Distributed Ledgers Part II: Clearing, Settlements and Legal frameworksTags: bitcoin, blockchain, clearing, distributed ledgers, settlement
“At his best, man is the noblest of animals; separated from law and justice he is the worst.” Aristotle.
I pointed to the difficulty the bitcoin blockchain has in providing clearing and settlement value in the financial services industry in a previous post, see here. This post expands upon my previous assertion.
No one will dispute that the technology supporting clearing and settlements in the financial services industry is antiquated. Few if any will argue the international legal framework that rules the clearing and settlement of securities is not working. Actually, the legal regime ruling the securities markets globally is fairly well harmonized and is the way that it is for good reasons. Therein lies the complexity of applying crypto solutions to clearing and settlements: how to replace the thing that needs replacing (the technology) whilst working within the thing that isn’t broken (the legal regime).
Securities settlement deals with the the ownership transfer of a property title from a seller to a buyer once a trade has been completed between seller and buyer on an exchange. The legal intricacies wrapped around a “property” are eminently more complex than with cash. Settlement is not as simple as going through the motions of a multi sig process on a blockchain. At any point during or after settlement there could be third party claims to the property transferred, such as a private or government lien, a collateralization agreement. The transferee needs to know that the property is his free and clear of third party claims.
This is, amongst other things, why securities settlement work under an intermediated regime where the intermediating agent performs tasks that assure free and clear ownership. Central Securities Depositories – CSD that are international such as DTCC, the Depositary Trust & Clearing Company, Euroclear, Clearstream, or that are national – and Central CounterParties – CCP and in some cases the CSD is the CCP as with DTCC – perform some of the tasks and interact with custodians who perform the accounting tasks which record settlements. Picture a tree-like structure where custodians roll up to CCPs and ultimately to CSDs.
These intermediaries cannot easily be disintermediated by a technology solution such as a distributed ledger, even though a distributed ledger may be more efficient at processing transactions than the current technologies used. The issue is entirely legal. The legal framework in place harmonizes within jurisdictions and across jurisdictions. The legal framework is incompatible with a technology where unknown actors would settle transactions, where the transaction settled would represent a security exogenous to the technology and where the technology could not deliver 100% of ownership. Hence, the bitcoin blockchain is not compatible with securities clearing and settlement in the financial services industry.
At this stage I will make a distinction between dematerialized securities. Equities, bonds, derivatives that are “public” in nature, and those that are “private”. The shares in a privately held company are not dematerialized. Private securities are another matter entirely. As a VC investor, Route 66 goes to great lengths to write appropriate reps and warranties and indemnification clauses in case a third party claims the shares purchased when investing in a startup. With private securities there is no finality of settlement, ever, and the bitcoin blockchain may be of use – see the pilot Nasdaq is working on with its private companies marketplace and Chain.com.
Back to dematerialized securities where finality of settlement is a requirement. If the bitcoin blockchain is not the solution, then what is? Distributed ledger technologies that are permissioned, where known actors do known and defined things, which have a certain grade of decentralization but are not as decentralized as a full peer to peer network. Distributed ledger technologies which have decentralized validation but authenticated and governed validators – the network topology remaining peer to peer. Distributed ledger technologies that will work with the current legal framework rather than ignore or displace it. Distributed ledger technologies that will focus on the accounting plumbings and escrow like functions of payment and delivery where there is no need for an intermediary and which will vastly reduce the interval of time between trade and settlement while reducing the cost of transacting a financial contract.