Blockchain Robinhood Series: 1. Understanding Blockchain applicability in Clearing & Settlement

You must be wondering why did I name this series as Blockchain Robinhood Series. Today a quick google search on Robinhood would give a dozen links talking about the popular Robinhood Financial Services company and I am definitely not referring them! Instead I am referring to the popular fictional hero Robinhood who used to steal from the rich and give it to the poor.

You must be still wondering why did I chose Robinhood name? I got into Blockchain about a one and half year ago and while doing in depth study and research about the various facets of Blockchain, I realized one thing that Blockchain has been suffering from a terrible marketing problem.In the last 3 to 4 years , we've had enterprise and government engagement in using decentralized technology, distributed ledgers, blockchains, and still we can see people making false promises. You see lots of 'Blockchain will do this'. 'Blockchain may transform that'. And on the other hand, you're also seeing the typical trough of disillusionment conversation saying blockchain is overhyped. It doesn't have its own killer app. It's never going to scale. It's never going to succeed. And the reality is, it's somewhere in the middle. And so far we have seen lots of great value creating opportunities where blockchain is one of many technologies has delivered value to the participants involved and the at the same time we've seen lots of examples where blockchain makes no sense whatsoever. So as a Blockchain Robinhood, I would want to help the people ( particularly from non technical background) to get more familiar with Blockchain use cases.:)

So Welcome to Blockchain Robinhood Series and through this series I aim to demystify blockchain with real-world examples for beginners and experts alike. This is the first article, in the series and I will try to explain the use case of blockchain applicability in Securities Clearing and Settlement in Financial Services.

So, let's first understand What is Clearing and settlement in first place?

Earlier the financial markets operated on a T+5 settlement cycle – trade date (day on which the transaction is done) plus five days to settlement. In 1995, U.S regulators reduced the settlement cycle from five business days to three business days (T +3). In 2017, after many years of a wide-reaching, extensive technology and operational effort – coordinated and harmonized across global markets and regulatory bodies – another day was removed from the settlement cycle. Today, the industry effectively completes settlement for trades in equities and certain debt securities on the second day after a trade is executed, T+2.

Whenever we purchase or sell stocks, the entire trade is completed online. For purchase transactions, money is debited from our account and we receive the shares and for sale transactions, shares are debited from your Demat account while the selling price is credited to our banking account.To ensure smooth operations and minimal risk, regulators have designed a trading cycle, as well as, a clearing and settlement process. The transaction cycle is 3 days. As an investor, we don’t need to get into the technical details of these processes. But its always good to have a high level understanding of the processes involved .Any transfer of financial instruments, such as stocks, in the primary or secondary markets involves 3 processes:

1. Trade Execution – This is where the buy or sell order is executed by us. This happens on the first day which I am going to refer as T-Day.
2. Clearing – Here is where the responsible entity identifies the number of shares that the seller owes and the amount of money that the buyer owes for every trade. It also determines the obligation of all parties and assesses risk. This is done on the Day 2 (T+1 Day.)
3. Settlement – Here is where the shares are moved from the seller’s account to the buyer’s account and the money is moved from the buyer to the seller. This is done on T+2 Day.

Fig : Capital Markets Today

All the above processes and systems are typically organized around a specialized third party, called the Central Securities Depository (CSD), which transfers legal ownerships of securities against payment. Still, many other intermediaries, such as brokers, custodians and payment agents, are involved in facilitating the clearing and settlement of a trade, making the settlement process rather time and cost intensive. As a consequence, settlement cycles in many fragmented securities markets tend to be fairly long and fixed at particular time intervals – such as T + 2 or even longer – to coordinate actions among intermediaries. The U.S. financial industry’s clearance and settlement model has evolved to be among the most cost-effective and efficient in the world. has been to help the industry mitigate risk and reduce cost in clearing and settlement by driving out operational and capital inefficiencies.

So What's the main risk today while dealing with securities trading?

The principal risk in securities markets is settlement risk, where the seller of a security fails to deliver the security while receiving payment or where the buyer of a security fails to deliver payment while receiving the security. To deal with such risk, securities settlement systems have been put in place in many markets to ensure a delivery versus payment (DvP) mechanism where the settlement of the cash and the securities leg in a trade are intrinsically linked.

How could Blockchain Technology improve current settlement arrangements? ( Key Benefits of using Blockchain)

1. Reduced Settlement Latency

An oft-cited benefit of applying Blockchain technology to a securities market which has adopted a multi-tier securities custody model is reduced settlement latency. This is mainly related to the nature of dispersed information in the trading process and the costs of reconciling this information, because many intermediaries operate back office systems that are incompatible with other financial market infrastructure.This leads to duplication of costs for record-keeping and often involves substantial costs for reconciling such records. However, while reducing settlement latency, it also reduces settlement risk, liquidity risk may well increase as netting possibilities reduce.

