FinS đ˛ for the Soul (27 Sep 2021): DTCC's new DLT-based equity trade settlement system
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Latest headline:
DTCC begins development of a DLT-based trade settlement system
Background:
The Depository Trust and Clearing Corporation (DTCC), a U.S.-based post-trade financial services firm, is to move into the development phase of its prototype settlement platform built on distributed ledger technology (DLT). Dubbed Project Ion, the initiative could support the industry-wide movement to shorten the equity trade settlement cycle from two days (T+2) to one day (T+1), or even support same-day or instantaneous settlement (T+0).
The platform is slated for launch in the first quarter of 2022. It will support bilateral deliver order transactions and serve as a parallel book and infrastructure for such transactions. An authoritative record of transactions will continue to be held by Depository Trust Company (DTC), a subsidiary of DTCC.
Project Ion opens the possibility for cryptocurrencies and other digitised assets to be integrated in the future, and efficiencies in trade reconciliation to be realised.
Balancing the need for speed with resilience in the financial system.
Same-day settlement is not a new capability. DTCCâs National Securities Clearing Corporation (NSCC), the equities clearing subsidiary and DTC can clear and settle transactions on the same day (T+0) a trade is executed. This is supported in some cases, but in a relatively smaller quantum due to legacy operational industry processes and market convention.
Shortening the trade settlement cycle can decrease margin requirements, increase capital efficiencies, and reduce counterparty and market risk. Recent events have created a greater impetus for an accelerated trade cycle. In January, the 1,600% surge in share prices of GameStop resulted in a $3B margin request posted by DTCC. This forced the retail trading platform Robinhood to halt purchases in GameStop and other stocks to cover its clearing margin, to the ire of its investors.
DTCC has disclosed that an average of $13.4B is held in margin every day to manage risk in the trading system. The organisation found that its margin can be decreased by 41% by moving to a T+1 settlement. This would help to release trapped liquidity and increase capital efficiency for borrowers and lenders. With a shorter time frame, the risk of unpredictable events affecting the transfer of cash and securities is also reduced.
Speed is not everything. A move to shorten the trade settlement beyond T+1 to instantaneous settlement comes with its own set of problems. Currently, the end-of-day multilateral netting process at NSCC reduces the value of payments that need to be exchanged by an average of 98% or more. For instance, if 100,000 shares were bought through a broker, and 98,000 shares were subsequently sold to a different investor on the same day, the same broker would only need to settle 2,000 shares overall at the end of the day.
NSCC typically processes an average of $1.7T in equity transactions on a typical trading day, with $38B in total value settled at the end of each trading day. Real-time gross settlement will eliminate the liquidity and risk-mitigating advantages of current netting features. All transactions will need to be pre-funded on an unsecured basis and thereby increase the difficulties of arranging for financing and the number of failed transactions.
Moreover, equity settlement is presently performed multilaterally through the DTCC, which acts as the counter-party between the two sides of a trade and guarantees the settlement of remaining obligations. In a bilateral trade settlement that the DLT-based system will provide for, there is no intermediary. Parties can exchange securities and cash at the same time directly without a central counter-party. The loss of trade guaranty by a central clearing party would similarly need to be mitigated by the pre-positioning of securities and cash in lieu of a guarantee.
The need for interoperability.
Project Ionâs platform will be designed to be seamlessly interoperable with the classic settlement platforms at The Depository Trust Company (DTC). Interoperability refers to the basic ability of different systems to readily connect and exchange information with one another without the use of middleware for translation.
For two or more systems to be interoperable, they must be able to exchange, interpret, and present shared data in a way that is understood by the other. This involves adopting a common data format and common data structure protocols, and the addition of metadata that links each data element to a controlled, shared vocabulary. Within this shared vocabulary is a data model that represents a set of concepts within a domain and the relationships among those concepts.
In 2018, DTCC started testing its updated credit derivatives Trade Information Warehouse (TIW) that uses DLT. The current version, created in collaboration with IBM, Axoni, and R3, is responsible for processing $10T of cleared and bilateral derivatives. Since then, there has been no public news on this initiative.
Moving accounts in DTCCâs TIW to a customised digital shared ledger will create a single view of the movement of securities and cash and further reduce the amount of reconciliation required. The DTCC warehouse keeps an electronic âgolden recordâ of events such as maturity dates, payment calculations, and other activities needed to clear and settle these securities daily.
Unfortunately, each participant in a securities transaction also keeps its own records in its accounting and collateral management systems. These records need to be reconciled multiple times before the transaction is settled. By moving those records to the blockchain that is visible to all participants in real-time, most of those redundancies would be unnecessary. This will result in the elimination of layers of databases and translations between those databases.
In addition, the current landscape of multiple DLT providers creates fragmentation in the clearing and settlement process that may introduce operational friction. Corporates have tended towards adopting âpermissionedâ DLT networks with a gatekeeper that allows or denies participation in a private network. Axoniâs AxCore and others like Paxos run on different permissioned versions of the ethereum blockchain. Enabling communication between these networks with an inter-blockchain protocol will unify all industry players within a single digital ecosystem.
Other implementation issues require consideration.
Any technology implemented must meet the industry standard of handling two to three times the current market peak volume of 25,000 transactions per second to complement existing systems. Despite enormous progress, the throughput rates (i.e., maximum transactions that can be created and endorsed in a given time window) on the blockchain continue to pose a limitation to the thorough implementation of the technology.
Furthermore, the blockchain solution will need to straddle the virtual and real worlds in providing a feasible settlement solution. DTC was spun out of the New York Stock Exchange in 1973. It was established to custodise and process an overwhelming amount of paper share certificates that often led to settlement failures due to late deliveries and loss of certificates.
While most certificates have been âdematerialisedâ through recording them in an electronic format, one percent of its share certificate inventory representing $780B is still held in paper form in the DTC vault as of 2020. Tokenisation â the digital representation of assets, such as securities on a blockchain, can assist in the dematerialisation of share certificates and reduce the need for time-consuming reconciliation.
Conclusion:
A major reaction to the GameStop situation by regulators and industry players has been a call for shorter settlement times. DTCC has responded to these calls for action with a proposal to orchestrate an industry-wide move towards a T+1 settlement by 2023.
Blockchain technology will undergird a more transparent shared ledger and enable better record keeping. In the absence of its adoption, other operational industry processes can be adjusted to achieve accelerated trade settlement.
The continued maturation of the DLT technology will serve to support the digitisation of the physical certificate inventory, a widening number of use cases, and increased trade volumes.
Despite the above benefits of using DLT to reduce the margin posted with the central clearing party, one has to be mindful of the reduced flexibility in financing resulting from real-time bilateral trade settlement. Failing to consider the ensuing reduction in leverage may ironically disincentivize trading and curtail the flow of capital within the financial markets.
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