We see Exchanges world wide, will look at transitioning from T+3 to T+2 settlement cycles sometime in the near future (2016).
Quite simply the move to T0, will lower the systemic risk for the market as a whole, via a reduction in liquidity demands, especially during periods of market volatility, while reducing the counter party risk for individual investors participants and the clearing houses..
I see the ASX, believes Australia will a world leader, if it can achieve T+2 clearing from march 2016 for cash equities, so lets start with these as they are the simplest to look at, but the same process can be applied to other instruments and markets.
This blog, looks at why T0 needs to be the objective solution, for Australia to just compete..
Anyone who thinks T0 settlement, is decades into the future, needs to take a look at systems like "bit shares" while this solution has some serious flaws and probably not commercially viable, it proves the point, its the change in the "state of mind" which is important. The mantra has to be the trade is the settlement, antiquated back office systems, must catch up with real-time trading front office systems.
Technologies exist today, which can fill the bit share gaps, without off chain entries, or dumping 20 years of operational experience.. but I digress into the technologies and this blog is not about technologies for technology sake, but rather about a vision and execution path to better harness, utilise capital world wide..
Why not T0?
When one looks at the "transition" strategies in place for T+3 to T+2, one see a whole wade of "legacy system" issues, herein lies the problem, just like the existing payments systems, these legacy security systems are not going anywhere any time soon. There is nothing new about this, these issues has been well known by anyone who developed and deploys systems for the last 40 years, its a fact we all live with, and the tried and tested solutions are still the same.. Lets take a look at the ASX for a moment, the T+2 solution will touch Chess, which is a batch process, see the similarities to BECS in the payments systems, there is a common thread here, old systems consuming significant resources, and limiting change. What was once a "barrier to entry", is today a ball and chain around the neck of the "incumbents".
Additionally it is obvious that if one does not fix the payment side, of settlement then we are all going nowhere, so lets start with a solution that integrates new payments system (real-time) with real-time trades and secure T0 settlement processing.
The problem "is" the legacy systems and the whole wade of processes and procedure which exist simply to support T+X clearing today, it is a self fulfilling system, which creates the problem in the first place,and then seeks to mitigate the risks associated with these introduced processes.
If it is "batch" or related to "cut off" times, it is a dodo, and is part of the problem, and will not be part of any T0 solution space, its this simple, the back office settlement systems need to match the front office trading systems, any artificial or introduced delays are the problem.
Why T0?
In a single word KISS..
Plus the financial imperative "Managing, clearing and settling trades costs the financial sector between $65 billion and $80 billion, according to figures from consultancy Oliver Wyman" .
But this is actually about market efficiency, and in particular the most efficient use of "capital" on a global scale, tying capital up in a inefficient process such as T+3 is simply no longer viable, if the risks can be reduced within T0 settlement. We see that "transparency" and regulatory costs associated with the current non-transparent process, can be addressed at the same time, resulting in a new "deal" for all.
Lets look a bit more at the problem..
- Trade Processing: trade processing activities including reference data, real-time trade matching, straight though processing and delivery of the "securities"
- Asset Servicing: stuff like ex-date, and cover/protect period computations for corporate actions
- Documentation: agreements and procedural stuff
- Regulatory issues: changes if any, to support T0 clearing and settlement.
Counter party risk
Counter party risk exists during the time between trade execution and settlement.
On the sell-side, the clearing member(s) assume the risk of counter party default and the clearing member is responsible for maintaining capital, in the form of risk-based margin requirements to be held in a clearing fund, to protect both its membership from this risk.
With T0, both the institutional and retail investors have reduced default exposure, by shortening the time between trade execution and settlement. Any decrease in counter party risk also results in a reduction in liquidity requirements for the participants, this is identical to the Payments World.
Hence the solution is pretty obvious, we will look at how tipple entry accounting combined with a Block Chain Ledgers, can be applied in the same manner as we do within the payments industry. It is a simple fact that an accounting ledger can process any asset today, the issue is how we can apply Block Chain Ledger Technologies as applied to payments to the securities world. The objective result is a highly scalable decentralised settlement system, which is integrated into the Block Chain Payments world to produce a fully integrated and atomic real-time settlement system.
In fact the solution proposed within this blog is a simple extension of the basic Block Chain Ledger solution for payments. The leap is a conceptual rather than technology one..
It is typically stated by the "established" entities that T1 and obviously T0 by extension will increase the complexity, we will show that moving directly to T0 will in fact simplify almost all elements of the solution, and hence T0 should be the objective solution.
The solution will be based on a completely independent and duplicated infrastructure, where legacy system will be deprecated and simply disappear over time. Trying to change existing legacy system has been rejected as a poor evolution strategy, and migration of the existing systems are simply too risky and costly to be seriously considered.
We also believe any migration of legacy systems is not in the interest of the Individual Investors or the global market. Note this solution is predicated on solving the global payments, including cross boarder issues, using identical technology sets, thus allowing a truly global solution, while addressing the audit, compliance, privacy and regulatory issues of sovereign states.
