On the chain

Alex Pugh explores how blockchain is shaking up the post-trade process.

Currently, a trade takes nanoseconds, a billionth of a second, but a whole ecosystem of post trade obligations must be fulfilled in sequence, such as validation and clearing, which can take at least a day, and a whole host of participants sharing information with one another to complete. Many of these processes are still manual. How will the use of blockchain address issues that are thrown up by the settlement and clearing process?

The post-trade process still largely follows the sending of payment orders or security transactions; the transfer of ownership and of compensation; asset safekeeping ensuring that holdings at central securities depository (CSD) are always equivalent to the value of securities owned by custodian’s customers; and value-added services after trade execution.

Market structure
A blockchain is a type of distributed ledger technology, a shared database that records data in a verifiable and immutable fashion. Nobody or entity in the blockchain can modify a record after it has been added to the shared ledger, unless a new data point is added. In the blockchain, actions can also be executed automatically through ‘smart contracts’ which outline conditions that need to be met for an action to occur.

Many firms, large and small, are already operating in the space. Most notably, in October, JP Morgan Chase went live with its first collateral settlement for clients using its Onyx blockchain. The firm’s Tokenised Collateral Network (TCN) was used by BlackRock to turn shares into digital tokens, which were then transferred to Barclays as collateral for an over-the-counter derivatives trade.

Again in October, the European Central Bank held an industry meeting regarding its planned digital Euro trials of wholesale settlement for DLT networks, including a wholesale digital euro. Blockchain payment netting service CLSNet, which provides settlement services to FX market participants to mitigate settlement risk, has been used by Goldman Sachs and Morgan Stanley since 2020.

Last year, the Depository Trust & Clearing Corporation’s (DTCC) Project Ion platform – a settlement system built on blockchain – was processing around 100,000 bilateral equity transactions a day.

Best execution benefits
The development of instantaneous settlement poses challenges for the management of liquidity as it requires all cash and securities to be in place at the time a trade is struck.

There would no longer be an opportunity to locate the cash and securities or to net trades against each other. And if each securities ledger has its own cash token, aggregate liquidity requirements could be increased.

Smart contracts fold in activities that, in conventional securities trading, are split across custody banks, exchanges, central counterparties and central securities depositories. For the end investor, fewer intermediaries should mean fewer fees. With fewer critical points in the chain, the potential points of failure in the system are reduced.

Consolidation reduces the number of intermediaries. This disintermediation could go further into a full decentralisation of the trade and post trade process.

In these models, smart contracts on the permission-less blockchain allow users to transact with pools of assets, rather than each other, and without handing over custody of their assets to a third party. This could further reduce costs and promote efficiency.

“Smart contracts are exciting, and open up a tremendous amount of opportunity,” Richard Baker, founder and CEO at Tokenovate, said. “In addition to consolidating and condensing pre-to-post trade functions and processes, we see an enlarged scope for smart contracts that introduces much needed operational efficiency through digital expressions of instruments.”

The use of blockchain in post-trade would potentially impact five key areas in the post-trade ecosystem:

• Speed: Blockchain reduces the need for intermediaries and automates transaction validation.
• Costs: Cutting intermediaries and processes lowers operational costs, which is particularly attractive to financial institutions looking to remain competitive.
• Security: Blockchain makes it near impossible for bad actors to manipulate or forge records.
• Transparency: All parties involved in a transaction have access to the same, up-to-date information.
• Transactions: Blockchain can simplify cross-border transactions, reducing the time and costs associated with international clearing and settlement.

The value (or otherwise) or automation
Tyler Welmans, consulting digital assets lead at Deloitte, expects new digital asset market infrastructure to play a role in shaping the future market structure, reducing the demand for some roles while creating demand for others, and ultimately improving the efficiency of global capital markets.

“While progress toward both digital money and digital securities is picking up pace, we are still some way from the universal multi-asset infrastructure that is often cited as a goal for the industry,” Welmans explained.

Some processes for error detection can involve automated or manual analysis of trade confirmation records before settlement, with a window of opportunity for error correction. In an instant execution environment, this safety net is removed, meaning up front controls and checks need to be well managed. The advantages are generally considered to outweigh the disadvantages, however. If deferred settlement is required, there is nothing stopping a blockchain-based service from embedding a settlement delay into the execution process.

