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Bitcoin in the Back Office: Applications in Securities Settlement

Introduction

Securities settlement refers to the process between the time a trade is made and the time a security is actually delivered to the counterparty. This unglamorous piece sits at the core of the entire financial industry and makes all trading and settlement of obligations possible. Just last year, the DTCC (Depository Trust & Clearing Corporation), the central securities depository in the US, cleared over $1.7 quadrillion worth of securities, from mortgage-backed securities to over the counter derivatives.

The settlement process can be fragmented based on the type of security – the settlement system for a publicly traded stock is very different from that of a collateralized loan obligation. They also operate in different legal and regulatory frameworks, making the process even more challenging.

The central securities depositories (CSDs) were born as a response to centralized settlement systems, and operate mostly through book-entry as opposed to physical delivery. Indeed, DTC in the United States was conceived after surging trade volume in the stock market in the 1960s caused a paperwork crisis on Wall Street. DTC merged with National Securities Clearing Corporation (NSCC) to form the current day DTCC. European counterparts like Euroclear and Clearstream work in a similar fashion by centralizing clearing. The systems built then are still in use today to settle trades on a variety of instruments. Each country usually has its own CSD where securities domiciled in that country are settled.

Even though the current securities clearing process via CSDs seems to be getting the job done, there are many inefficiencies in the system that end up costing investors, directly or indirectly, billions of dollars a year. The current centralized clearing systems have a high barrier to entry , making it difficult for firms without significant capital to enter the space and innovate. In addition, the system cuts off those at the bottom of the pyramid from access to most of the financial space. A more efficient settlement system is central to making the entire financial industry more fair and inclusive. Bitcoin (or another blockchain based solution) could provide for precisely that type of a system.

How CSDs Work, and Their Challenges

Before CSDs were adopted by all the financial institutions, the way stocks settled was simple: at the end of the day, the financial institutions netted all the trades of their clients and physically moved paper stock certificates from one institution to another. For example, if at the end of the day, on a net basis, the clients of Goldman Sachs bought 1 million more shares of IBM than they sold to JP Morgan, then someone from J.P. Morgan will carry stock certificates representing 1 million shares of IBM from the vault of J.P. Morgan to the vault of Goldman Sachs. That was essentially how stocks settled.

It is not hard to see how such a settlement process would be plagued by scalability and other issues like loss or theft, and indeed, the system was soon replaced by central clearing systems. A central clearing system meant, essentially, that the two vaults would not sit in the J.P. Morgan and Goldman Sachs buildings but in one central place. In addition, instead of moving paper certificates from one vault to another, CSDs used a book-entry system instead.

Even though the CSDs were fairly revolutionary back in the day and solved many problems with paper certificates, their form hasn’t changed much in the last 40 years. They have struggled to keep up with the complexity of financial instruments being traded, and they haven’t evolved fast enough to represent the current needs of the financial industry.

There are some notable drawbacks to the whole system of CSDs. For example, it is almost impossible for a CSD to hold a security belonging to another country. The DTCC in the United States cannot handle multiple currencies and foreign securities. In order to own foreign stocks, investors either need to go through a global custodian that has accounts at various different CSDs or buy receipts like American Depository Receipts (ADRs). Both these options are quite expensive and limiting.

The settlement process is also cumbersome. For stocks today, settlement happens two business days after the trade. Other financial instruments can take longer. Collateralized loan obligation (CLO) securities can take weeks to settle, even after the DTCC automated a lot of the processes in 2008. This requires heavy use of man-power and reconciliation systems.

The Blockchain Solution

At the heart of settlement lies the problem of reconciliation. CSDs, by being centralized ledger keepers, are better at reconciliation than individual banks reconciling their books in pairs. All the entities of a CSD have to be in agreement with respect to the trades that occurred, the instruments that traded, the cash flows that were received and promised, and many other data points surrounding each financial instrument.

The Bitcoin blockchain, a record of who owns what, introduced the idea of a distributed group of untrustworthy peers being in agreement as to the current state of a database. This is a powerful idea, since normally such a trust is established through existing connections and/or backed by the legal system. With this backbone, Bitcoin established the first truly digital and decentralized currency system.

