When you buy a carton of milk at your friendly neighborhood grocery shop, the transaction is straightforward. You complete the payment. The shopkeeper hands over the milk in a bag. “Thank you for shopping with us today,” he says with a smile. You part ways, and there is no lingering uncertainty.

Buying shares in a company should also be simple, but it isn’t. At most public stock exchanges, there is a delay of two or more working days, known as the settlement period. Even though stock exchanges have been run on fully electronic systems for many years now, moving towards same-day or even next-day settlements has proven extremely difficult.

What is behind this delay is something known in the industry as the delivery-versus-payment problem. Before we can allow any securities trade to be settled or finalized, we must be sure that the seller has the securities to complete the delivery, and that the buyer has the funds to complete the payment. It is not unlike the milk-versus-cash transaction.

The complication arises because of the need to reconcile ledgers across various parties to the trade. There is the exchange, that would have matched the bid and ask orders which triggered the need to settle. There is the central depository, which is the custodian of the securities. It sometimes also acts as the clearinghouse or the central counterparty to the trade. Then there are the two brokers representing the buyer and the seller.

Each party maintains a ledger that tells you who owns what at the moment. Paul has 1,000 Tesla shares and $100,000, while John has 2,000 Facebook shares and $500,000, and so on. These ledgers have to be frequently revised, as new transactions are executed. Because there are multiple ledgers instead of a single ledger, cross-ledger reconciliation must also happen. This need to reconcile is a major reason for slow settlements.

The danger of system-wide meltdown

But why are slow settlements a cause for concern anyway? Most trades do end up settling, so traders aren’t typically worried about settlements. From the trader’s point of view, a trade is for all intents and purposes concluded as soon as it is matched by the exchange, and this matching tends to be near-instant.

That is the view of the issue at a very micro level. A zoomed-out, macro perspective yields a significantly different picture. First, as long as a trade remains outstanding and hasn’t been settled, somebody somewhere has to maintain collateral to guard against the theoretical possibility that the trade ends up not settling. This possibility is sometimes known as counterparty risk.

Often, the clearinghouse is the party that bears this risk and therefore has to hold enough collateral to cover outstanding unsettled transactions. But there is no free lunch, of course. The clearinghouse charges a fee for bearing this risk, a portion of which will eventually trickle down to traders, like a kind of insurance fee for the transaction.

A second danger lurks beneath the surface. When a financial crisis or liquidity crunch hits the markets, such as the crisis of 2008, the risk of widespread non-settlement can go through the roof. If multiple parties fail to settle, there could be a kind of domino effect that poses an existential threat to clearinghouses and could ultimately lead to a system-wide meltdown. In such an Armageddon-like scenario, having instant settlements versus two-working-day settlements might be the difference between survival and going bust for many.

Is there a way out of this conundrum? Given that reconciliation between multiple ledgers is the major culprit responsible for settlement inefficiency, a single ledger is the obvious response to the problem. In fact, the technology already exists. Blockchain or distributed ledger technology is able to maintain a single ledger through a network that all transacting entities take part in.

With blockchain, each participating agency can occupy a node in the network. When a transaction happens, all nodes concurrently verify the information and update the common ledger. This allows trades to be settled in a matter of minutes.

Private exchanges taking the lead

None of this is science fiction. Private securities exchanges like ADDX are already using blockchain technology in this way, and thus enabling same-day or even instant settlements. For regulatory reasons, many such exchanges use a private, permissioned blockchain and not the public blockchain, so as to attain a higher level of assurance on cybersecurity.

Private market exchanges have been quicker off the blocks compared to public exchanges in implementing the new technology in part because the private markets were even more inefficient in the past, with many processes still carried out manually. The relative gains were therefore larger. There was an open, white space that could be filled by the new distributed ledger technology, which now looks likely to become the default infrastructure for the private markets, given the current pace of adoption.

Public exchanges are studying the new development closely. The Australian Securities Exchange and the Deutsche Borse are both exploring the use of blockchain technology for settlements. This is on top of other applications of blockchain being looked at by public exchanges, such as e-voting by shareholders and securities transfers between exchanges.

For public stock exchanges, the biggest barriers to change are legacy systems and processes. These exchanges have historically invested billions of dollars into building their current infrastructure and technology platforms. The existing systems represent a huge improvement from a non-digital era, even if enhancements to settlement times have plateaued. Moving from the legacy system to a blockchain-powered one would require a bold decision to dismantle and write off large parts of the existing machinery.

An idea whose time has come

In the meantime, as blockchain continues to spread in the private markets, the technology will extend its track record. The resulting efficiency will also prompt some capital to shift from the public markets to the private markets, as transaction costs fall in the latter. This poses a commercial threat to the public markets and may drive them to consider the new technology more seriously.

Either way, the brave new world of instant settlements for securities trading is upon us and will over time occupy a larger share of the overall market. It is an idea and a technology whose time has come.

Like the friendly neighborhood grocer selling us milk, exchanges and clearinghouses will one day be able to look us in the eye with a smile, saying: “Thank you for trading and settling with us today.”

And we will detect no lingering uncertainty in their voice.

Manuel Jaeger is Co-Founder and Head of Product at ADDX, a digital securities exchange.

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