Let’s Settle Down
Quicker settlement times within the financial system are a thrilling concept, but change will start small and private.
What if I told you that if you placed a security trade, security settlement would almost exactly match when your exposure began? In other words, settlement of the actual trade would be nearly instantaneous.
Woah, goosebumps? Well, if you work in investment management, you are probably on the edge of your seat.
For asset management institutions, the process of matching cash flows, equity sales, mutual fund applications, ETF trades, and FX transactions is a continuous and sometimes chaotic process. It is also a painful one. Everyday billions of dollars are locked up in our capital system as players from main street participants to multi-billion-dollar fund managers wait for instructions to work their way through the global financial plumbing. Settlement is just that. The actual movement of cash or ownership once a trade has been placed. You buy stock? That’s great, but you don’t get to actually walk out of the store with it. You’re not going to have actual ownership for two days. You purchase into a mutual fund? Awesome, but you don’t actually own shares in that fund until tomorrow.
Now, the average retail investor might not totally care about such things, but professional traders and institutional players definitely do. One trade might be a simple game of waiting, but there are a whole host of challenges that apply at scale. Reallocating exposure is a common example. Moving holdings from U.S. markets into British markets takes time and effort. In volatile and fast-moving market conditions this could mean massive lost returns for clients, most of whom include retired individuals or pensioners.
Cumulative risk during this time is also massive. It’s clear why. Say you purchased $100 million of product from some numeric address with no face and no name. You would want to get that product as soon as possible right? Every day you are waiting, there is the chance for something to go wrong. A market to break, a war to start or a company to collapse. Ideally, the money is paid and shares change hand immediately. Now, there are custodian banks that help address this problem amongst investment companies, but that is a stopgap in a wider problem.
Finally, settlement matters from a “working money” perspective. Ideally, capital is used efficiently. What that means is that it is helping to facilitate trade, provide liquidity and ensure business can be conducted fairly and easily. While cash is pending settlement, this is often not possible. It is not invested, it is not being utilized. Investment companies lose returns and everybody who is helped by a functioning capital system receives fewer net benefits.
The solution? You guessed it, an unchangeable ledger. A blockchain.
In this chain, smart contracts are coded to auto-execute settlement instructions in real-time, complete with participant verification. Created correctly, settlement would be automatic, and cash/securities could change hands instantaneously. Settlement failures would be avoided except if certain criteria were not met (e.g., insufficient funds, not holding the security in the first place) and the market would become a much more liquid, better-greased machine.
This is a good thing. However, when we discuss this problem, it is from an almost unimaginable scope. We are talking numbers beyond comprehension big. Too many markets, governed by too many regulations in too many countries for any individual to understand.
There have been a number of articles released that talk about the New York Stock Exchange (NYSE) switching to T+0 settlement. This will not happen. At least not before other major markets have already switched. The risk is too great. In addition, as noted by research conducted at the University of Pennsylvania Carey Law School under Professor David Hoffman, “Current custody methods and centralized securities holdings are designed to protect against adviser theft, misappropriation, or inadvertent loss of assets. But it is unclear whether a custodian of crypto assets will be able to mitigate against adviser fraud given the practical difficulty of truly securing bearer instruments like private keys. An investment adviser who wants to transfer crypto assets out of custody may so and then abscond with the assets no matter how robust the security measures were while the asset was under the custodian’s supervision.”
For major public institutions, this change is a long way away. Instead, where it will start is small and private. Institution to institution chains governing less liquid settlements in more niche, specialty contracts. Think of a particular conditional bond payment between HSBC and Morgan Stanley. If certain rate conditions are met, HSBC will automatically wire payments to Morgan Stanley. This will be governed by the blockchain. Because this would be a private transaction, certain legal considerations would not need to be considered.
Other examples could include more private transactions governed on Ethereum. The smart contracts need not even necessarily define monetary transfers but execute automatic indicators that could be enacted upon outside of the blockchain system to build trust.
Through time, institutions will rely more and more on these automatic executions to run core business processes. Especially, as businesses weave these processes into existing stacks, utilizing services such as Metcy’s Validation API to ensure a real-time ability to check contract data and validate ownership will be key. This will help provide confidence in the construction of newer, blockchain-based tools.
