The potential impact of blockchain technology on the financial markets

June 20, 2016

More experienced readers may recall the 14-day stockbroking account. Provided you bought and sold your shares during this period (and the price rose), you could get away without needing to part with hard cash and would just wait for a cheque for the differential to arrive from your broker.

If the account period expired and you wanted to continue to hold your shares, you then had a further 10-business day settlement period, in which to pay your broker for the shares and receive your paper share certificate. This settlement period allowed for the time it usually took for a courier to make the journey on horseback and by ship from the Amsterdam Stock Exchange to London. Most exchanges continued to use the same model for several hundred years.

With the advance of technology in the latter part of the 20th Century, most stock markets abandoned the 14-day account and adopted instead rolling delivery versus payment (DVP) settlement. Initially, stocks settled five days following trade date or T+5. However, with further technological development, this time-period has fallen from T+5 to T+3 and then in 2014 to T+2 in tandem with the European Commission's Central Securities Depositories Regulation.

Of course, in rapidly moving financial markets, much can still go wrong in a settlement period as short as two or three business days, as creditors of Lehman will testify. As a result, banks and brokerage houses invest millions of pounds evaluating operational, settlement and counterparty risk. At the same time, since the 2009 G20 Accords, we have witnessed an ongoing revolution in financial services law and regulation, in particular in the form of MiFID II, Dodd Frank, EMIR and MiFIR, much of which is aimed at reducing the systemic and operational risk, which at one point seemed on the verge of collapsing the global financial system.

The blockchain is a public ledger of Bitcoin transactions. What set it apart from other ledgers was its independence, security, speed of delivery and immutability. A network that belongs to everyone belongs to no one.

Whilst the Bitcoin blockchain continues to grow, we may now be on the cusp of a revolution in financial services technology as tech providers and financial market participants embrace the same technology that built the blockchain with a view to creating distributed ledger technology (DLT) capable of transforming the settlement, clearance and risk profile of financial markets transactions.

Unlike the Bitcoin blockchain, many of the newest DLT developments may be offered on closed or private basis, only to those firms who subscribe for or invest their services. We are seeing increasing investment in blockchains, which will support financial and commodity markets trading activities.

Private settlement DLT will potentially allow members to transact securities transactions on a T+0 basis, i.e. with minimal settlement and counterparty risk. It is hard to predict the effects this will have on the markets, as such technology is still quite embryonic. However, it is possible to envisage an era of minimal financial markets risk. This would enable banks and brokerage firms to trade with traditionally high-risk counterparties without the need for credit enhancement offered by prime-brokers and clearers. Higher credit limits could allow greater democratisation of financial markets as the barriers to entry fall.

As with most technology revolutions, the regulators are doing their best to keep up. However, for now, it seems that DLTs will need to fit in with the plethora of new regulation, designed to combat post the credit Crunch market and systemic risk. For example, under EMIR and MiFIR certain trades will need to be posted via Central Counterparties (CCPs). Similar to how big businesses adopted the internet and bought up tech firms in and around 2000, for now DLT operators may need to work with existing regulations and bodies such as CCPs, rather than compete with them. However, a time may come when one of the major exchanges acquires what is currently still a start-up for what seems a staggering amount of money, or failing that, is itself swallowed by a minnow of today. As with all revolutions, the future is unpredictable but certainly exciting.


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