Using Distributed Ledger Technology for Post-trade Processes

Using Distributed Ledger Technology for Post-trade Processes

We explore the role that Distributed Ledger Technology (DLT) can play in handling the issuance of securities and post-trade processing, after a transaction is agreed.

Introduction

The markets for securities are some of the largest and most liquid in the world. For example, the size of the bond market in 2021 was around $128tn.1 The sheer size of daily transactions implies that even small gains in efficiency when issuing and transacting securities can have a very big positive impact in absolute terms. The main bottleneck in achieving efficiencies is in handling the post-trade process.

When a trade is agreed between a seller and a buyer, the transaction is finalised only after certain post-trade processes are complete. These include verifying the details of the transaction and approving it, updating ownership records and arranging the exchange of the securities and cash. Post-trade processing is often slow, especially if it is paper-based and/or involves traders in different jurisdictions. For example, trading a simple stock in the US typically takes two working days to settle (T+2). Distributed Ledger Technology (DLT) has the potential to make the process much faster via automation, and more efficient by removing any intermediaries. However, the technology is still new and there are several challenges, which we discuss in this note.

Issuance and Handling of Securities

Incorporating distributed ledgers in the issuance and handling of securities can take a variety of forms. 

In model 1, shown in Figure 1 below, securities are issued as digital assets that are native to the ledger. As there is no physical representation, all transactions are initiated and finalised on the distributed ledger, thus fully automating post-trade processes. Custody and safekeeping of assets can only occur within the distributed ledger, either directly by the owner who keeps the private keys, or through an intermediary. An example of such a platform is LiquidShare, a private blockchain network for the issuance, holding and transfer of digitally native securities. Settlement occurs in real-time and is facilitated by tokens which are backed by fiat currency (i.e. stablecoins).

Figure 1: Model 1 – Securities Issues as Native Digital Assets

 

 Source: “The use of DLT in post-trade processes”, European Central Bank.2

Securities can also be issued physically, using the traditional system, but certain events of their life cycle are recorded on the distributed ledger. Depending on how the traditional (physical) system interoperates with the digital one, we have three subcases. 

In model 2a, shown in Figure 2, the traditional system records all the events of the security’s life cycle, but custody activities and settlement take place in the distributed ledger. Interoperability between the two systems is needed because activities in the distributed ledger are then recorded in the traditional system, hence there is a one-way information flow from the distributed ledger to the traditional system.

Figure 2: Model 2a (one-way) – Securities Recorded in a Conventional System and Migrated to a DLT based Solution

 


Source: “The use of DLT in post-trade processes”, European Central Bank.2

In model 2b, shown in Figure 3, there is a two-way information flow, as events in the traditional system trigger an updating of the distributed ledger and vice versa. Although securities are issued and recorded in the traditional system, custody and settlement are performed in both systems, that need to be in a constant sync to avoid any errors or arbitrage opportunities.

Figure 3: Model 2b (two ways) - Bridging Conventional and DLT-based Systems to Issue and Record Digital Financial Assets

 


Source: “The use of DLT in post-trade processes”, European Central Bank.2

Finally, in model 2c, shown in Figure 4, the securities are first issued and recorded in the traditional system, then they are tokenised and represented in the distributed ledger.

As the underlying securities exist in the physical world, the tokens are not securities themselves but ‘security tokens’. Because both the securities and the security tokens can be traded in principle, there should be clear safeguards to prevent double-spending or regulatory arbitrage opportunities; for example, arbitrage opportunities could arise if the tokens and the securities are treated differently across jurisdictions.  

Source: “The use of DLT in post-trade processes”, European Central Bank.1

Figure 4: Model 2c – Securities Recorded in a Conventional Environment and Referenced by Tokens in a DLT Environment
 

Source: “The use of DLT in post-trade processes”, European Central Bank.2

Key Benefits and Challenges from Using DLT

The main advantages of using DLT stem from automating post-trade processing and from reducing the time it takes to finalise a transaction, as well as creating efficiencies by removing any intermediaries. Inefficiencies in traditional systems also occur because of their lack of interoperability, as each system uses a different database structure, which means that they are incompatible with each other, and they cannot exchange information or transfer ownership easily. DLT provides a standardised technology that can onboard all these systems and make them interoperable.

The main challenges of using DLT are ensuring the proper communication and synchronisation between the offline and the online worlds, as well as clarifying any regulatory issues. Are the operators of the distributed ledger regulated and in which jurisdiction? What are the implications for owners and issuers of securities who reside in a different jurisdiction from that of the ledger? This is especially important when there is both a physical asset and a digital representation, as in model 2b. Who governs the distributed ledger and what safeguards are in place to ensure its longevity? Without clear answers to all these questions, it will be difficult for institutional actors to trust DLT and participate in such a platform.

The issue of governance is very important but has received limited attention from regulators thus far. An interesting question is whether a public or a private blockchain is better suited to act as the platform where securities are issued and handled. On the one hand, it may be easier for a regulator to ensure that a private blockchain meets the criteria of good governance, because it is controlled by few validators who are eponymous, hence their actions can be monitored. On the other hand, a private blockchain may facilitate the emergence of anti-competitive practices, especially if the validators are also the issuers of the securities. A public blockchain is more difficult to control and manipulate, however it is also harder for regulators to impose conditions on how they operate. Moreover, market conditions in a public blockchain can change quickly, for example transaction costs may increase suddenly, adversely affecting the trading of the securities.

Finally, a key issue that could create a point of failure is the custody and safekeeping of assets. If custody occurs within the distributed ledger, as in Models 1 and 2c, then knowledge of the private keys is what effectively enables the control of the digital assets. Self-custody means that the owner of the digital assets knows the private keys and is responsible for them. Alternatively, a third party controls the keys on behalf of the owner. In either case, if the keys are lost or compromised, the digital assets are effectively lost. This could be rectified if those who maintain the blockchain agree to rewrite some of the blocks or issue new digital tokens that point to the same physical assets. Such an outcome would be easier in a private as opposed to a public blockchain. However, in both cases this would negate the immutability of the blockchain, a key advantage of DLT, eroding market participants’ trust in the platform. Note that, in either case, key sharding techniques have reduced the risk posed by the storage of private keys.

Conclusion

When it comes to handling post-trade processing, DLT has the potential to provide a more efficient platform, by reducing the time it takes to finalise a transaction through automation and the removal of any intermediaries, as well as providing an interoperable environment where information flows seamlessly across different distributed ledgers. However, DLT is still a new technology and it will take time until all legacy systems are onboarded to a distributed ledger. Moreover, this can happen gradually, as the regulatory framework becomes clearer, both in terms of governance and in terms of how the real world communicates with the digital world across different jurisdictions.

Footnotes

1 See https://www.icmagroup.org/market-practice-and-regulatory-policy/secondary-markets/bond-market-size/ for more details.
2 The report can be accessed at https://www.ecb.europa.eu/pub/pdf/other/ecb.20210412_useofdltposttradeprocesses~958e3af1c8.en.pdf.  
3 For more information on tokenisation, see “Alternative Investments and Tokenisation” at https://en.aaro.capital/Article?ID=2742899f-3441-49a8-b41b-c3a62b8a1554 and “The Challenges and Limitations of Tokenisation for Alternative Investments” at https://en.aaro.capital/Article?ID=625492f6-98ae-4d1b-af21-c12e5eb8af9f.

Disclaimer

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