Distributed Ledgers Part II: Clearing, Settlements & Legal frameworks
"At his best, man is the noblest of animals; separated from law and justice he is the worst." Aristotle.
I pointed to the difficulty the bitcoin blockchain has in providing clearing and settlement value in the financial services industry in a previous post, see here. This post expands upon my previous assertion.
No one will dispute that the technology supporting clearing and settlements in the financial services industry is antiquated. Few if any will argue the international legal framework that rules the clearing and settlement of securities is not working. Actually, the legal regime ruling the securities markets globally is fairly well harmonized and is the way that it is for good reasons. Therein lies the complexity of applying crypto solutions to clearing and settlements: how to replace the thing that needs replacing (the technology) whilst working within the thing that isn't broken (the legal regime).
Securities settlement deals with the the ownership transfer of a property title from a seller to a buyer once a trade has been completed between seller and buyer on an exchange. The legal intricacies wrapped around a "property" are eminently more complex than with cash. Settlement is not as simple as going through the motions of a multi sig process on a blockchain. At any point during or after settlement there could be third party claims to the property transferred, such as a private or government lien, a collateralization agreement. The transferee needs to know that the property is his free and clear of third party claims.
This is, amongst other things, why securities settlement work under an intermediated regime where the intermediating agent performs tasks that assure free and clear ownership. Central Securities Depositories - CSD that are international such as DTCC, the Depositary Trust & Clearing Company, Euroclear, Clearstream, or that are national - and Central CounterParties - CCP and in some cases the CSD is the CCP as with DTCC - perform some of the tasks and interact with custodians who perform the accounting tasks which record settlements. Picture a tree-like structure where custodians roll up to CCPs and ultimately to CSDs.
These intermediaries cannot easily be disintermediated by a technology solution such as a distributed ledger, even though a distributed ledger may be more efficient at processing transactions than the current technologies used. The issue is entirely legal. The legal framework in place harmonizes within jurisdictions and across jurisdictions. The legal framework is incompatible with a technology where unknown actors would settle transactions, where the transaction settled would represent a security exogenous to the technology and where the technology could not deliver 100% of ownership. Hence, the bitcoin blockchain is not compatible with securities clearing and settlement in the financial services industry.
At this stage I will make a distinction between dematerialized securities. Equities, bonds, derivatives that are "public" in nature, and those that are "private". The shares in a privately held company are not dematerialized. Private securities are another matter entirely. As a VC investor, Route 66 goes to great lengths to write appropriate reps and warranties and indemnification clauses in case a third party claims the shares purchased when investing in a startup. With private securities there is no finality of settlement, ever, and the bitcoin blockchain may be of use - see the pilot Nasdaq is working on with its private companies marketplace and Chain.com.
Back to dematerialized securities where finality of settlement is a requirement. If the bitcoin blockchain is not the solution, then what is? Distributed ledger technologies that are permissioned, where known actors do known and defined things, which have a certain grade of decentralization but are not as decentralized as a full peer to peer network. Distributed ledger technologies which have decentralized validation but authenticated and governed validators - the network topology remaining peer to peer. Distributed ledger technologies that will work with the current legal framework rather than ignore or displace it. Distributed ledger technologies that will focus on the accounting plumbings and escrow like functions of payment and delivery where there is no need for an intermediary and which will vastly reduce the interval of time between trade and settlement while reducing the cost of transacting a financial contract.
Thanks for sharing your views Pascal. My first question is : I am convinced that the stake is to know who is the owner of which amount of securities. And we all know that’s the actual job of the custodians. With blockchains and a distributed ledger, it will be more complex to keep a track of this ownership. However, when people are currently buying (mostly forbidden!) things with bitcoins on darknet, the algorithm is able to make the link between the seller and the buyer and transfer credit from one account to the other. Could it be replicable to securities buys/sells ? If such thing would be replicable to custodians and banks, this will announce the death of the dinosaurs… My second question is about the constant volume of bitcoins exchanged. Couldn't it be a limit for buy/sell flows, especially when the market go crazy?
Founding Partner
9 年Great context to cut through a lot of the hype. In as much as the legal and technical framework internationally for securities ownership is a solved (albeit at times suboptimal) problem, OTC to me seems like an area where legal frameworks are complex and bilateral and possibly a more interesting application of the technology.
Co-Founder at Silver 8
9 年Pascal, thanks for sharing your views. Quick comment: I find the fundamental problem is that of first defining and then enforcing "ownership" or "property". In BTC, the definition of "ownership" is given by access to a private key: if you have it you own it (how you get that access to a private key is irrelevant); the process is binary and does not allow for disputes (either you own it or you don't), therefore, the whole legal system seems not to play any role. As the mantra states: there is no need for any third party. Is that really the case? In my view, the legal system still plays a role: we cannot simply forget that modern society is based on the recognition of rights and obligations and the enforcement of procedures to sort out disputes. Is a record in the blockchain enough for a legal recognition of ownership? As of today, it is not, not even for btc (pls, correct me if I'm wrong). Thus, strictly speaking, not even btc is a digital asset! It'll be interesting to see how courts rule on cases where the evidence of ownership is a blockchain record and a private key. Property rights are the base of capitalism, we all know, but notice the word "rights", rights are guaranteed by the existence of a third party: the legal system. Capitalism does not work in a vacuum, it requires freedom and law, both. I guess my point is that in the domain of ownership and transfer of value, there is always a third party involved. For this technology to take off, both frameworks, technology and legal, will have to adapt. It will just happen. Having said that, and besides the long list of relevant concerns that you point out, the invention of a means to transfer ownership digitally is absolutely fascinating. One does not need to be a visionary to realise that the implications could be enormous. Now, one other question altogether is how to sort out the problems, how to figure out the applications and how to participate in these developments. Bitcoin is very complex, it has many angles: politics, economics, technology and business considerations, all interacting. I don't think anybody can anticipate its evolution, but I also think you don't need anticipate it to benefit from it. In my view, Bitcoin is far from dead, it is just being born.
Building tools to help Product and Engineering teams scale more effectively with AI
9 年Pure distributed ledgers are technically impressive but we (PeerNova) concluded they were challenging from a regulatory perspective for far too many applications. The trick is to make a permissioned ledger keep the immutability characteristics of a decentralised one.