Smart contracts are able to consolidate a lot of the settlement processes across both trade and post-trade functions, taking on the roles held by custody banks, exchanges, central counterparties and central securities depositories.

Best execution and its mirror image, trade surveillance, both involve the analysis of trading activity over time. Adding more time adds more context, which in turn can help explain why a particular trade was done at a certain time, price, size, style and so on. It should also be understood in the context of quotes, orders, indications of interest and other activity that was taking place around that time.

Nick Philpott, co-founder and chief operating officer (COO) of Zodia Markets, said: “I think many of the functions of post-trade settlement will sit at the custodial layer or be rendered as smart contracts. I can see a richer ecosystem of instant gross atomic settlement, delayed net or gross atomic settlement and multilateral net settlement.”

Stephen Prosperi, DTCC’s executive director, innovation strategy and digital assets, said: “While there is evidence that many functions performed by financial institutions and financial market infrastructures (FMIs) might become more automated through the use of smart contracts, it will likely not replace the role of these parties who are well positioned to govern, operate and use the smart contracts and the networks they live on.”

Moving to instant settlement (T0) could reduce counterparty risk exposure considerably, and free up reserves to be put to more efficient use faster which would bring overall operational efficiency gains. Market behaviours would need to change, and initial funding pressure may increase. However, over time, the efficiencies secured from management automation should deliver more structured pricing of assets. And as more and more assets are tokenised natively, the market will increase the availability pool of assets that can be used for better liquidity management.

Tokenisation
Tokenisation of securities could improve liquidity by making securities much more international than they are today as well as democratising ownership through fractionalisation. “Many of them are constrained by borders and I think tokenisation onto permissionless networks could allow many more participants to engage in a market,” Philpott said.

There are many ways tokenisation of securities can positively impact liquidity. For example, the tokenisation of assets enables rapid collateral mobility, improving overall transparency, increasing market accessibility, and so risk positions become clearer. This, in turn, will unlock liquidity faster – offering the chance to put that liquidity to use again. Also, securities that perhaps are not eligible for use as collateral or liquidity management today may very well be accepted once they are natively digital. Again, this will increase the size of the pool of available assets, improve liquidity and reduce funding costs across the industry.

“Looking ahead, digital asset platforms may also enable the digitisation of typically illiquid assets, such as product inventory, or novel asset types, such as IP rights. This is an emerging space, but offers the potential to extend the range of assets that could be used to address collateral or liquidity needs,” Welmans said.

Prosperi believes the tokenisation of securities alone will not improve liquidity; it could enable a business model that supports more efficient distribution of assets if the foundation components are established, such as standards and interoperability. “Progressing standards and interoperability is critical to enabling liquidity of tokenised assets,” Prosperi added.

Liquidity management
Whether instantaneous settlement poses challenges for the management of liquidity, and whether liquidity management is a potential barrier for adoption of blockchain technology, depends on the use case.

DTCC’s Prosperi said: “Currently, many of the digital asset initiatives that show the most promise tend to focus on asset classes or use cases that are not fully optimised or automated. Because of this, transactions may be lower volume/higher value, and liquidity management is not the primary barrier to adoption, rather this tends to be the lack of a wholesale cash (or cash equivalents) on chain.”

Zodia’s Philpott said instantaneous settlement should not be viewed through an all-or-nothing lens. There are entities who would like to have it and others who would be more ambivalent about the speed of settlement.

By placing different assets and asset classes on the same settlement networks, plus their means of payment either as stablecoins or CBDCs, atomic settlement becomes that much easier. For example, placing all the world’s currencies as stablecoins on a single chain will make them much easier to network than arranging bilateral settlement between all 180 of them, which would be something in the order of 16,000 different bilateral relationships.

“In some way, post-trade settlement is finally catching up with the rest of the world,” Philpott added.

Interoperability
As this new medium of value exchange matures, and is better understood, one can expect technical and legal standards and protocols to make interoperability more practical.

