For a technology that promises speed and cost reduction for financial transactions, blockchain has taken its own time to find its way into the regulated corridors of Wall Street.
Even as other industries embrace blockchain’s uses, Wall Street is still hesitant. Which is why the announcement last month of an SEC no-action letter issued to New York-based startup Paxos is a game-changer.
The letter enables Paxos, which counts former FDIC chief Sheila Blair among its Board members, to conduct a two-year pilot project for settlement and clearing of securities on a distributed ledger. More importantly, it cracks the door open for blockchain experimentation in the plumbing infrastructure for money markets.
So what does Paxos hope to achieve for that infrastructure? The primary use of blockchain lies in shortening settlement times for securities. The current time to settle securities is T+2 days (trade date, followed by two days). In a world of instant gratification, that time almost seems anachronistic. Paxos intends to reduce that settlement time to the same day that trades are agreed upon.
Nick Cowan, CEO of Gibraltar Stock Exchange (GSX), said the current settlement process has onerous capital requirements which lock up capital with Central Counterparty Providers (CCP), who act as guarantors for a transaction for extended periods of time, making instant settlements difficult. “[The capital requirements] use up the balance sheet of the broker,” he explained. The use of CCPs also amplifies risk, propagating it through the entire system resulting in crises, as the chain of events that led to the 2008 financial crash demonstrated.
The sheer number of actors and their disparate technology systems, back-office processes, legal management, and liquidity management also add up costs to a trading firm’s balance sheet. Research by Broadridge, a financial services industry consulting firm, in 2015 estimated a post-trade spend of approximately between $17 billion to $24 billion by firms in the industry. The same research stated that the industry could garner annual savings of between $2 billion to $4 billion from standardized and interoperable post-trade systems.
There’s also the question of geography. While the Internet may have made short work of geography, barriers between countries still exist in the financial ecosystem. Cowan says regulatory and legal requirements prevent financial institutions from clearing and settling transactions instantly.
How can blockchain help Wall Street?
The main utility of distributed ledger technology lies in removing counterparty risk through a shared database architecture, unifying systems and processes from multiple parties onto a single platform. But several important questions about its implementation in financial infrastructure remain unanswered.
A recent Wall Street Journal article provides a high-level overview of the architecture for Paxos’ proposed project. For example, it is not clear whether the system is permissioned or permission-less. The latter system achieves settlement via consensus mechanisms involving potentially thousands of nodes—an expensive and fraught undertaking for security.
On the other hand, a permissioned system retains the role of central entities, such as depository institutions, in its architecture. It is also easier from a compliance and regulatory standpoint. Such a system could be installed globally (across geographies), eliminating the need for a CCP to maintain transactional integrity, said Cowan from GSX.
“You can reduce the reconciliation burden to what is an effectively automated system,” he explained. “That system could be spread across multiple geographies, allowing for interoperability.”
That said, evidence regarding the perceived cost savings associated with settling security transactions remains mixed. A pilot project initiated by Bundesbank and Deutsche Boerse in 2016 found that blockchain was slower and more expensive computationally as compared to existing systems.
Regulation, already a significant stumbling block for crypto, could also hamper blockchain’s utility in securities settlements. The Paxos system envisions digital representations of securities. The regulatory status of these digital equivalents is not clear. Cowan also said regulation concerning T-0 settlements in Europe is absent. (Incidentally, the EU has been a forerunner to the SEC in its use of Distributed Ledger Technology (DLT) for securities settlement).
Perhaps it is for these reasons that blockchain was notably absent from the Depository Trust & Clearing Corporation’s announcement of a settlement optimization project last year.
If the history for introduction of technology into clearing and settlement systems are any indication, however, it might just be a matter of time before blockchain is introduced.
Technology systems shortened and standardized settlement times to T+7 days (trade date, followed by seven days) initially and later to T+3 days (trade date, followed by three days) in 1995. A subsequent lull ensured that it took 22 years, from 1995 to 2017, to slash another accounting day from that time in the US. Paxos’ project itself is expected to last two years and may not have an immediate impact. But it’s a start.