Will Blockchain Change Back Office Settlement?

Blockchain is the buzzword of the day with both incumbents and start-ups trying to develop use cases for the application. The banking world is rife with opportunities to streamline operations and provide better prices and/or speed for customers. Is back-office settlement one of those areas?

Satoshi Nakamoto, the mysterious creator(s) of the blockchain protocol set it up as a way to securely store and transfer the bitcoin cryptocurrency. Each bitcoin represents an asset.

It could be exchanged as a unit currency by itself, or it could represent something else (e.g., a contract, an option, a debt etc…) by embedding information within the block.

The blockchain distributed ledger has the theoretical beauty of being universally accessible, immutable and trusted. For the purpose of this article, we refer to both public distributed ledgers and private ledgers as “blockchain”.

Back Office Settlement

In the modern era, we have come to expect real-time everything. At least with consumer facing transactions we have become accustomed to an order being filled when it is made. Online trading, payments and transfers from a banking perspective have all given us a false sense of security.

What happens behind the scenes, away from the public is a bit more involved and can sometimes take several hours to several days to actually “settle”. When an investor buys or sells a security, the broker has to ensure:

  1. the security is available at the price bought/sold
  2. the client / house has enough money to clear the trade
  3. the ownership of the asset can be transferred to the right party

Most assets settle anywhere from one to three days AFTER the transaction. In other words, from the investor perspective, the instantaneous order is fiction…the transaction will be voided if the trade doesn’t settle properly.

By September 2017, the Securities and Exchange Commission (SEC) will change this settlement period to T+2, but this still seems like an eternity. Especially if you’re a retiree looking to cash out on securities. Why should you have to wait up to 2 days to get cash from liquidating a position? In fact, the China markets have same day settlement, so why can’t this happen in the US?

Playing the float

Part of the reason that same day settlement has yet to happen in US markets is due to inertia from vested interests. Cash is king and companies, more than consumers, like to take money in quickly, but take time to pay money out.

Brokers can take advantage of “the float” or the time between when obligations are due relative to when cash is coming in. Stretching this out is a good way to manage cash flow and free up capital for other activities.

Consumers who consistently pay their monthly balance do this with credit cards. They charge the card to fund activities in the current month and benefit from those expenses in the current month, but do not have to pay for those benefits until the bill comes due the following month.

Brokers currently have a huge incentive to keep the trade settlement window open for as long as possible. They can charge fees on idle cash held as margin.

Is blockchain relevant in this space

There is disagreement whether a generic distributed ledger application will work to overturn the back office settlement infrastructure. This is due to the fact that blockchain is a platform or protocol akin to VHS vs Betamax rather than a solution in and of itself.

For a system to replace the current back office settlement process, it would have to be universally adopted and interoperable.

If you have a VHS machine and the local movie rental place only stocks Betamax, you’re out of luck. In a similar way, the broker and counterparty have to be on the same system or at least have a way for the systems to communicate to allow for settlement.

In the case of the secondary debt market, investors currently play a similar game as brokers in the equity market. They benefit from the slow settlement process to earn income between the transaction and settlement date.

One could argue that the use case in the debt markets is more straight-forward than adoption in the equity markets. Value of debt is less volatile and in the case of the secondary market. It’s also a much larger addressable market than the equity market.

The debt market also dwarfs the public equity market in terms of size and trading volume. A 2011 estimate from McKinsey values total financial assets at USD225 trillion. Of that, nearly 80% are debt in the form of government bonds, corporate bonds and both securitized and unsecuritized loans.

Another critique of using blockchain to solve the settlement problem rests on whether we are using a public vs private blockchain. Tim Swanson of R3 Consortium points out public blockchains are still susceptible to proof-of-work or similar attacks and ledgers aren’t as unchangeable as marketed.

To be clear, a public ledger gives a probability that the value of the asset is x and it belongs to Joe Smith at time t. A private ledger gives a certainty. This difference between a probabilistic and certain outcome would be hugely important to investors, regulators and the public at-large.

A Possible View of The Future

Given the sheer size of the debt market, there is a possible paradox. Preston Byrne’s assertion that clearing and settlement is a poor use-case for blockchain could be valid while simultaneously allowing to scale and disrupt the space in a narrow niche.

Imagining the future isn’t easy. Forecasts are notorious for getting things wrong. Marc Andreessen famously predicted that 2014 would be the year of bitcoin. 2014 has come and gone, and we have not entered a new era.

While it does appear more frequently in Google search, the interest in bitcoin per se seems to have died down since 2014.

However, what has gotten more interest (and more importantly, investment dollars) are blockchain concepts. Again, think of bitcoin as VHS/Betamax and blockchain as recording technology. It’s the platform that is far more important than the specific application.

In Q1 2016, investment in blockchain finally overtook bitcoin.

As investment in blockchain platforms increases and more financial institutions collaborate, the most likely outcome will be a private blockchain solution to replace the existing back office settlement infrastructure. It’s anyone’s guess whether this is 5 or 10 years away, but it’s almost certain that it will happen.

Subscribe to our mailing list and we’ll send you a monthly digest of interesting articles straight to your inbox.