Blockchains provide a write-only database that is owned by no single entity but is trusted by all the participating entities. The problem with traditional databases is that they are siloed within an organization and any data that flows out of them cannot be automatically trusted by another organization. Such data needs to be reconciled against the receiving firm’s own records. In the securities world, the CSD is the ultimate authority on the final holdings, but the data needs to be reconciled against the internal databases of each of the participating institutions.

Blockchains solve this problem at once, since there is really no need to run a reconciliation process; by the nature of a blockchain, all participating entities agree to the state of the database at each point in time. Therefore, if there is one Universal Blockchain that says Bank X holds 100 million shares of Apple, then all participating entities agree to this number, and there is no further need to reconcile this number with any other records. In addition, client records can also be automatically reconciled (depending on the privacy level, they might be encrypted) automatically against trades, or on a net basis at the end of each trading day, depending on the trading frequency.

Bitcoin or Blockchain – A Matter of Trust

Bitcoin demonstrated how to achieve these goals using a blockchain. The central idea behind Bitcoin is that two sources can still trust a decentralized database without trusting each other. In general, it is possible to establish trust outside the blockchain in the “real world” through legal and regulatory mechanisms. In those cases, it might be more efficient to run a private blockchain which can eliminate proof of work completely.

A nice hybrid approach could be regular ‘pegging’ to the Bitcoin blockchain through a hash of the blockchain at specified snapshots. Factom, for instance, does this once every Bitcoin block, so that whatever data may be produced in the Factom blockchain, it is taken as a hash and added as a single transaction in the Bitcoin blockchain, thus ensuring that no one could retroactively change the Factom blockchain. This ensures that it would be impossible to reverse data in the private blockchain beyond the last update in the Bitcoin blockchain, without double-spending on the Bitcoin blockchain – a considerably harder thing to accomplish than double-spending on a private blockchain.

Establishing Smart Contracts

In addition to creating decentralized write-only databases with an auditable history, the other innovation in this space is the creation of smart contracts – a computer program that executes the terms of the contract automatically based on predetermined criteria.

A blockchain-based solution to securities settlement will encode the securities and cash through tokens. Corporate actions, such as dividend payments or stock splits would be encoded within the blockchain in the form of smart contracts. This eliminates another major process in the back office today by automating these actions that happen to securities after they are issued.

Take dividend payments for instance. An issuer, with its private key (or a financial intermediary working as a proxy for the issuer) will declare a dividend and set parameters like amount, currency, payment date, etc. This payment will be automatically handled in the blockchain, and everyone holding on to a token of the stock, will receive additional tokens corresponding to these dividends. This is all public, verifiable, auditable and incorruptible. A spinoff would be similar, except instead of sending tokens of currency, the investors would receive tokens of shares representing the new company.

When blockchains are coupled with powerful smart contracts, not only does it make the existing system obsolete, it also enables many new forms of trading and finance, not limited by decades-old technology and prohibitive costs. It may also be possible to realize the holy grail of back office: the trade is the settlement.

Regulatory Gains

A blockchain based settlement system would use digital tokens to represent everything from Apple stock to US Dollars and smart contracts to automate capital market rules. There is still a need for the existing financial, legal and regulatory systems. The major difference, however, would be transparency in the capital markets. The data becomes more transparent not just for the financial institutions but also the regulators. Regulators can easily monitor and track everything from short-trading activity to capital reserves to repos. Market manipulating events will be much harder to pull off. All this at a lower cost to both the regulators and the financial institutions.

In addition to ensuring transparency in the capital markets, regulators will be able to create rules that are based on smart contracts. For instance, over a certain period of time, regulators might decide to make short-selling illegal in certain issues. Today, complying with such a decree is a tall order. In a blockchain-based system, however, such a rule can go into effect at any given point in time, and if a trade seems to violate this rule, it can be stopped from settling in the first place. This especially applies to markets like the futures market that has programmable rules defining the behavior of the market.

Photo Credit: John St. John Photography

1 Comment

July 03, 2017 at 11:00 am, EMILIA Villa said:

I can’t get in to my account through back office login, please help me.

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