So lets start..
We begin at the point of Trade/OTC Trade capture, i.e. just after the Exchange order execution below.
Figure one: Proposed T+2 settlement processing.
Trade Funding: One of the key strategies is to link in the Payment->Block Chain Ledger, which supports real-time and atomic ( read finality) of payments including cross border payments.
When issued settlements, not we need to be careful that we are not overselling a T0 settlement solution, the scope has been initially limited, and there are areas when trades are conditional, i.e authorised but in fact not issued, such as stock splits ect, see starting point above, these types of trades will continue to take days or weeks..or even months in some cases for the foreseeable future.
The confirmation and affirmation process is an important component of trade processing and varies depending on whether a trade is executed on behalf of an institution or a prime broker. In both instances, after a trade is executed, it is allocated, confirmed and affirmed, and is sent for clearing and settlement, refer to figure one.
Asset Servicing, T0 impacts asset servicing functions, corporate action processing, compliance and reporting. This blog proposes that a specialist Trade-> Public Block Chain Ledger based on "participants" in the first instance, forms the basis of deriving all associated functions. This Public Block Chain Ledger, forms what has become known as the "golden record", and like the Payments Block Chain ledger, is executed atomically, as a decentralised Block Chain Ledger, this has the capability to process any number of translations, we expect each node to be capable of handling ~ 40,000 tps peak using commodity technologies.
New T0 Architecture
Firstly, lets move the existing centralised "congestion and failure" point in the existing system into a decentralised set of Block Chain Ledgers, then link these into a global virtual "Public Block Chain Ledger" after all these are just block chain secured accounting ledgers, nothing radical here.
As investors and issuers maintain a common and public "golden record" of ownership, asset and cash management are no longer separate or system specific, settlement and cash occurs 24*7 365 days a year on a continuous cycle across the globe. The real-time settlement between counter parties remove the need for capital intensive clearing processes.As a truly global set of decentralised Public Block Chain Ledgers, which navigated as a single virtual Block Chain Ledger, there is no single point of failure, plus due to the unique triple entry accounting process, each leg of the transaction can be completely reconstructed from scratch, from any of the two other Private Block Chains ledgers.
In addition, both institutional fund managers and hedge fund managers are facing pressure from their investors to provide more transparency into their operations, so that they can better understand the balance between risk and return, for the first time the Public Block Chain Ledgers provide this transparency in real-time.
If we look at the current situation (see figure to the right), there are a few boxes which simply cease to exist with T0, and integrated payments settling. There is no need for any "registries" as, the golden record is atomic, final and the single source for all parties.As both the Seller and Buyer have their own Private Block Chain Ledgers. the two custodians disappear, as does the custodian of custodians, the Central Securities Repository, looking good so far.
Given that the third leg of the Public Block Chain is the Exchange or Participant, does not really matter, the Clearing House(s) also disappear, finally a simple objective solution, the key is T0 gross settlement..
The "golden record" secured within the Public Block Chain Ledger, is atomic, final and the single source for all parties.
The Big Plus
All of this is interesting, as are all new technologies, but the big gains will not come from the improved gross settlement times, but the fact that this all works in the existing audit and compliance world, there is full support for AML and cross boarder issues,and all existing audits will continue to function,as this is just accounting ledgers.. There is simply no need, in a modern digital world, for any "net" settlements systems.
With access to timely and precise information ( the Block Chain Ledgers), coupled with the appropriate analysis tools, banks can perform a pre-trade optimisation assessment to give traders an accurate view of stock availability and the cost of the collateral associated with a derivative trade. Delivering collateral effectively can therefore have a profound impact on the trading desks’ efficiency, and allow banks to deliver a range of new services to market participants.
Derivative collateral optimisation, is just one area that banks can focus on, to reduce the impact of the inevitable post GFC, interest rate increases. In January last year, central securities depositories in Germany, Spain, Brazil, South Africa and Australia formed an alliance to tackle the expected global shortfall in collateral arising from new financial regulation. The Banks which grasp this challenge and harness their data effectively, in a fully transparent manner, will undoubtedly reap the benefits.
Some new ways to do traditional activities.
With as small twist to the crypto, one can now track, ownership, and lending of individual shares, and once and for all time stop naked short selling. Keys are close to zero incremental cost, so one simply splits up the trade from the entry point above and splits out individual keys and associated SINs for each share of the stock. This allows an owner to "lend" an individual or group of shares, via time standard time limited cryptographic "tokens" which cannot be sold, and close the market to any entity that cannot provide cryptographic proof of ownership.
Lets get real
All interesting stuff, but what can be actually done today, do we need yet another committee or "incubator"?
- Commercial Private Block Chain Ledgers exist today, the same technologies can be applied to any traditional double entry accounting system, not rocket science.
