How Smart Contracts for Finance Will Make Stock Markets Faster, Cheaper and Less Error-Prone

This is the first in a series of posts looking at projects aimed at using smart contracts to solve real, pervasive, urgent problems. In my previous post, Three Ways That Smart Contracts Will Change the Way You Do Business, I gave an overview of smart contracts and I how they will transform business.

In this series, I’ll be reviewing projects applying smart contracts to different industries. This first post focuses on finance, and specifically using smart contracts to manage buying and selling securities.

How Smart Contracts Will?/Might?/Could? Make the Stock Market Faster, Cheaper, and Less Error-Prone, aka The “Securities Settlement” Problem

Every day in the United States there are over one million stock transactions, ranging in size from the individual investor in Dallas putting some of her savings into Amazon stock, to a huge pension fund selling millions of shares to rebalance its portfolio. Every one of these stock transactions, large and small, involves numerous steps — largely invisible to the rest of us — and handoffs between multiple players, including the buyer’s broker, the seller’s broker, the clearinghouse, and the transfer agent.

Most of the time, these players get along, the handoffs between them happen smoothly, and the transaction is settled without issue. But given the sheer volume involved, mistakes happen, and, human nature being what it is, fingers get pointed.

When a mistake in a trade happens, someone loses money. And given the amount of money involved — 1.5 Quadrillion Dollars last year (and don’t feel bad because I had to look that up too, that’s 1,500 trillion dollars) — even when problems rarely occur, these problems can still mean big losses. Losses mean potential liability for each of the players, so it’s not surprising that, each player keeps its own records of each transaction. And because the players do not entirely trust each other, they have to engage in a fairly laborious process of reconciling their various records against each other.

As explained by FinTech Network, a business intelligence provider, these costs have led many in the industry to explore whether smart contracts could handle some of the heavy lifting, thus reducing costs, errors, and settlement time:

Smart contracts can take over the onerous administrative task of managing approvals between participants, calculating trade settlement amounts and then transferring the funds automatically once the transaction embedded within the smart contract has been verified and approved.

(Fintech Network, Smart Contracts — From Ethereum to Potential Banking Use Cases, October 10, 2017)

The Many Steps from Share Seller to Share Buyer

We tend to take for granted that if we are buying a share of stock, we’ll wind up with the share we ordered or, if we are selling a share, that we’ll wind up with the cash in our account. It’s just like ordering a movie from a streaming service, or turning on the hot water in the shower. It just happens.

The point of settlement is:

to provide the buyer with irrevocable delivery of a security from the seller at or very near the precise moment when the seller receives final and irrevocable payment for it from the buyer.

(Group of 30, Global Clearing and Settlement, A Plan of Action, 2003)

That word “irrevocable” is the key. The buyer who just bought shares wants to know that she owns them, end of story. The same for the seller who just sold, who wants to know that the money is in his bank account, end of story. Neither wants to bear any risk that there was some problem in the transaction.

In other words, as Richard Gendal Brown, CTO of R3, explained in a fantastically helpful piece, A Simple Explanation of How Shares Move Around the Securities Settlement System, the buyer and the seller do not want to take on any operational risk that the trade gets bungled up somehow. Note that, by definition, both are taking on some version of market risk, i.e. that the shares will go up or down in value. But, in an ideal universe, where the settlement process is perfect, the market risk is the only risk that they are each taking on:

Ideally, if you buy shares in MegaCorp, the only risks you want to be exposed to are those associated with MegaCorp itself, realized through changes in share price or dividend payments. So, the ideal state is when you just face this market risk.

“Irrevocable” 100% guarantees, where this is no operational risk, where there are no mistakes anywhere in the process, don’t come easy or cheap. Especially when there are multiple steps in the process, with multiple handoffs, from the purchaser to the purchaser’s broker to the stock exchange, to the purchaser’s custodian, to the clearing house, and then there’s the seller’s custodian, and the seller’s broker, and the seller. And I forgot to mention the transfer agent, the market makers, and the central securities depository.

A full treatment of all the steps in this process, and the handoffs, and all the players is way beyond the scope of what I can cover here, but the important thing to understand is (1) that there are multiple steps in the process of settling every sale of securities (2) different players handle different steps and they all have to coordinate with each other and (3) this coordination is expensive, in part because it is aimed at, as much as possible, eliminating the risk of errors.

For those curious to understand the nuts and bolts, I highly recommend the aforementioned Richard Gendal Brown post does a great job explaining the issues behind settlement and all the players involved and what they do.

Why Stock Trade Settlement Is A Candidate for Smart Contracts

As explained by John Ream, Yang Chu, David Schatsky of the consultancy Deloitte, Smart Contracts are likely to be used first in “applications in which contracts are narrow, objective, and mechanical, with straightforward clauses and clearly defined outcomes” (Deloitte Insights, Upgrading blockchains: Smart contract use cases in industry, June 8, 2016)

Stock settlement looks like a promising candidate for application of smart contracts because:

  1. The terms of each contract can be, without too much trouble, formally specified. Specify the identity of the buyer, the identity of the seller, the specific shares, the price, and the time and date of the transaction. In theory, that’s it. There are no “I’ll know it when I see it” terms, such, e.g. “at the end of the lease, tenant will deliver the premises to landlord in the same condition as at the start of the lease reasonable wear and tear excepted.”
  2. By design, contracts for the sale of securities are supposed to execute quickly, and therefore there is less likelihood that circumstances will change in the interim; and
  3. Under the current system, the parties don’t entirely trust each other, so they engage in costly and labor-intensive procedures to verify each other’s performance, i.e. keeping track of each transaction and reconciling their records with each other, and they could therefore save money if they could trust the smart contract to track all this.

