A Senior Analyst on Greenwich Associates’ Market Structure and Technology Team has produced a whitepaper and participated in a series of videos that challenge “DLT maximalist” claims that distributed ledger technology (DLT or “blockchain”) can effectively replace the roles played by central clearinghouses in securities settlement.
The report, “Steampunk Settlement: Deploying Futuristic Technology to Achieve an Anachronistic Result,” essentially claims that current DLT systems cannot manage netting and require that all trades be fully collateralized up front, which ultimately reduces liquidity in securities markets by around 40x.
As, well, disperse, self-settled platforms would introduce new friction by refracting settlement and making market oversight and response harder.
Problems with exclusively gross (one-to-one) settlement systems like DLT were already recognized by European market participants 500 years ago, says the report’s author, Ken Monahan, in one of the interviews, but DLT maximalists believe they are have reinvented the wheel:
“(With modern DLT systems) You basically get to save the $8 billion dollars that is posted in the reserve fund but you have to prefund $400 billion a day on an unsecured basis. Which is the entire purpose of all of this infrastructure to begin with, was that having to do that put such a burden on the financial system that people were like, ‘We have to do something better here.’ And for the last 500 years they’ve been incrementally working on something better…and the DLT maximalists…say…’I can solve this. Just with these few lines of code, I can solve this.'”
Small firms would like to be able to wade into the sector without having to put up substantial collateral at clearinghouses at the outset, said Monahan:
“The ground for this argument (of ‘DLT maximalism’) has been prepared by people…new to clearing or who think, ‘…If only I didn’t have to post all this margin, things would be so much better.'”
But the matter has just not been thought through by modern advocates, says the author, who told Michael McClain, Managing Director and General Manager of Equity Clearing & Settlement at the DTCC in the brief videos:
“The weakness in this is that they carry the argument only halfway…They say…all of these things about the existing infrastructure, all of the regulation, all of the capital, all of these things that you have to do, we can get rid of that and solve the problem technologically. People love hearing that….What they don’t say is they’re also going to eliminate netting and…also externalize the internalized function that the NACC and DTCC perform.”
The DTCC (The Depository Trust & Clearing Corporation) is one of the main entities responsible for providence clearance and escrow to American financial markets.
“Disintermediating” clearing, Monahan warned, would mean incumbent, DLT-based trading platforms would ultimately have far less capital on hand, said Monahan:
“What does that mean? (And they never say this) That means you have to refund every trade on a transaction by transaction basis.”
“That wouldn’t be popular,” said McClain, who confirmed that clients of the DTCC (have proposed modified DLT settlement (“trade plus 1”) “so (they) can benefit from netting but without the CCP so we don’t have to pay the margin.”
In practice, said McClain:
“(W)hat we find then is the capital charges they have to reserve for bi-lateral counterparty risk far outweigh the margin they post at a central counterparty…at that point it kind of gets rid of the whole value proposition…”
The DTCC and similar entities have been portrayed by “blockchain securities” proponents as possessing an unfair monopoly over trade settlement, a monopoly rightfully “disrupted by automation.”
But in the whitepaper, Monahan explains that third-party ledger-makers emerged to help give order to markets and to enhance their liquidity through pooled collateral and oversight:
“Once ledger entries could be used by creditors as evidence in court to force debtors to pay, credits and debits for future payment themselves became a medium of exchange. This created a uniform system for moving money backward and forward through time. Payments expected in the future could be pledged today and vice versa, greatly expanding access to credit. This freed Europe from monetary constraints: The money supply of Europe was no longer limited by the physical amount of gold and silver circulating within it.”
But as in modern times, early experiments with credit were also taken to excess, Monahan writes:
“Venetian merchants were among the most aggressive, fueling their expansion using leverage created via ledger accounting. As a result, they were among the first to develop ‘systemically important’ financial institutions and the first to watch in horror as speculative excesses lead to their implosion.”
Following the consequent economic meltdown, Venetian rulers “outlawed private banking altogether,” said Monahan, and instead, “set up a state bank, the Banco di Rialto, operated by government appointees”:
“There would be no more bankers enriching themselves by creating credit at the stroke of a pen. The Rialto bank could only extend payment on cash that had been deposited in the bank—all accounts had to be fully collateralized.”
But one-for-one trading systems pushed markets backward to make them more resemble times when merchants had to carry wares across geographies, take payment in person and then go back.
“In other words, they dissolved the banking system and replaced it with a payments system,” just like DLT, said Monahan.
