The technology at the very heart of Bitcoin, blockchain, is an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable permanent way. When the blockchain technology was announced in 2008, it was an innovative mix of public key cryptography, cryptographic hash functions, and proof-of-work. There are seven basic principles underlying the technology:
Every party can verify the record of its transaction partners directly and without an intermediary
Communication occurs directly between peers instead of through a central node (hence, the blockchain is a decentralised technology)
Every transaction (and its associated value) are visible to anyone with access to the system
Users can choose to remain anonymous or provide proof of their identity to others
Records cannot be altered, because they are linked to every transaction record that came before them (hence, the term “chain”)
The network reconciles every transaction that happens in ten-minute intervals (each group of these transactions is referred to as “block“)
It cannot be corrupted: altering any unit of information on the blockchain would mean using a huge amount of computing power to override the entire network.
However, relating to the last point, the South Korean cryptocurrency exchange Coinrail was hacked last weekend: bitcoin dropped $500 to $6,627 on the Luxembourg exchange Bitstamp. With blockchain, one can imagine a world in which intermediaries like lawyers, brokers, and bankers might no longer be necessary: individuals, organisations, machines, and algorithms would freely transact and interact with one another.
In clear opposition to blockchain technology, clearing and settlements are highly-centralised industries, run by central banks, Central Counterparty Clearing structures (CCP), and Central Securities Depositories (CSD). It is an area ripe for change:
India-based trading technology company, uTrade, announced the launch of its uClear blockchain solution, for real-time clearing and settlement of contracts across the cash and derivatives segments of the financial markets. The first stage of adoption will be led by the OTC segments without existing central clearing infrastructure, such as foreign exchange and the fixed income securities markets. Founder and CEO Kunai Nandwani came up with the solution and outlined how treasury may benefit. While any stock exchange is typically backed by highly inefficient legacy infrastructures – settlement of deals typically takes two or three days – uTrade clears trades within seconds.
SETL, a London-based firm that develops blockchain-powered institutional payment and settlement infrastructures, has unveiled its first commercial offering: a new platform that allows market participants to commission and run permissioned-registry services for payments, settlement, and clearing of cash and other financial instruments (permissoned-registries are not open to everyone in the world, while Bitcoin and Ethereum, for example, present a permissionless and open environment, which anybody can be a part of).
The world’s first industrial-scale blockchain in financial services will be switched on between September 2020 and March 2021: the Australian Securities Exchange (ASX) will offer the possibility of settling trades in one day rather than two to reduce risk. The ASX’s distributed ledger will be used to clear and settle the $2trn Australian cash equity market. While fund managers, stockbrokers, and custodians will be able to continue to operate in the same way they do now, if they take a node on the distributed ledger (DLT), it will let them see real-time data on equity ownership without them having to reconcile their own ledgers with ASX’s. ASX has also said it will consider adopting DLT in the cash debt market (which ASX clears through its Austraclear business), and the derivatives market.
Euroclear, the largest International Central Securities Depository (ICSD) and one of the world’s biggest settlement houses, announced their first product trial: a new settlement system for the London gold market will be created. This announcement comes in the form of a partnership between US startup itBit and Euroclear. As a result, both companies are in talks with various banks and broker-dealers. In the end, the goal is to create a blockchain network for clearing, tracking and settling trades in real time. With gold being a huge market on a global scale, using a distributed ledger can have an immediate impact.
CITI and CME Clearing have implemented a real-time distributed ledger platform developed by Baton Systems (a payments technology provider). The innovative solution allows banks to view the collateral in its ledgers in real-time, send cash or securities with one click to a Clearing House, and receive an immediate acknowledgement, regardless of the current technologies they are deploying. The blockchain-inspired software could materially reduce the cost of back-office operations and speed up margin funding times.
The importance of CCPs has been elevated following the passage of the Dodd-Frank Act (in the US) and the European Market Infrastructure Regulation (EMIR), which have mandated a growing number of over-the-counter (OTC) derivative transactions to be centrally cleared through these market infrastructures. Since blockchain operates on a real-time trade settlement time-frame, and since there is complete transparency that trading counterparties can meet their obligations at the point of settlement finality, some have questioned whether it will remove the need for CCPs. However, this is overly simplistic: CCPs are likely to maintain their role in a “blockchain era”. Also, blockchain could potentially replace T2S if the technology developed exponentially fast. T2S (TARGET2-Securities) is a European securities settlement engine, which offers centralised delivery-versus-payment (DvP) settlement of securities and cash in central bank money across all European securities markets (the T2S project comprises 24 CSDs across multiple markets). T2S has removed barriers and eliminated differences between domestic and cross-border settlement, by offering a single market infrastructure solution. Hence, how could Blockchain disrupt T2S? The answer is real-time trade settlement, reduced counterparty risk, more efficient DvP, and enhanced automation.
A Santander report estimated that inefficiencies in the global collateral management market are estimated to cost banks up to $4bn annually: the blockchain technology can have a huge impact in clearing and settlement. However, there are two main lines of thinking:
David Rutter, CEO and founder of R3CEV (a distributed database technology company that leads a consortium of more than 200 firms in research and development of distributed ledger usage in the financial system), in an exclusive interview at Consensus 2016 said: “Clearing and settlement is another area which is attracting a lot of interest at the moment, but it is unlikely that we will see blockchain solutions in this space in the first wave, it’s more likely to be the third or fourth wave.”
On the other hand, Adam Ludwin, CEO of Chain, said: “When people say blockchain technology will change clearing and settlement, what that really means is that blockchain technology will make clearing and settlement redundant. It’s as if I gave you a 10 dollar bill, and then asked you how do we clear and settle that payment. You would look at me funny, because it doesn’t make sense.”
In summary, the question is not if the blockchain technology will revolutionise the clearing and settlement industry, it is merely a question of when.