When Distributed Ledger Technology (DLT) was first revealed to the world, many within the securities services industry believed that this could be the solution to a number of challenges. With banks attempting to reduce their operating costs and eliminate inefficiencies across post-trade, DLT was widely viewed as being something of a remedy. Although the technology’s capabilities were initially over-hyped, major banks and Financial Market Infrastructures (FMIs) have since become increasingly targeted and pragmatic in how they apply DLT when looking to solve their real-world challenges. However, market participants also recognize that the absence of proper global standards is delaying critical mass adoption.
DLT Opens Up New Asset Classes
DLT is currently being trested at a number of FMIs to help them support the trading and settlement of digital assets such as security tokens. In the case of security tokens, industry experts believe the digitalization of difficult-to-trade assets in private markets, such as real estate or fine wine will help generate deeper liquidity by optimizing the investment process. Beyond FMIs, a number of central banks are looking to leverage DLT as they explore the development of central bank digital currencies. Elsewhere, there are a series of initiatives focussed on the creation and maintenance of StableCoins, which are crypto-currencies pegged to fiat money or other assets such as government bonds. For many, digital assets are where the custody industry’s future lies. “We believe custodians will be supporting a number of new and different asset classes in the future. This is going to force the industry to evolve, and further develop their technology capabilities,” said Ryan Marsh, Global Head of Distributed Ledger Technology & Digital Innovation at Citi Securities Services.
Tangible progress has been made across a number of markets in regards to DLT and digital asset adoption. In Switzerland, the Six Digital Exchange, which is operated by SIX, the country’s primary stock exchange group, is building a fully integrated issuance, trading, settlement and custody infrastructure for digital assets. Singapore has also made impressive inroads with its DLT and digital asset development. In 2018, the Singapore Exchange (SGX) together with the Monetary Authority of Singapore successfully tested DLT to provide delivery versus payment settlement for digital assets as part of its Project Ubin initiative. More recently, SGX used its DLT-enabled digital asset issuance platform to issue its first-ever digital bond. Meanwhile, the Australian Securities Exchange is looking to replace its equities clearing and settlement system with DLT, although launch has been delayed to 2023. Increasingly, the technology is being used to establish new regulated FMIs, such as BondEvalue in Singapore and Archax in the UK, as firms look to take advantage of the growing investor interest in digital assets and processes.
Driving Operational Efficiencies
DLT may help bring about a number of operational advantages too. “One of the principal benefits of DLT is that it can significantly improve the way in which data is used within an ecosystem. Technology such as shared ledgers can ensure that golden source data is disseminated and distributed along value chains in a controlled and permissioned manner. The expectation is that this will increase the speed and integrity of data, synchronize activities and remove duplication and reconciliation, which not only improves efficiency but also reduces risk,” says Marsh.
Enhancements to data distribution can also facilitate instantaneous trading and settlement, potentially helping to reduce intermediation, further increase efficiency, and drive down industry costs. This was illustrated by a recent Citi survey at The Network Forum Autumn Meeting, which revealed that 31% of respondents believed the biggest advantage of digital assets would be a more efficient post-trade settlement process, followed closely by access to new asset classes.
“In markets with immediate trading and settlement, the role of clearing could disappear meaning there may no longer be a need for a central counter-party clearing house. As DLT provides a single source of truth, all market participants will be working from the same data sets thereby reducing the number of messages exchanged between counterparties and diminishing the need for reconciliations,” says Nadine Teychenne, Director of Custody Distributed Ledger Technology and Digital Assets Product Development at Citi Securities Services. “By having a single source of irrevocable truth between all parties to a trade, the likelihood of mistakes or errors being made during the transactional lifecycle may recede, and with it, so will risk.”
The availability of a single source of truth will also have a significant impact on other post-trade asset servicing activities such as corporate action processing, which have historically been higher risk and involve manual intervention, creating added costs and inefficiencies in the transactional lifecycle. While COVID-19 has led to some progress around digitalization such as the removal of physical signatures, a renewed uptick in e-voting, virtual Annual General Meetings in various markets, many experts believe the adoption of DLT will help eliminate a number of the pain-points and risks synonymous with post-trade processing.
Overcoming the Barriers to Adoption
There are a number of operational challenges with the technology itself and some of the new processes that will be supported by it. Immediate atomic trading and settlement is one such example. “Immediate settlement can cause problems. At the moment, market participants settle on T+2 but a shift to immediate atomic trading and settlement would force counterparties to pre-fund their transactions creating liquidity problems. It is possible custodians could provide credit lines in order to solve this problem,” says Marsh. Moreover, simply layering DLT onto existing mainframe technology is not viable either and could actually exacerbate operational risk. As a result, integrating DLT into legacy systems will need to be carried out carefully.
Most significantly, DLT adoption rates will stay subdued unless standards are created. “Our industry is very mature and has spent a great deal of time defining standards around operational processes and financial messaging. The issue with DLT is that there is a significant lack of standards meaning several different types of DLT protocols and associated processes have emerged,” notes Marsh. In the absence of any common standards, the progress of interoperability solutions between different financial DLT systems will be impacted.
“More broadly, as highlighted in our recent survey, other challenges facing DLT include a lack of established markets and internal technology investment. These will need to be overcome before we will see wider adoption of DLT in this space,” adds Teychenne.
Progress So Far
Regulators have largely been receptive to DLT. For example, the European Commission’s recently published Digital Finance Package contains proposals outlining a pilot scheme for FMIs looking to incorporate DLT into their operating models. The Commission’s package also argues for the establishment of an EU-wide harmonized framework to oversee the issuance of crypto-assets. “Regulators in France, Germany, and Switzerland are also being proactive about DLT and digital assets. Now that leading market regulators are beginning to champion DLT, this will help accelerate the industry’s adoption of the technology,” says Teychenne.
Getting to The Next Stage
If rolled out successfully, DLT may have a major impact on how securities markets operate by driving efficiencies in trading, settlement and asset servicing. Although the technology has massive potential, it can thrive if the industry finds agreement on the standards governing it. “If the industry is to agree on standards, it is vital that market participants reach out and engage with industry associations rather than conducting bilateral discussions between themselves,” says Marsh.
Moving forward, it is critical the securities services industry finds a way to monetize the technology in order to generate benefits for the entire value chain. If the securities services industry achieves this important milestone, DLT can truly shine.