement.
Implementing blockchain technology into the current security settlement process may not lead to real-time settlement or a large reduction in settlement related costs, but the technology is available and should be utilized. If new technology is not adopted early it will only be more difficult to change the ways things are done in the future.
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Thank you for such an informed article. With the use of smart contracts, blockchain technology can help us remove the need for intermediaries and conduct settlements between two parties.