- A range of Specialist Public Block Chain ledgers are being developed, and the first preview of Payments and Trades with associated protocols already exist. Genesis blocks can be created at will by any existing institution such as banks and exchanges.
- The secure Global identification framework to under pin all payments, trades with full AML support is operational and available for free, yes a SIN can be a global Holder Identification Number..
- Secure 100% hardware backed, algorithm agile keys; under pin the security of the Public and Private Block Chain ledgers today..
- Turning Complete specification (BPEL4WS), to ensure integrity of settlement protocols.
- Via integrated payments Block Chain ledger, and orchestration can process multiple instruments and multiple currencies across multiple markets.
- Existing participant settlement and clearing systems need to process at least 1,000,000 trades per day, the Public Block Chain Ledger can process ~1 billion transactions per day per participant node.
The objective is technically possible today..
A strict simultaneous, irrevocable and final DVP settlement process this means there is no time gap between the cash leg settlement and the securities leg settlement, a truly atomic, cross block chain ledger transaction. Nonetheless, the entire DVP process may still technically be fragmented in a set of orchestrated sequential events.
The exist real-time settlement systems today such as Swiss CSD, SIX-SIS which settles in 4.12 seconds, the problem is this must be zero seconds, the transfer MUST be atomic, the transfer of the payment and security must be atomic any time delay will be exploited by increasing processing capabilities, this applies to all asset transfers contingent on a payment, not just security transfers.
A strict simultaneous, irrevocable and final DVP settlement process this means there is no time gap between the cash leg settlement and the securities leg settlement, a truly atomic, cross block chain ledger transaction. Nonetheless, the entire DVP process may still technically be fragmented in a set of orchestrated sequential events.
The exist real-time settlement systems today such as Swiss CSD, SIX-SIS which settles in 4.12 seconds, the problem is this must be zero seconds, the transfer MUST be atomic, the transfer of the payment and security must be atomic any time delay will be exploited by increasing processing capabilities, this applies to all asset transfers contingent on a payment, not just security transfers.
The real problem..
Thirteen years ago, the industry was examining a move to a T+1 settlement cycle. The initiative was abandoned as a result of competing priorities. While there is no debate that shortened cycles are in the best interests of investors, issuers and the global economy, the commercial reality is that a lot of money is made from the current inefficiencies,and the existing barriers to entry limit competition within the settlement, and registry area today. Many of the current participants have invested significant capital and resources in antiquated systems and mostly manual processes, and enjoy the benefits of significant capital reserves needed to keep the system operating. Change will not come easily, just because it is technically possible.. this mirrors the existing payments system situations.
The most likely catalyst for change is if one of the incumbents realises the opportunity these new generation systems can offer, change will then happen overnight, the new world of true competition.
The opportunity is now, who will blink first..
Also check out
The Global Block Chain Ledger, as a Payment System for the Digital World
Secure Global Digital Identity, for the Digital World
Identity Theft and Digital World
Global Public Block Chain Ledger Navigation
Postscript
Warning soapbox stuff..
Bitcoin, and other "consensus" based currencies are not suitable, as are off chain solutions.
For those that want the full story here, but the quick bits
- limited to 7 tps, variants of block size and off block transactions don't help.
- votes (proof of work) are based on MIPS alone, proof of stake variants do not actually help, all will eventually become centralised, conceptually flawed.
- no certainty of any transaction being included on any specific block, at any specific time.
- no AML support, or any other regulatory compliance or reporting, not even basic audit compliance.
- does not understand commercial realities and "trust", crypto is not equal to security or trust.
- cannot scale
- there is no actual security, needs mandatory HSM key protection at a minimum.
The "unbanked" and the securities world..
The issues realtign to the unbanked of the world also apply to the securities world, not only are the majority of the worlds population excluded from banking services, they are aslo excluded from the securities world and all of its services, the two are related. Witness the growth of crowd funding, this si the litums test theat the securities world has failed the world in the same way as banks have been unable to make a profit from the unbanked population.
Underpinning this blog is a vision of a world which is inclusive, and if the banks and exchanges of the world thought about it, creating a global economy where access to commerce and investment funds are globally available is good for everyone, its only a win-win situation.
In order to address the first barrier, a global secure identity (SIN) solution, which can meet the unbanked and yet have full AML support is now available, and can be accessed for free, anywhere any time across the planet. The global infrastructure is on-line and operational today, and can scale to support the entire population of the world. The SIN is under the control of the individual, and can be used in any system, payments or a Holder Identification Number across the globe.
Notes
1, Statement Regarding Proposals to Shorten the Trade Settlement Cycle by SEC.
2. T+2: Settlement Time
3. Reasons why T+1 was not considered as a valid option.
4. Japan moving ahead with migration to T + 1 settlement
Disclaimer The contents of this site should not be understood to be accounting, taxation, legal or investment advice but rather as general educational information that may or may not meet your specific requirements. This blog is not an offer for sale, but rather a catalyst for discussion on the topic.
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