While the U.S. ponders crypto and blockchain regulation, large institutional investors are building the infrastructure necessary to handle the possible private and sub-chain transaction methods likely coming with Web 3.0. Legislation is desperately needed to give certainty to entrepreneurs and large institutions planning for the block sub-chain and to the crypto industry generally. One likely outcome is the movement towards using blockchain technology to “settle” securities transactions. This is occurring now but may become widespread in the near future. With a traditional securities trade, settlement can take days, creating market and operational risk. With blockchain settlement, the settlement is instantaneous. For securities trades to be settled, the transaction information (transfer of ownership or payment) needs to be recorded in the blockchain. Investors communicate information to a peer-to-peer network. Thus, much of the risk is eliminated. Many large institutions are working on systems that would allow for such settlement techniques.
Regulation of blockchain would do a great deal to accelerate the growth of the industry, and provide legal security for its use. An article published by the DTCC titled “Will Blockchain Revolutionize Clearance and Settlement” provides a succinct overview of the history of the current clearing and settlement system.[1] Regulation is particularly needed to overcome some of the hurdles of blockchain settlement. The current clearing and settlement system for securities trading can be traced back to the 14th century when double-entry ledgers were invented.[2] The creation of the double-entry ledger revolutionized trading in Europe due to the ability to record multi-party transactions occurring over a span of time and across countries in a central location.[3] Decentralized, multilateral clearing continued for more than 300 years and was utilized by groups such as the London Clearing Club, the London and Amsterdam stock exchanges, and the Chicago Board of Trade.[4] As the trading volume and the number of counterparties increased, clearing started to become centralized.[5]
Moreover, prior to 1892, every exchange of cash for shares on the New York Stock Exchange (“NYSE”) had to be paid in full, with cash or a loan secured by the shares acquired in the transaction.[6] However, this system did not provide enough security to money markets and the banking system, which could be severely stressed during market volatility and surging trade volumes.[7] Thus, in 1892 the NYSE created the New York Stock Exchange Clearing House (“NYSE Clearing House”), which was later replaced by the Stock Clearing Corporation in 1920.[8] The NYSE Clearing House net down obligations on a member-by-member and security-by-security basis.[9] To resolve this, regulators and the U.S. securities industry created The Depository Trust Corporation (“DTC”), a central securities depository for storing all stock certificates traded in the U.S. market.[10] Over time, nearly all certificates were converted into electronic form, greatly streamlining the trading process and reducing the burden on the clearing and settlement system.[11] Moreover, the NYSE Clearing House was merged with Amex and NASDAQ clearing functions, culminating in the National Securities Clearing Corporation (“NSCC”).[12] This integration further reduced payment and transfer activity volume by enabling multilateral netting across the entire U.S. equity market.[13] In an effort to streamline the clearing process further, the DTC and NSCC were consolidated into The Depository Trust & Clearing Corporation.[14] Thus, clearing and settlement were able to take place in a single, vertically integrated entity.[15]
Blockchain can bring significant record-keeping improvements to the securities industry, but blockchain settlement only works if the settlement process is better regulated. Thanks to the self-enforcing contracts, blockchain technology could be the next step in the evolution of the clearing and settlement. As stated above, this would make settlement instantaneous, negating the need to post collateral, which would free up capital.[16] However, without regulation, this technology could require the U.S. market to be funded on a transaction-by-transaction basis, which would significantly hinder the liquidity and risk-mitigating benefits of the current system.[17] Further, the instantaneous settlement would prevent the ability to fund a trade on a secured basis because traders could only pledge transacted shares as collateral.[18] What this means is that all trades using blockchain must be prefunded and on an unsecured basis. This would severely limit market liquidity. Thus, regulation is necessary to allow the benefits of instantaneous blockchain settlement not to be overshadowed by the illiquidity effects of such settlement. If such creative regulation could be implemented, then blockchain for securities settlement can become widespread, creating the next evolution of securities trading.
[1] Will Blockchain Revolutionize Clearance and Settlement, DTCC (Mar. 10, 2021), https://www.dtcc.com/dtcc-connection/galleries/2021/march/10/will-blockchain-revolutionize-clearance-and-settlement.
[2] Id.
[3] DTCC, supra note 1.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Id.
[12] Id.
[13] DTCC, supra note 1.
[14] Id.
[15] Id.
[16] Id.
[17] Id.
[18] Id.