According to Monahan’s whitepaper:
“The Senate soon discovered that it had solved one problem only to create another: It had made the credit crunch permanent by banning credit extension altogether. The volume of trade was reduced to merely what was secured by cash on hand, making it impossible for Venice to retain its commercial preeminence. Chastened, the Senate quickly reauthorized private banking and with it, the extension of credit via ledger entries. They discovered that credit risks can be mitigated, but they cannot be eliminated entirely without losing the benefits of credit creation.”
Market participants have been working on the problem of how to extend credit in financial markets for centuries, Monahan writes:
As stock markets began booming in the US in the early 20th century, liquidity once again became a problem:
“To reduce this strain on money markets, the NYSE, created the New York Stock Exchange Clearing House, which netted down purchases and sales conducted on the exchange among members. It would present to them, on a memberby-member and security-by-security basis, the net requirements for cash and securities transfers among them….greatly reduc(ing) the need for funding, though the complex web of payments and securities transfers remained in place.”
Clearing housing kept funds moving by providing net (total, intraday) settlement as well as gross (one-to-one) settlement programs.
Stock markets continued to grow, and bigger, centralized settlement entities were created cooperatively by industry and government, Monahan writes:
“In the 1960s, the complexity of the settlement system was overwhelmed by the increase in volume, which nearly brought the system to its knees. The securities industry, in partnership with the SEC, created the clearing and settlement system we know today. First, it created the Depository Trust Company (DTC). DTC is a central securities depository (CSD), a venue for storing stock certificates. All the share certificates were brought together in the CSD and then dematerialized— changed into electronic form to make processing transactions faster and simpler. This finally put an end to messengers running stock certificates up and down Wall Street, and the obvious operational risks inherent in that system.”
Firms currently deploying blockchain-based securities platforms want to compete with centralized clearinghouses, but Monahan says companies marketing stocks across various platforms benefit from consolidated clearing:
“Next, the NYSE’s Stock Clearing Corporation merged with those of the AMEX and the Nasdaq into the National Securities Clearing Corporation. This consolidation enabled multilateral netting across the entire U.S. equity market, still further reducing the payments and transfers necessary. Finally, DTC and NSCC were consolidated into the Depository Trust and Clearing Corporation (DTCC) so that U.S. equity clearing and settlement could take place in a single, vertically integrated entity.”
In the interviews that accompany the release of the “Steampunk Settlement…” white paper, Monahan defends the oversight role played by central clearinghouses, calling them ‘an industry utility’:
“(Clearing) is sort of put all your eggs in one basket and then watch the basket…The authorities that are trying to de-lever and secure the financial system…they know what they’re doing… Reducing bank leverage that’s part of it and moving people onto central counterparties…And from a political perspective it’s also much easier to deal with sort of and industry utility…than a large number shareholder-owned entities independently.”
McClain confirmed Monahan’s contentions:
“(Pooled collateral) aligns incentives…the NSCC organization that I’m a part of is user-owned- everybody’s watching themselves.”
The centralized DTCC also had a hand in mitigating the last financial crisis in the US, Monahan wrote:
“This system has proven itself under duress. In the most recent financial crisis, it was the decentralized, multilateral clearing system for CDS that put the system at risk. The centralized and adequately capitalized system of DTCC processed the extreme volumes and volatility during the crisis. It was also able to resolve the collapse of Lehman Brothers not only without any government intervention, but with hardly a ripple at all. It was so successful, in fact, that both the Congress and the Bank for International Settlements (BIS) have designed the post-crisis rule system to move as much OTC clearing onto central counterparties (CCPs) as possible.”
But the benefits of central clearing cut both ways, says Monahan- they also benefit industry by allowing them to post far less collateral overall:
“Because real-time gross settlement also precludes netting, it requires funding all transactions in the market on a transaction-by transaction basis. That’s actually turning the clock back to 1891 and the era before the New York Stock Exchange Clearing House enabled marketwide net settlement.”
“This is precisely the lesson the Venetian Senate learned in 1584 in a strikingly similar way: By substituting a payment system for a credit system, they sucked liquidity out of the economy. Unlike the Venetians, who really did blaze a new path, we have the benefit of learning from history, and this is its lesson: DLT has a big role to play in improving the quality of the settlement infrastructure, but it cannot replace it entirely without imposing the very costs it was designed to reduce.”
Monahan says that by “cutting the numbers several ways,” he found that across-the-board gross settlement imposed by universal DLT would result in a 40x reduction in available credit in securities markets:
“With DLT you can’t benefit from intraday market making…the total amount of gross versus net funding requirements is reduced (by DLT) by about 90% which is basically the same number they got in Frankfurt in 1866. I think the result was about 40-t0-1…every dollar posted in the reserve fund secured forty dollars of transactions during the course of the day.”