To facilitate greater interoperability the market should collaborate and initiate cross-border projects with continued investment in digital financial market infrastructure. The underlying blockchain technology must also support extensive scale – hundreds of thousands of concurrent transactions – combined with very cheap costs in order to succeed.

Interoperability is perhaps the biggest challenge for international trading, with the need to span technical, operational, legal and regulatory aspects across countries. Countries like Singapore, Switzerland, Germany and France have been notably active around DLT experimentation with support from the regulators.

DTCC’s Prosperi believes the interoperability of DLT systems will be essential not just for international trading, but also domestic trading. Today, the digital asset ecosystem is highly fragmented which contributes to the adoption challenge.

While not every DLT system will be operated by or directly involve FMIs, they tend to support and represent large swathes of market participants across asset classes and regions, and as such are well positioned to help drive the topics of standardisation and interoperability.

Philpott said: “I don’t get the impression that this is a question of regions or countries. DLT offers the opportunity for assets to have the accessibility, availability, low costs and scalability of the internet. If a security or stablecoin is on a public permissionless chain then it is available wherever the open internet is also available.”

“The internet has already done the heavy lifting of interoperability. Where there may be tension is where national regulation goes against the grain of this market evolution,” Philpott added.

The future role of CCPs
Blockchain technology can facilitate trustless delivery vs. payment (DVP) settlement without any intermediary which may affect CCPs.

Tokenovate’s Baker said: “With the emergence of some digital assets, we can already see how a custody bank that holds tokenised assets can atomically move the assets or the associated rights and privileges under custody. This gives us a glimpse into a new future for clearing and settlement. We believe that as more real-world assets are represented as digital assets held in a custody account, the function of the clearing house can be completely transformed.”

But Philpott thinks that CCPs will still have a place. “However, I don’t think CCPs are the cure-all that they are sometimes held up to be. For example, they mutualise risk and can introduce tight coupling as well as a massive too-big-to-fail. That doesn’t mean CCPs are bad, but rather the notion that we would be better off if everything were cleared is flawed,” Philpott added.

CCPs play an important role in facilitating market efficiency and mitigating various risks in traditional trade environments. “While digital asset platforms that facilitate atomic trade between counterparties appear well placed to reduce or eliminate some of these risks, such as counterparty risk or settlement risk, Others, such as legal risk, may be harder to overcome. New risks, such as novel failure or dispute scenarios, may also arise,” Welmans said.

DTCC’s Prosperi noted that while there are examples of ‘trustless DvP’ use cases that have been explored, it does not exist at scale and likely will not for the foreseeable future, at least in the US.

“There is a distinction between automated and trustless. In cases of automated DvP, there is a reliance on networks, smart contracts and other applications that are inherently governed and operated by CCPs (or other FMIs), so while the processes may happen in a more distributed manner, they are not inherently ‘trustless’. We anticipate these more automated and distributed forms of settlement will continue to proliferate, but will likely be supported by CCPs who will also continue to provide solutions to manage counterparty risk for settlement models that are not pre-funded.”

Niki Beattie, CEO of Market Structure Partners, said market infrastructure exists for a reason and it has a protected status in the law. “The law allows it to provide things like settlement finality and ability to handle insolvencies without waiting for traditional insolvency practices/laws to kick in. Imagine how the Lehman failure might have been handled if we had to wait for administrators to argue about valuations or who owned what.”

In theory, transferring DvP settlement to a blockchain can potentially remove the need for CCPs as they operate today. However, in reality, regulators and standards bodies may advise or indeed require the role of CCPs to remain, albeit in a new shape that is more suitable to DLT.

There are still extant risks associated with blockchain – the code can be forked and duplicates of ownership made – without any legal protections, there is no guarantee whether you own the original product or the duplicate. There is no dispute resolution in a smart contract. It is unlikely that trillions of dollars of assets will simply be moved to a public blockchain with these sorts of possibilities.

“Credit risk will never go away. Even if you think that just an exchange and a blockchain will solve everything, it is incorrect. That model requires everything to be pre-funded or pre-positioned. This is not how institutional markets work – there is no pre-funding in markets today – the market infrastructure is relied on to handle this. Asset managers do not want to pre-fund as it is a drag on their performance,” Beattie concluded.

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