2. Enhanced Transparency in the entire Security Trading Custody Chain.

Use of Blockchain Technology would also encourage straight-through transparency of the chain of custody. In the current multi-tier holding system, investors and other intermediaries typically have access only to the account kept by the intermediary closest to them in the chain. The potential of the blockchain is to merge these silos of information into a single master record. This could, for example, be made fully transparent to the issuer and the CSD, and either fully or partially transparent to relevant regulators and intermediaries in the chain of custody. This could also provide investors with direct links to the issuer of a security, potentially facilitating the direct exercise of investor rights and actions with that issuer.

Reduced Custodian Risk :

In a traditional multi-tier holding model, investors are exposed to custody risk – the risk that one of the custodians in the chain fails – and also to errors in the reconciliation of securities at any point throughout the custody chain. The blockchain model, by obviating the need for reconciliation, and removing database redundancies, could materially reduce the magnitude of these risks. 

Furthermore, blockchain-based securities settlement could improve the functioning of markets that are too thin to warrant formal settlement arrangements. Examples are markets like private equity, where transactions are few and infrequent, or cross-border trading, where there are no common record-keeping systems in place. These markets are often dominated by financial institutions that provide expensive services that substitute for settlement systems. A viable threat from settling on a permissionless blockchain can reduce market power and thus can provide indirect costs savings for market participants.

Below is the comparison of various financial instruments existing today in the markets (current state vs Blockchain system) based on reduction in the settlement days:

Challenges - What's the Catch?`

1. Legal Certainty

One of the biggest unanswered questions for blockchain in capital markets is if a smart contracts solution can really replace clearing houses. Regulators will have to be convinced that an automated, decentralised blockchain could fulfil this role.Key regulatory questions will be:  

• In a distributed system, who should be held responsible for any operational failures in the blockchain?
• ? Where a mistake is spotted, how should it be rectified? 

2. Settlement Finality

Settlement finality is a conceptual construct often used in statutory, regulatory, and contractual literature. Finality of settlement ensures that transactions made over payment networks will, at some point, be complete and not subject to reversal even if the parties to the transaction go bankrupt or fail. It is the assurance that even in times of financial system uncertainty, turmoil, or crisis the transaction being undertaken will go through ((ECB, 2005; BIS, 2012).A blockchain-based securities settlement system would require to possess two key attributes: certainty and correctability.

Certainty of settlement incorporates two concepts: first whether, at a given point in time, a transaction can be considered final and irrevocable and, second, whether the transfer of securities against cash at the point of settlement is final and irreversible.

Another concept associated with settlement finality is ‘Correctability’ – in other words, how easy it is to reverse a transaction, either in response to a mistake or a regulatory or legal mandate.Recourse is another inherent problem of blockchain solutions. Once a blockchain-based transaction has been recorded in the ledger it cannot be rolled back. The immutability of blockchain records is one of the technology’s key strengths but there will be exceptions where transactions do need to be rolled back. This is only possible through a second, reverse transaction on the blockchain’s ledger and while a work around, isn’t ideal.This issue could be addressed in an agreement entered into by parties participating in the blockchain system which could, for example, provide for indemnification of parties verifying a fork reversing a transaction in respect of which they had no interest. In summary, it depends on the design of the blockchain protocol and whether a central authority would be present. Correctability, if needed, is a concept that can be included in such a protocol.

Conclusion- Advantages Too Good to Ignore :

Even with the political and regulatory resistance, the adoption of the blockchain technology for this particular use case has been moving forward. As understanding increases, decision makers will be coaxed into action by the following advantages:

1. Drastically reduced transaction costs
2. Near instant (real time) settlement and clearing
3. Easier Risk management
4. Increased Transparency & Higher Liquidity

Phew! That was a marathon! Thank you for having this journey! We together covered a lot of ground together in understanding How Blockchain promises to transform clearing and settlement process. Hope that this article would have given you a good starting point and would further prompt you to indulge in more study on this topic. Good Luck.

Should you have any thought, idea, feedback, suggestion or even a clarifying question, Lets start a conversation. I am reachable on  [email protected]

References :

1. Groww.in - Clearing-and-Settlement-Process-in-Stock-Market/
2. DTCC - Project ION Case Study
3. DLT in payment, clearing and settlement - Bank of International Settlements
4. Bank of Canada - Blockchain-Based Settlement for Asset Trading

5. Accenture-Blockchain Technology - Preparing for a Change.

6. Bobs Guide - BLockchain in Capital Markets - Benefits and Challenges

7. Medium - Settlement finality in DLT for digital securities.