Blockchain Disrupts Securities Settlement Model

Could pilot projects involving the use of a distributed database for the issue, transfer and settlement of securities herald a wider rethink of the way financial market trades are recorded?

Central securities depositaries (CSDs) were a key post-war technological innovation in the securities markets and have supported the explosion in equity and bond trading witnessed during recent decades.

In the US equity market, following frequent bottlenecks during the late 1960s in the settlement of securities trades, CSDs smoothed the post-trade process for transferring share ownership by eliminating the exchange of paper certificates and recording transactions in central, computerised book-entry systems.

The international CSDs, Euroclear and Cedel (now Clearstream) played a similar role in the Eurobond market from the 1970s onwards, helping to simplify the process for the transfer of physical (bearer) debt securities.

In the last decade, especially following the failure of leading financial institutions during the 2008/09 crisis, CSDs have taken on system-wide importance as the primary means of ensuring safe and efficient securities settlement.

Via laws such as the European Central Securities Depositories Regulation (CSDR), the Settlement Finality Directive (SFD) and the Financial Collateral Arrangements Directive (FCAD), regulators have sought to set common requirements for securities settlement systems, enforce “dematerialisation” for securities, shorten settlement cycles and reduce systemic risk by defining the point at which settlement becomes “final”, thereby minimising the effect on a settlement system of the possible default of a market participant.

The central role of CSDs in the financial market infrastructure is also reinforced by the practice of settling securities trades in the books of CSDs in central bank money: in other words, the cash component of a securities transaction takes place via an account held by the CSD, or its client, at a central bank.

Now, however, some market participants are sponsoring initiatives in securities settlement that are the polar opposite of the CSD model. These pilot programmes rely on the technology behind the Bitcoin currency: a distributed database of transactions (called a “blockchain”) that removes the need for a centralised ledger.

In May 2015 US securities exchange Nasdaq announced that it would start using a blockchain-based technology for the issuance, transfer and management of private company securities. However, the exchange’s CEO made it clear that he has more ambitious plans in mind.

"Utilising the blockchain is a natural digital evolution for managing physical securities," said Bob Greifeld, CEO of the exchange, in a press release.

"Once you cut the apron strings of need for the physical, the opportunities we can envision blockchain providing stand to benefit not only our clients, but the broader global capital markets."

Nasdaq plans to build its new settlement process via a so-called “coloured coin” protocol, built on top of Bitcoin, the electronic currency first introduced in 2009.

Other major financial institutions have recently announced investments in Bitcoin-related ventures. In January this year the New York Stock Exchange said it had purchased a stake in Bitcoin wallet and trading platform Coinbase, while a Goldman Sachs-led consortium has bought into a separate company focused on consumer payments using Bitcoin.

Bitcoin is a decentralised, virtual currency used in peer-to-peer transactions. The currency is created as a reward for payment processing work by a subcategory of users called “miners”, who receive new bitcoins after having verified and recorded transactions in a shared ledger. This ledger, the “blockchain”, is updated every ten minutes, with all the miners in the blockchain network having a complete and agreed record of past bitcoin transactions.

As a store of value and means of payment, Bitcoin has so far met widespread scepticism: in particular, the currency’s exchange rate has seen major volatility, rocketing from 15 US dollars per bitcoin in early 2013 to over 1200 in December the same year, before declining dramatically. In 2015, the currency’s US dollar value has so far settled in the 200-300 range. There have also been repeated frauds at Bitcoin exchanges (where users convert bitcoins for fiat currencies, and vice versa).

However, by subdividing a bitcoin (the smallest amount of bitcoin is one “satoshi”, a hundred millionth of a bitcoin unit) and “colouring” it, users can use the currency in an entirely different way. Effectively, a Bitcoin user can pay a small notarial fee (in the form of a satoshi) and record property transactions in the blockchain on its recurring ten-minute cycle. For securities settlement, the attractions of such regular updates, as opposed to a complicated process of agreeing the terms of trades, followed by a wait for two- or three-day settlement at a CSD, seem obvious.

“The financial institutions who have looked at this technology closely are attracted by the way a distributed consensus can replace reconciliations,” Robert Sams, Founder and CEO at technology firm Clearmatics, told Thomas Murray IDS.

“Currently the financial system depends on messages passing through SWIFT and FIX, followed by multiple reconciliations, which are slow and expensive.”

The potential of Bitcoin’s blockchain to act as a base for large-scale securities transaction or financial payment processing is still largely untested: so far the average number of transactions across the network is still orders of magnitude lower than that typically handled by CSDs (in securities) or banks (in payments).

And not everyone sees the Bitcoin blockchain as the ideal infrastructure for securities settlement: Clearmatics’ Sams says that a different type of blockchain, with transparent legal entities acting as validators, is a better model than relying upon the anonymous verifiers (“miners”) involved in Bitcoin’s blockchain.

But even Bitcoin sceptics see the possibly revolutionary implications of the new technology.

“This is potentially a more important shift than the move to securities dematerialisation in the late 1960s,” argues Sams.