In 2015, Santander predicted blockchain technology would drive a $15-$20bn (£11.8-£15.7bn) reduction in banks’ annual infrastructure costs by 2022. Now, three years on, the first commercial blockchain projects are beginning to realise this prediction — especially in financial markets.
The Australian Securities Exchange(ASX) became the one of the first global organisations to embrace distributed ledger tech: announcing plans late last year to replace its settlement system with a blockchain solution. The new system, scheduled to go live in 2020, will allow participants of the $2tn (£1.57tn) Australian cash equities market to settle in a shorter timeframe, reduce counterparty risk, and improve operational efficiency. It won’t be long until other markets follow suit.
Blockchain is poised to energise financial markets and there are a number of benefits tokenised 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 listing: the process of listing a stock on two or more exchanges with the aim to access greater liquidity. 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 Depositary (CSD).
The trouble with traditional systems
In short, 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. An example is 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 (small to medum-sized enterprises), which, ironically, are also the businesses most in need of the wider access to liquidity that this process brings.
Secondly, clearing and settlement is barely more streamlined today than it was more than 40 years ago. Back in the 1960s and 1970s, a paper crisis caused huge setbacks in settlement, where deals took five days to complete because transaction forms were delivered by mail or messenger. Fast-forward to 2018 and clearing and settlement is still a burdensome back-end procedure that takes two days in equities markets, and many more in other securities markets.
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 have to be manually confirmed by parties on both sides, it’s not unusual for errors to delay the process, adding further cost.
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. 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 and clearing and settlement.
1. Cross listing
By having a decentralised point of reference, containing all the security pricing information, multiple exchanges can more easily reference the same security. This process has been demonstrated successfully in the crypto currency world, where multiple crypto exchanges easily list the same tokens, where changes in transactions and pricing from all exchanges synchronise with the same decentralised ledger.
As the crypto world evolves and becomes mainstream, this process becomes cheaper and more accessible. Coupled with the right regulation, this will dramatically alter the landscape for SMEs seeking access to capital.
2. Clearing and settlement
The impact of blockchain on clearing and settlement is set to be even starker, potentially removing these stages of the securities trading process completely. By directly issuing securities in blockchain form and using crypto currency, a trading venue can publish immediate changes directly to the respective security and currency blockchains. This results in instant settlement and entirely eliminates the need for a CCP and CSD.
Smart contracts don’t require manual intervention as self-executable computer programmes set up the contract and continuously harmonise records. These programmes streamline deal management, minimise the risk of human error, and 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 in-built rules that align with financial regulations, reducing compliance overheads, and minimising risk to both issuers and investors.
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 allowing post-trade processes to come into the 21stCentury. Deals can be completed instantly, without intermediaries, streamlining and simplifying both capital raising and secondary market trading.
The foundations of the securities industry need to change to accommodate blockchain technology. In fact, the well-established rules and regulations are conducive to its success. Blockchain securities eliminate unnecessary bureaucracy and ignite the finance industry of the future.