Distributed ledger technology (DLT) is a cryptographically encoded, highly detailed ledger of transactions, distributed across a public or private network that promises substantial benefits of transaction speed and security, process efficiencies and cost savings.
Survey participants identified DLT as the technology likely to have the greatest impact on the CMIP value chain, specifically in the areas of clearing and settlement. Expected benefits are shortening of settlement times to a few minutes, mitigating counterparty risk, and reducing the amount of collateral posted against trades. The potential flexibility of DLT could lead to applications across the value chain, from capital raising to regulatory reporting.
Although DLT may have the most potential among the technologies fintechs are deploying in capital markets solutions, it may also be the furthest from realization at scale. In addition to having to live up to high expectations, DLT applications must also be fashioned to fit the current market infrastructure, and at the same time satisfy any relevant regulatory requirements. McKinsey expects the early challenges to be overcome, however, and that networks of participants in DLT solutions will grow. But rather than creating system-wide solutions, development will emphasize focused-use cases. Markets showing the most promise include OTC derivatives, equities and repurchase agreements, where DLT can match assets, manage collateral, and synchronize the movement of cash.
The first large-scale application is the implementation of a DLT clearing and settlement system at the Australian Stock Exchange (see “ASX: DLT for equity post-trade processing,” page 42). Other early implementations are more modest in scope, but nonetheless revolutionary (see “Exchange blockchain use cases,” page 43). For example, CME Group and Britain’s Royal Mint are nearing introduction of a digital market for gold-based on a DLT. Through a blockchain and digital vault, a test group of institutional investors are trading digital tokens; rather than representing shares in a commingled fund, they instead record ownership of one gram of physical gold in the vault of the Royal Mint.
Nasdaq has developed a blockchain ledger technology dubbed Linq, and its first use, in late 2015, was to record a trade in shares of a private company in the Nasdaq Private Market. The DLT application ensures comprehensive records of share issuance and transfer. Trading began with six private companies, including Chain.com, a collaborator with Nasdaq on the Linq technology.
These initial cases are encouraging. Nevertheless, successful large-scale application requires long-term commitment, coordinated within the industry as a whole, calling for firms that are usually competitors to collaborate and invest together in the new technologies for the long term.
*Drawn from the WFE & McKinsey research paper: Fintech Decoded: Capturing the Opportunity in Capital.
ASX: Distributed Ledger Technology for equity post trade processing
One of the primary bottlenecks in conventional equities trading is the need to reconcile transactions between different market users and financial market infrastructures. This is caused by delays in finding securities in time for settlement, and from mismatches of settlement instructions.
These restrictions are in turn the result of brokers, exchanges and custodians all using their own custom-designed solutions for transaction capture, and a lack of common technologies and standards. This makes the process of identifying errors in reconciliation time consuming and expensive. Post-trade systems based on DLT can eliminate many of these issues, as they are centrally managed and work with common data models.
DLT post-trade systems require building in new means of data privacy and security for participants, and thus will require features that are not available in public blockchains. In some senses, this represents a leap of faith for incumbents as they strive to understand the technology and its application, but the benefits of DLT mean it still stands a strong chance of widespread acceptance: No one vendor “owns” the underlying technology, and there are many different types of DLT platforms being developed in public- and private-permissioned DLT environments. Having said this, there is a general and growing understanding of what DLT can deliver — cost savings from reduced reconciliation, greater scale and speed for future operations, greater fintech innovation, and shared costs of development.
Following extensive testing of DLT and validation of its security, capacity, and resiliency, the Australian Securities Exchange (ASX) is introducing a DLT application to replace its existing CHESS system. It is being developed in conjunction with Digital Asset Holdings, a fintech based in New York. The ASX plan calls for a private and permissioned DLT system operated by the exchange — thus addressing the requirement of regulators to continue to have full accountability lodged with one party to operate the market (ASX) and ensuring that all users of the platform are known and meet appropriate regulatory standards (including KYC and AML).
The ambition is that participants will enjoy lower costs, improved functionality and potentially shorter settlement times. It also provides the opportunity for participants to greatly reduce the manual process of reconciliation. With a central operator, ASX provides a single “source of truth” for all clearing and settlement data that can be independently and mathematically verified by participants as being correct without the need for reconciliation.
The system will provide for open access where customers are able to interact with the exchange’s systems through traditional message-based interaction, or directly with the distributed ledger via taking a “node” of the database operated by ASX. Importantly, the node preserves privacy as it only contains the information related to a participant’s own transactions and is not a full copy of the ledger.