How can tokenized securities improve cross-listing, clearing and settlement processes?
In 2015 Santander predicted blockchain technology would drive a $15 to $20 billion reduction in banks’ annual infrastructure costs by 2022. What Santander didn’t and couldn’t have predicted, however, was that Covid would, in the intervening years, inject uncertainty and instability into the global economy on an unprecedented scale, slowing this progress. Now, seven years on, the first commercial blockchain projects are beginning to realise this prediction — especially in financial markets.
This wave of innovation has seen market participants from exchange groups to investment banks exploring ways to leverage the efficiency gains blockchain technology promises.
The Australian Securities Exchange (ASX) became one of the first global organisations to embrace distributed ledger technology (DLT) announcing plans in late 2017 to replace its legacy settlement system with a blockchain solution. The new system – scheduled to go live in 2020 but delayed until 2023 – will allow participants of the $2 trillion Australian cash equities market to settle in a shorter timeframe and reduce counterparty risk while improving operational efficiency. With the worst of Covid-related disruption now behind us, it won’t be long until other markets follow suit and return to the project of upgrading their platform’s technology.
Likewise, the Wall Street Journal recently reported that both Goldman Sachs and JP Morgan already have blockchain-based trading platforms in place.
Blockchain has already energised financial markets but there is still so much more potential to be extracted. We summarise several of the benefits tokeniz
sed trading brings.
Securities trading 101: definitions
To understand the advantages blockchain offers, it’s important to clarify some key terms. For starters, we have ‘cross–
Next is ‘clearing’, which involves ensuring securities are available for delivery to every party involved in a deal, usually managed by a Clearing Counter Party (CCP).
Finally, ‘settlement’ refers to the exchange of securities and cash once deals are done, managed by a Central Securities Depository (CSD).
The trouble with traditional systems
Conventional trading has two major areas of inefficiency. Firstly, there is a gap between the theory and reality of cross listing. Businesses that cross list securities gain greater access to liquidity across multiple markets, however in practice, cross listing is usually accessible to only the largest of multinationals, because of the sizeable costs it entails.
IBM listed on both the New York Stock Exchange (NYSE) and London Stock Exchange (LSE). The businesses least able to afford this process are SMEs, which, ironically, are also the businesses most in need of the wider access to liquidity that this process brings.
Secondly, clearing and settlement is hardly any more streamlined today than it was more than 40 years ago. Back in the 1960s and 1970s, the so-called paperwork crisis meant huge delays in settlement were routine, with deals regularly taking five days to complete because transaction forms were delivered by mail or messenger. Fast-forward to 2022 and clearing and settlement is still a burdensome back-end procedure that takes around two days in equities markets, and many more in other securities markets. However, the search for active solutions to reduce the waste inherent to the old clearing and settlement mechanisms has started to yield results.
Consequently, counterparty risks are high on all sides. For example, investors may pay in advance only to find there is a delay in delivery if brokers lack the securities needed to finalise deals when the market closes. In such instances, the CCP buys securities on their behalf to guarantee delivery, using the broker’s margin to cover the difference in price, adding a further layer of complexity and fees. Equally, as all settlement instructions still must be manually confirmed by parties on both sides, it’s not unusual for errors to delay the process, adding further cost to a procedure crying out to be automated.
Better with blockchain
Blockchain’s fundamental features make it a reliable and fast means of facilitating securities trading. Transactions processed using blockchain technology are logged and held on a decentralised ledger, which means all parties have access to a single store of information or ‘source of truth’ and — provided that they have permission to do so — can add details, which are available instantly to all permissioned participants. Furthermore, once records join the chain, they cannot be deleted or tampered with, thereby making blockchain both transparent and corruption free.
This has major implications for cross-listing, clearing and settlement processes:
By having a decentralised point of reference, containing all the security pricing information, multiple exchanges can more easily reference the same security. The technical feasibility of this process has been fully demonstrated by the existence of multiple cryptocurrency exchanges, with various exchanges easily listing the same tokens and where changes in transactions and pricing from all exchanges synchronise with the same decentralised ledger.
While both the value and the utility of the underlying crypto assets can be questioned, the technical advances this synchronisation is based on undoubtedly make cross-listing, clearing and settlement processes cheaper and more accessible. Coupled with smart regulation, this will dramatically alter the way in which securities list simultaneously on multiple exchanges in the near future.
2. Clearing and settlement
The impact of blockchain on clearing and settlement is even more profound, with full automation effectively removing these stages of the securities trading process completely. By directly issuing securities as digital tokens registered to a blockchain, a trading venue can publish immediate changes directly to the respective blockchains, capturing ownership of given digital assets in real-time. This results in instant settlement and entirely eliminates the need for a CCP and CSD to process orders manually.
Smart contracts don’t require any employee time or input to function; as self-executable computer programmes which automatically carry out their functions when certain conditions are met, they can continuously harmonise the relevant records without the risk of human error. These programmes streamline deal managementand have the capacity to finalise instantly. So, instead of taking at least two days, post-trade processes can be wound up in seconds.
They can also be constructed with built-in rules that align with financial regulations, reducing compliance overheads and minimising risk to both issuers and investors. In this way, remaining compliant become as simple and easy for all participants as possible.
Financial markets function efficiently in many respects, but there are several elements of the capital raising and secondary market trading processes that require rejuvenation.
With blockchain, listing a company on more than one trading venue becomes more streamlined and cost-effective, while bringing post-trade processes into the 21st century vastly accelerates clearing and settlement processes. Deals can be completed almost instantly, without third parties, streamlining and simplifying both capital raising and secondary market transactions.
The foundations of the securities industry are set to be disrupted and rebuilt by blockchain. The efficiency gains to be had are currently galvanising both start-ups and incumbents to harness the potential of DLT to improve numerous back-office functions. Already, the ability of smart contracts to automate processes that currently consume inordinate amounts of employee time and effort is driving the adoption of blockchain-based solutions. The path to vastly accelerated clearing and settlement processes is open; the race to extract the maximum potential from these advances is beginning.