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Disrupting Finance: How Blockchain Can Streamline Capital Markets

This article explores how blockchain is disrupting finance and streamlining capital markets across the securities’ life cycle, from trade execution to post-settlement.
Distributed ledger technology (DLT) has been touted as the most promising technological innovation since the internet. Blockchain technology, perhaps the best-known example of distributed ledger technologies, has the potential to disrupt a wide range of industries and sectors. Moving away from the notoriety of extremely volatile cryptocurrencies, there is significant interest within the financial industry in exploring the use cases of the underlying technology towards the securities markets in a bid to enhance market efficiency.

Market Potential

Securities trading represents a core function of the capital markets and is a reflection of a country’s economy. Billions of dollars trade hands on a daily basis globally, with the United States capturing a sizeable market share of trading.

On the New York Stock Exchange (NYSE) alone, more than $50 billion worth of securities is electronically traded on a daily basis.

On a global scale, there are more than 60 major stock exchanges with a combined total value of over $69 trillion.

The strategic importance of securities trading represents a tremendous opportunity for new technologies in disrupting finance and more importantly, enhance the efficacy of public marketplaces, especially in the wake of increasing digitalization.
Based on reports from Goldman Sachs, DLT could eliminate transaction costs relating to underwritings by $2 to $4 billion annually in the USA alone.

An analysis by a consortium led by Anthemis Group, Banco Santander, and Oliver Wyman found that DLT could significantly reduce financial institutions’ infrastructure costs – pertaining to cross-border remittances and securities trading – to the tune of close to $20 billion annually.

The World Economic Forum (WEF) went a step further and estimated that up to 10% of the value of global GDP will be stored on the blockchain by 2027. All these studies suggest a deepening interest in the exploration of DLT.

Current Clearing & Settlement Process

The securities trade cycle consists of 3 vital features:

  1. Execution: Transaction whereby the seller agrees to sell and the buyer agrees to buy a security.
  2. Clearing: The process of updating the accounts of the trading parties and arranging for the transfer of money and securities.
  3. Settlement: This refers to the actual exchange of funds and securities between the parties of a trade on the settlement date after agreeing earlier on the trade. This entails the accurate and timely transfer of securities to the buyer and funds to the seller.
Within the scope of the cycle, there are numerous functions executed by specialized intermediaries to facilitate the execution, clearing, and settlement of securities.

The complexities of the functions within each cycle and the cumulative centralization involved in the execution of these functions reinforce the need for all participants to have total trust in the institutions involved in facilitating the full-functioning of the capital markets.

For every security that is traded, the following intermediaries are present:
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  1. Stock Exchange: The central point where buyers and sellers converge to trade.
  2. Buyer’s Broker: An institution that sources the best deal for the buyer and executes the trade in an agency capacity.
  3. Seller’s Broker: An institution that sources the best deal for the seller and executes the trade in an agency capacity.
  4. Market Maker: Liquidity providers that create a market by quoting both sides of the market using their own accounts.
  5. Custodians: Entities that safeguard the share certificate of the buyer and perform accounting, book-keeping, reporting, and security functions.
  6. Clearing Houses: Entities that orchestrate the clearing and settlement functions, as well as assuming the role of a central counterparty in the transaction to mitigate against counterparty risks from the buyer and seller.
  7. Registrar: Entities that work on behalf of the company (of which its shares are traded) by maintaining a registrar of shareholders and updating it after each transaction. They are also responsible for managing and paying out the dividends to shareholders.
  8. Central Securities Depository: Known as the “Custodians of the Custodians”, CSDs are trusted third parties that mediates the accounts between the seller’s custodian and the buyer’s custodian, ensuring a single system of records for all custodians.
The traditional market cycle for securities trading involves numerous layers of intermediaries that each perform a specific function that is each compensated for their work.

This means that each layer of intermediary takes a certain portion of value in the form of fees charged to the end-user.

