The post-trade industry is undergoing a seismic technological transformation, a process which has dramatically accelerated over the last few years, and even more so during the pandemic. This is largely in part due to the exponential growth of digital assets coupled with the growing maturity of distributed ledger technology (DLT), both of which are disrupting the traditional market ecosystem. There is a growing demand for secure and trusted custodian services and the industry is responding in kind.
Incumbents embrace DLT in the face of growing competition
Conscious of the market-wide innovations taking place elsewhere, financial market infrastructures (FMIs) are embracing new technologies such as DLT in order to make investing more efficient and to shorten settlement cycles. For example, stock exchange groups in both Australia and Hong Kong are currently using DLT to enhance their existing processes. In the case of the Australian Securities Exchange, it plans to replace its CHESS clearing and settlement system with DLT by 2023. Meanwhile, Hong Kong Exchanges and Clearing is utilising smart contracts to automate post-trade activities — principally settlements — on the Stock Connect linkage.
“In addition to existing FMIs re-platforming and becoming increasingly efficient, we are seeing some interesting new market infrastructures entering into the space, and competing with the incumbents,” says Ryan Marsh, global head of DLT and digital innovation for Citi Securities Services.
One area where DLT is likely to be especially impactful is in trade settlements. Current market best practice dictates that trades should settle two days after execution in what is known as T+2, but adoption of DLT could speed up the settlement cycle to T+0 or even facilitate immediate, atomic settlement.
"DLT allows for a golden source of data to be shared immutably across the value chain in real-time. If entities in the value chain have possession of trusted data earlier, then it is possible to re-engineer processes by making them more efficient, thereby compressing the settlement cycle.”
- Ryan Marsh, Global Head of DLT and Digital Innovation, Securities Services, Citi
FMIs — including the Depository Trust & Clearing Corporation (DTCC) in the US are actively exploring the application of DLT in trade settlements, while a handful of new entrants have successfully trialled the technology. For instance, Paxos — a US-based DLT-enabled settlement platform — recently supported Credit Suisse and the brokerage arm of Nomura in settling a US equity trade on a same day basis.1
Overcoming the barriers that lie ahead
However, the wider integration of DLT into post-trade processes is likely to face a number of impediments. Although there are various DLT based platforms emerging which do not use batch cycles and operate 24/7 in real-time, they cannot compress the settlement cycle in isolation. “Irrespective of whether you have an FMI operating 24/7– if it is connected to a legacy payment settlement system that operates in batch cycles, then that will ultimately impair moves to T+0 or T+1. Efficient cross border same day settlement can only be achieved by having a real time 24/7 digital FMI connected to a real time 24/7 payment infrastructure,” explains Marsh.
Perhaps the most significant obstacle preventing the market from transitioning to T+0 immediate, atomic settlement is that it current models require counterparties to pre-fund their trades, which creates added costs and counterparty risks. However, Marsh noted that banks could find ways of extending credit lines to clients more efficiently — precluding them from having to pre-fund positions for trades settling on T+0.
Another barrier is the absence of any industry-wide DLT standards, something that could make it harder for different DLT platforms and protocols to interoperate with each other. Work in this area is progressing with the development of smart contract language which straddles multiple DLT protocols. However, more needs to be done in this field.
While DLT offers significant benefits, a number of hurdles need to be overcome before its full potential can be realised. However Citi is focussed on reducing these barriers by developing middleware access solutions that minimise the technical changes required by clients.
An industry in the midst of disruption
Digital assets are also likely to usher in an evolution in how post-trade operates. “The emergence of new assets — such as cryptocurrencies and non-fungible tokens — are being created based on blockchain technology and they behave very differently to traditional assets,” says Marsh. What was historically a retail-orientated market is now becoming increasingly institutional as sophisticated investors incorporate digital assets into their portfolios.
A recent survey by Citi and Global Custodian found that 91% of respondents view digital assets as the future and 48% of financial institutions believed institutional investor appetite for digital assets would grow rapidly. This will likely be fuelled by the various investment and operational benefits digital assets confer. For example, 30% of respondents believe that digital assets would facilitate efficiencies in the investment process while 25% indicated that these assets could potentially boost returns.
The industry is responding to these changing dynamics, but it must do so in a way that does not compromise existing services. A number of digitally native banks servicing digital assets are obtaining banking licenses allowing them to hold cash and provide traditional services. In response, existing custody providers will have to evolve their capabilities to meet increasing client demand for digital assets.