Utility Settlement Coins – the race to T+0?

You may have seen the recent announcement that UBS, Deutshe Bank, BNY Mellon, Santander and ICAP are working on a “Utility Settlement Coin”, based on Blockchain technology. If you’ve read our blogs or tweets before then you’ll know that we love Blockchain technology. The utility settlement coin concept sounds like it could be potentially a great opportunity, but there are a few big barriers to entry before you’ll see it fundamentally changing the way settlements are performed, and we’ll explore some of these in this blog article.

Firstly here is a primer on the end to end settlement process. The settlement process is described as post trade, in a typical equity trade the transaction lifecycle is as follows; A financial market participant would generally place an order through a broker, with an instruction to buy or sell shares in a company, the broker would execute the trade through an exchange or market venue, interacting with another broker at the other end of the trade (eg: one party is always buying and the other is always selling), once a trade is executed (there may be multiple ‘trade fills’ at different prices), the trades are matched, the exchange clears the transactions between both brokers and then finally a settlement instruction occurs. Settlement is typically the exchange of currency for shares (in a buy trade) or shares for currency (in a sell trade). On most equity markets settlement typically occurs on a T+2 or 3 basis, which means that it happens two or three days after the date of the transaction occurring. If you’re not familiar with financial markets then you’ll probably ask “why so long after?” and the only true answer is that its simply current market practice, however it also enables the market participants to prepare all activities in preparation for settlement, such as organising payment (which may involve a prior transaction).

In the Blockchain world there has been much discussion about whats being referred to as “the race to T+0", essentially bringing forward settlement times from T+2 or 3 days to the day of trade. So what would the settlement process look like with a “utility settlement coin”? Well at a high level what this would mean is that the exchange of assets (stocks, bonds, really anything tradable) would need to switch from being an exchange of a tradition currency (eg: US Dollars, Euro’s) to an exchange for this new utility coin. Why would this beneficial? Well in financial markets there is a key risk that is always present, which is described as settlement risk. Essentially what this means is that cash is either not available, or delivered late at the time when settlement is scheduled then this can lead to overdraft payments / charges being made on the settlement account. Some markets help mitigate this risk by enforcing “pre-funding”, which means that a broker needs to confirm prior to execution that the client has the required cash in their trading account to execute the trade, this isn’t that popular for investors as its not a consistent market practice and its typically often difficult to know pre-trade how much cash will be required for settlement pre-trade (as the execution price has not yet been struck) and the investor may also typically trade with more than one broker, and need to have cash sitting in many accounts.

Lets compare the concept of a utility settlement coin to bitcoin, most people by now would have heard that theory that the true innovation of bitcoin is that it solves the “double spend” problem of digital currencies, as the blockchain it runs on is immutable this means that a bitcoin can only be spent once (or technically its key only owned by one party) across the entire bitcoin blockchain. This would enable near real-time (i’ll say near real time as it takes a while to execute a bitcoin transaction) settlement of a transaction in BTC, and the same theory would be the case with a utility settlement coin, however there is obviously one big differences between the world of bitcoin and financial markets, being that when companies issue stocks or bonds, they are always denominated in a traditional physical currency (eg: USD, Euro, GBP) not a utility settlement coin! It is not uncommon for companies to issue multiple classes of shares, and to list in multiple currencies or exchanges (ie: American & Global Depository Receipts), but they would typically do this to open up opportunities for foreign investment (eg: a Russian company listing on the NYSE), not to make it easier for investors to settle transactions. So whilst the full details of the utility settlement coin have not yet been publicly revealed, there would really only be two options;

1: Companies to reissue their shares / bonds in a utility settlement coin (this could even be Bitcoin)

2: Have some kind of agreed exchange rate between the utility settlement coin and the actual currency of settlement

Both of these options have some big barriers to entry; option one would benefit the financial market participants, but it really wouldn’t benefit the companies who are issuing securities. Companies issue securities to raise capital or debt, and they do this to fund other activities. They would then most likely need to exchange the utility settlement coin for physical currency, which would expose them to currency risk and would most likely not be very popular. The second option has more challenges, whilst its great that UBS, BNY, Santander, Deutsche and ICAP are working on standards, the reality is that they are one five parties out of millions of financial market participants. Banks, brokers, custodians are the parties who settle transactions on behalf of their clients (ie: retail or institutional investors), proprietary trading by banks is in decline. So this would mean that their clients would be the ones who would be required to hold the utility settlement coin, and as you can imagine this could further complicate the process as there would first need to be a transaction from a traditional currency into the settlement coin. This may eventually become future market practice, but there appears to be much more to it!

So at this stage more questions than answers, but good to see some innovation in progress!

Thanks for reading

FinSaaS.io