It is obvious that current transactions are manually intensive, relies on multiple intermediaries, and involves multiple data sets that constantly need to be reconciled.

The firewalls between each intermediary entail independent databases and necessitate the origin of several intermediary functions.

The alternative is even worse, where a single entity assumes several functions within the trade cycle, thereby dominating the trading ‘vertical’.

This leads to massive centralization that requires absolute trust on the part of participants in the system.
Fun Fact: In the USA, almost all publicly-traded equities and bonds are owned by Cede & Co., the nominee of Depository Trust & Clearing Corporation (DTC), which is the largest securities depositary in the world. In the pursuit of efficiency, a critical tradeoff is that holders own beneficial ownership of a security instead of actual ownership. This means that at any time, the securities anyone ‘owns’ does not have ‘trueownership’ in a legal sense.

Disrupting Finance & Capital Markets Using Blockchain

Blockchain could have a huge role in disrupting finance and disintermediate the current trade cycle by introducing transparency and efficiency.

Public blockchains are fully transparent and are censorship-resistant, with each transaction immutably recorded in a unified public ledger managed by global participants.

Real-time verification of asset ownership and fund availability allows for streamlined transactional operations within the capital markets.
The distributed nature of blockchains ensures that data is synchronized across multiple stakeholders, which facilitates tamper-proof records of the clearing and settlement process that is instantly available to all participants.

More importantly, this eliminates the security risk of a single point of failure.
Blockchain could also aid in the following technical processes:

  1. Reduction in Reconciliation: Having a unified public ledger maintained by a global userbase eliminates redundant and manually-intensive reconciliation between various intermediaries in the current trade cycle process. This could even open up the potential for automated clearing and settlement that significantly enhances efficiency.
  2. Cost Removal: Blockchain disintermediates the securities cycle by removing the need for multiple intermediaries. A public and unified ledger remove the costs and fees that are charged by intermediaries, resulting in the reduction of the overall costs between participants. The absence of value removal would optimize value across the board.
  3. Transparent & Real-Time Settlement: With a single database and transparent validation of transactions, it reduces the capital expenditure of financial infrastructure systems and simplifies the process. With greater transparency in transaction handling, the trust would be removed from the system and there will be a greater degree of automation which would enhance real-time settlements.

Blockchain Development in Securities Trading

Developments in the securities trading ecosystem have been rampant, with several projects and proof-of-concepts exploring the viability of disrupting finance and integrating blockchain technology to manage financial transactions.

Several prominent examples include:
  • The Australian Securities Exchange (ASE) has signed an MOU with Digital Asset and VMware to pioneer post-trading solutions in Australia and New Zealand, specifically in addressing ASX’s equity clearing and settlement process.
  • Nasdaq launched its own private securities issuance platform that is based on blockchain technology in 2015. Linq leverages a private blockchain to facilitate the insurance, cataloging, and recording of shares of privately-held companies on the NASDAQ Private Market.
  • A new European central securities depository (CSD) backed by blockchain technology called ID2S was launched in the second quarter of 2019. ID2s is the first CSD in Europe to offer a real-time settlement of investment and financing transactions for the money markets in central bank currency. It was developed to facilitate the issuance, trading, and settlement for custody paper.
  • The Canadian Securities Exchange (CSE) developed a blockchain-based securities clearing and settlement platform that allows firms to issue equity and fixed income securities for their business via a security token offering (STO).

Conclusion

The application of blockchain in disrupting finance and the capital markets is truly an appealing proposition that is validated by key players in the industry developing solutions to streamline their operations.

The numerous functions and intermediaries involved in the traditional process results in a value-extracting environment both in terms of resources and fees, that could be better optimized through a unified and transparent database.

Blockchain has the ability to remove the need for trust in the system and eliminate various intermediary roles that could significantly enhance efficiency and reduce costs tremendously.

Not only that, this emerging technology could yield substantial economic cost savings in the wider financial industry due to the reduction of back-office costs tied to manual reconciliation of conflicting trade data.
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