A new report assessing distributed ledger technology has concluded that introducing real-time gross settlement will turn the clock back on market developments by over 400 years and impose the very costs it was designed to reduce.
Ken Monahan, a senior analyst on the market structure and technology team at Greenwich Associates opined that from a funding perspective implementing instantaneous settlement is a “gigantic step backward”.
He cited the clearing and settlement regimes rolled out in 1584 following the collapse of the Venetian banking system caused by the simultaneous bankruptcy of the Pisani and Tiepolo Houses, which brought down every bank in the city, causing massive losses.
Monahan tracked the history of clearing and settlement from 1584 to the current day, taking into account the emergence of clearing houses to the establishment of the DTCC, highlighting that there has been a reason for each step in the timeline.
Despite admitting that DLT has a big role to play in improving the quality of settlement infrastructure, he claimed that DLT cannot replace it entirely without imposing the very costs it was designed to reduce.
“A real-time settlement system is, of necessity, a bilateral gross settlement system,” said Monahan. “Its bilateral nature precludes multilateral margining. So DLT maximalists are turning the clock back to 1919, before the Stock Clearing Corporation internalised the margining system on a multilateral basis.
“But this is not really far enough. 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 market-wide net settlement.
The report showed that over a 28-day sample in the volatile months of November and December 2018, the average gross settlement balance in the US equities markets was $326 billion, and the net was $32 billion. It showed how 90% of the funding needs were eliminated via netting and that through the multilateral margining and risk management protocols of DTCC, these $32 billion in net settlements were secured with $8.2 billion in commitments to the reserve fund from market participants.
“It is not an exaggeration to say that it would save $8 billion in reserve funds at the cost of requiring hundreds of billions in prefunding, creating a burden on money markets that participants have spent over a century developing systems to alleviate,” he added.
“In 1891, an investor could secure a call loan against shares during the day it took to settle them, using the transaction receipt as collateral. With instantaneous settlement, it’s not possible to secure funding with shares you have yet to transact. This means you need to prefund the trade, but you must prefund it on an unsecured basis. So, it’s really turning the clock back to the brief period in 1584 when the Venetian Senate required prefunding of all trading.”
Monahan’s argument brings up the frequently debated topic of whether DLT is evolutionary or revolutionary – with incumbents infrastructure providers and market challengers often lining up on each side of the argument, respectively.
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