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Will Blockchain Revolutionize Clearance and Settlement?

What Medieval Bankers Can Teach Us About Distributed Ledger Technology

Based on Greenwich Associates’ 2019 white paper:
Steampunk Settlement: Deploying Futuristic Technology to Achieve an Anachronistic Result

In the Beginning: From Ledger to Settlement

Today’s clearing and settlement system for securities trading evolved from double-entry ledgers invented in the 14^th century.

The ledger revolutionized trading in Europe, allowing multi-party transactions to occur over a span of time and across countries, to be recorded on one day in a central location.

Spurred by further innovations in 16^th century Venice, ledgers produced important effects to Europe’s legal and payments systems:

Creditors began to use ledgers as evidence in court to force debtors to pay.
Credits and debits for future payment became a medium of exchange, creating a system for moving money backwards and forwards through time.
The ability to pledge payments in the future greatly expanded access to credit.
Europe’s money supply was no longer limited by the physical amount of gold and silver circulating

Clearing the Books: The Pre-Electronic Version of DLT

Due to the number of parties involved, using ledger entries as a medium of exchange had its risks. In response, by the late 1500s European merchants created a way to “clear the books” – that is, reduce their aggregate outstanding credit.

At the end of market fairs across Europe, debtors and creditors with mutual obligations would pair off where possible to cancel their reciprocal debts. Merchants who couldin’t clear all their obligations in the first round would proceed to a multilateral stage where they resolved those remaining obligations through a series of “clearing cycles” and “clearing chains.”

Clearing cycle: 'A' owes 'B' 5 units, 'B' owes 'C' 5 units, and 'C' owes 'A' 5 units. Through netting, all three parties’ obligations are resolved.

Clearing chain: 'A' owes 'B' 10 units, and 'B' owes 'C' 10 units. 'B' removes itself from the chain by assigning its obligation such that 'A' pays 'C' 10 units.

Fast-forward to today: like DLT, these early clearing systems were multilateral and deployed a series of sequential algorithms meant to net and clear transactions.

Growing the Markets: From Decentralization to Central Clearing

Decentralized, multilateral clearing continued for more than 300 years at gatherings like the London Clearing Club, the London and Amsterdam stock exchanges, and the Chicago Board of Trade.

By the mid-1800s clearing started to become centralized, as trading volumes and the number of counterparties kept rising. For instance, the Frankfurt exchange in 1867 turned its membership into a mandatory clearing club that, through netting, reduced total obligations to be funded to 10% of the gross enabling huge growth in the markets per increases in trading. Accomplishments like this one built trust in the concept of a centralized solution.

New York, New York

Prior to 1892, every exchange of cash for shares on the New York Stock Exchange had to be paid in full, with cash or a loan secured by the shares acquired in the transaction. Using a messenger network, the shares were delivered within one business day.

Under this system, money markets and the banking system could be severely stressed during periods of market volatility and surging trade volumes.

In 1892 the NYSE created the New York Stock Exchange Clearing House (replaced in 1920 by the Stock Clearing Corporation), which net down obligations on a member by member and security by security basis.

What About the Stock Certificates?: Creating Today’s Clearing and Settlement System

While the NYSE’s Stock Clearing Corporation improved risk mitigation and efficiency, it didn’t address how securities certificates could be moved from the vaults of sellers to the buyers.

In the 1960s the U.S. securities industry, in partnership with regulators, resolved this issue by creating The Depository Trust Corporation (DTC), a central securities depository for the storage of all stock certificates traded in the U.S. market. Over time nearly all certificates were converted into electronic form, greatly streamlining trading processes.

Additionally, the NYSE’s Stock Clearing Corporation was merged with Amex and NASDAQ clearing functions, creating the National Securities Clearing Corporation (NSCC). This integration enabled multilateral netting across the entire U.S. equity market and further reduced the volume of payment and transfer activity. In 1999 DTC and NSCC were consolidated into The Depository Trust & Clearing Corporation (DTCC), enabling clearing and settlement to take place in a single, vertically integrated entity.

In today’s U.S. equity market, counterparties can trade into a position on one exchange and out of it on another, and both trades clear and settle through DTCC.

Applying Blockchain to the World of Finance

By permitting ledgers to be shared collectively and securely, DLT is a major advance in books and records technology, with these capabilities::

The ledger itself, which contain a history of all transactions, contract terms and programmable instructions, or “smart contracts,” to use for payment of coupons or automatic enforcement of exchanges within the ledger.
“Nodes” which are assigned various rights and tasks -- administrator, issuer, proposer, validator and auditor -- for generating the consensus that certifies the ledger.
Cryptography, employed to secure a DL and serve as a gatekeeper for access to the DL.
Tokenization, the digital representation of real-world assets within a DL, analogous to the dematerialization of share certificates within DTCC.

Simply put, in a DL’s nodal system, nodes can certify parties’ transactions as they are entered into the DL, reducing or eliminating the need for costly and time-consuming reconciliations. Nodes also let the DL be a golden data source for all members, reducing reconciliation to the individual books and records of member firms.

Can There Be a DLT Revolution?

DLT can bring significant record-keeping improvements to the securities industry, but can it do the same for clearing and settlement processes?

DLT “maximalists” propose that the technology could remake the settlement system by eliminating the need for central counterparties, thanks to the tokenization of assets and cryptographically-secured, self-enforcing contracts This would make settlement instantaneous, therefore abolishing the need to post collateral – freeing up capital that could be used for other purposes.

However, as revealed in the white paper by Greenwich Associates, DLT’s weaknesses at the payment and funding stages of settlement can undermine its potential for replacing the current system.

DLT – Bringing Clearance and Settlement Back to Medieval Times

Implementing DLT seems like it could be a big step forward for the financial market system – but actually it represents a gigantic step backward, according to Greenwich Associates.

DLT’s real-time settlement would mark a reversion to pre-1891 bilateral gross settlement, requiring that all transactions in the U.S. market be funded on a transaction-by-transaction basis, losing the liquidity and risk-mitigating benefits of today’s netting features.

Further, instantaneous settlement makes it impossible to fund trading on a secured basis, because it doesn’t allow traders to pledge shares they have yet to transact as collateral. What this means is that all trades using DLT must be prefunded, and on an unsecured basis. This would severely limit market liquidity – as medieval Venetians learned before correcting this shortcoming in the late 1500s.

DLT Settlement: Moving Forward or Turning Back the Clock?

DLT is capable of making the online records of securities transactions more secure and accessible than ever before – and the industry should seize the opportunity to utilize the technology for this purpose.

But DLT processes would have a disabling affect if applied to clearance and settlement, by forcing market participants to forego the long-established benefits of netting and risk margining. In essence, “DLT advocates arguing for the replacement of the current system are really arguing for the expensive deployment of futuristic technology in order to achieve a medieval result.” –Greenwich Associates

Read more about what 500 years of banking practices can help teach us about potential DLT applications in Greenwich Associates’ white paper, Steampunk Settlement: Deploying Futuristic Technology to Achieve an Anachronistic Result