Measuring the Potential Impact of Smart Contracts

Pragmatic Marketing, a product management training firm, offers three questions to ask when evaluating the potential impact of a new application: (1) is the problem urgent? (2) is the problem pervasive, i.e. is there a large enough group of potential buyers? and (3) will these potential buyers be willing to pay for a solution? (Pragmatic Marketing, Tuned In Process: Six simple, yet powerful steps to create products, services or ideas that resonate)

Let’s examine each of these three questions in some detail.

How Urgent is this problem of clearing and settling securities trades?

Settlement Fails

When a trade does not go through, this is known a Settlement Fail.

According to a 2011 report by the European Central Bank, given the lack of uniform standards and methods for tracking settlement fails, it is hard to determine the scope of trade settlement fails, but, the ECB notes, settlement fails can create several problems. First, of course neither party gets the benefit of its bargained for price. Second, either party can wind up in a liquidity crunch, when the seller doesn’t get the money it was expecting, or the buyer doesn’t get the shares that it might have been planning immediately to re-sell. Third, failures can create more systemic problems, as for example, when those who lend securities are reluctant to do so because of concerns about settlement failures.

(European Central Bank, Settlement fails — Report on securities settlement systems measures, April 2011)

Trade Breaks and Manual Reconciliation Costs

Slightly less severe than a complete settlement fail is a trade break. A “trade break” refers to a situation where a trade cannot be completed due to discrepancies between records concerning the trade instructions between buyer’s and the seller’s orders. According to Ignatius John, President of Alpha Omega Financial Systems, generally, a trade break requires expensive and laborious manual reconciliation to prevent a full on settlement fail:

Trade breaks are extremely disruptive to the post-trade process, resulting in unnecessary cost, manual intervention and a race to meet settlement deadlines

(Ignatius John, Trade Break Pain — Feeling Unsettled?, October 5, 2015).

While hard numbers on trade breaks are difficult to come by, a report by Goldman Sachs estimates that “roughly 10% of trading volume requires some manual intervention” and that this accounts for approximately $1.4B in costs across the entire US Securities Industry (Goldman Sachs Group, “Blockchain: Putting Theory into Practice,” May 24, 2016, at 47–48).

As Martin Walker explained in a report for enterprise blockchain software firm R3 “investment banks are more focused than ever on attempting to increase profitability by cutting operating costs” and are thus particularly open to considering new ideas such as smart contracts:

“Noise” or “friction” has other indirect costs in addition to the labour costs of paying people to fix problems. It needs more layers of control. In a fragmented, “noisy” infrastructure, those layers of bolted-on (rather than integrated) controls can become another source of noise and error. All the resulting complexity becomes progressively more expensive to run (and to change) because the quality of data required to make the right decisions deteriorates as it becomes more dependent on people and interpretation.

(Martin Walker, Bridging the Gap Between Investment Banking Architecture and Distributed Ledgers, April 2018).

Pressure to speed up settlement

The costs and urgency noted above is likely to increase due to industry pressure to speed up the settlement process. In March of 2017, the United States Securities and Exchange Commission put in place the new “T+2” rules requiring that all trades must settle within two days of execution. For more details on the changes required to implement this new standard, see the 2015 report Shortening the Settlement Cycle: The Move to T+2 by consultancy PricewaterhouseCoopers. Note that in Europe, T+2 was implemented several years earlier, in 2014.

How pervasive is the problem of clearing and settling securities trades?

The DTCC is the organization that handles most of the trades in the United States, last year they processed 345 million transactions worth 1.5 quadrillion dollars. That Dr. Seuss sounding number, is about one and a half million billion dollars. Alternatively, since Jeff Bezos’s net worth is about 150 Billion, then 1.5 quadrillion would be a thousand times that much. If you had 1.5 quadrillion dollars you would have 1,000 times as much money as Jeff Bezos.

The volume is so mind bogglingly big that even when mistakes a very rare, they are still a problem. If a serious mistake happens in one in a million transactions then you’d still expect to see about one serious mistake per day.

Will anyone be willing to pay for a better solution?

According to an estimate by Goldman Sachs, switching to Smart Contracts on a distributed ledger could save the industry over two billion dollars per year in reduced costs and reduced capital requirements. (Goldman Sachs Group, “Blockchain: Putting Theory into Practice,” May 24, 2016, at 47–48).

Given the potential savings involved, it’s no wonder that the major players are open to exploring smart contracts. Several exchanges around the world have already launched projects to use smart contracts for settlement.

In Part II, we’ll examine several of these projects currently in the works.

Thanks

Thanks to Chris Wilson and Vanessa Davis for many helpful comments on an earlier draft of this post.