Distributed ledger technology offers a wide range of possibilities for DTCC’s future, from improving the client experience to reducing costs, but as with any new technology, it comes with risks as well as rewards.
When assessing technology, the key questions for DTCC remain the same: Can we use it to:
- Reduce risk for our clients and the industry as a whole?
- Reduce costs for our clients, which usually translates to whether there are potential efficiency gains?
- Provide a better client experience?
- Deliver on our regulatory obligations more easily and efficiently?
Consider some technologies that have been adopted widely in the past decade or so, such as mobile applications for consumer banking or cloud computing for enterprise data management. The questions have been answered for these technologies, checking some or even all the boxes.
During my panel “Trading and Market Consideration” at the recent SEC Fintech Forum 2019, I explained that DTCC is re-platforming our Trade Information Warehouse (TIW) solution onto a cloud environment and will also host DLT software. I addressed the above questions when describing the potential for DLT in the TIW case, which will include a reporting function. The opportunities here are not only to reduce costs and deliver a better client experience, but also potentially create a better experience for regulators as well.
With TIW, one of the longer-term practical benefits are the learnings we’re gaining from our hands-on work with the technology.
DLT and Settlement
At the conference, I also had the chance to share what I’m hearing from some industry leaders, who say that DLT has the potential to deliver cost savings and risk reduction to the clearing and settlement of securities. While the length of the current T+2 settlement cycle does introduce a degree of risk, real-time gross settlement can bring its own challenges and concerns.
It’s worth noting that traditional technology can be used to reduce the settlement cycle. DTCC has the capability today to settle trades nearly instantaneously, but the overwhelming majority of firms prefer to follow the T+2 cycle. However, DLT could possibly be used in the future to eliminate some of the intermediaries in today’s securities ecosystem. Because trading platforms and post-trade platforms are now separate and distinct in the U.S., the potential exists for them to be combined into one under a DLT system.
However, having multiple trading venues and one CSD – today’s U.S. market structure -- allow for fungible securities to be traded in many places, which, along with other credit efficiencies, helps facilitate liquidity. Having many vertically-integrated securities DLT platforms would require more than one central securities depository, bringing with it an assortment of new costs and complexities for market participants and the firms involved in supporting that activity.
While the question is being debated, it’s also unclear that multiple vertically-integrated DLT platforms would achieve the liquidity levels that market participants expect and policy makers consider healthy. To achieve such a level, this type of market structure would require seamless interoperability between platforms for market participants, itself a complex concept, which would pose a big challenge.
Also at issue is the finality of transactions, a critical concern because it sets the settlement guidelines if a counterparty fails before a trade is settled.
The nature of blockchain technology, especially in permissionless systems, could mean that, at a single point in time, the requisite number of nodes may not agree on the state of the ledger, or an adequate number of blocks may not have confirmed a transaction. As a result, whether final operational settlement has occurred may be probabilistic due to the difficulty of determining the point at which the transaction becomes final. This matter will likely require guidance from policymakers on the minimum number of blocks needed to confirm a transaction before settlement is considered final.
DLT can help mitigate risk, for instance, in the case of real-time gross settlement systems, whereby reducing settlement time to zero correspondingly lowers credit risk and liquidity risk to zero. However, the risk reduction of RTGS systems is not cost-free as it requires participants to keep enough liquid assets on hand to be able to settle transactions in real time, which would tie up assets that could be used for other purposes. This concern is compounded when institutional investors need to separately ensure liquidity on numerous, distinct DLT platforms.
A reduction in the settlement cycle could also make financing securities more difficult, a practice that generates considerable market and economic activity. While this might be acceptable to a consensus of stakeholders, it’s a tradeoff that must be understood before decisions are made.
Finally, it’s important to remember that SEC rules require a securities transfer and the payment transfer to settle simultaneously, which, in turn, requires that the securities market and payment system interact.
Unless the Fed begins to issue tokenized dollars, and/or otherwise makes changes to its systems, a real-time gross settlement system will necessarily depend on some intermediary, typically a bank, which can interface with the platform to deliver U.S. dollars. That introduces new risks to the platform relating to funds held by the bank. Digital currencies may play a role, but any consideration of digital currencies, rather than government-issued currency, for payment would entail a very different risk profile. And in any case, ultimately users in the U.S. will want dollars for those digital tokens.
There are additional concerns and tradeoffs that must be considered with this nascent technology. Stakeholders, including policymakers, need to understand the benefits and pitfalls as DLT is adopted. The SEC Forum was an excellent opportunity to advance this discussion, and I look forward to continuing this conversation in the months ahead.