Enabling Efficiencies in European Capital Markets
The deployment of blockchain can transform capital markets by enabling a T instant model with no settlement delays writes Nick Cowan, CEO of the GSX Group
The current financial markets infrastructure landscape is defined by unnecessary congestion, damagingly protracted processes, and a restricted flow of capital. Finding a remedy to these issues revolves around one key word – "instant." Unfortunately, the underlying infrastructure of traditional financial institutions has remained fairly static over time, with limited progress being made over the last couple of decades. This is particularly surprising considering the substantive growth of the capital markets in that timeframe, as well as the technological advances that have been made, particularly in the last several years.
The European Central Bank has previously identified market fragmentation as a key concern for the European Capital Markets, an issue that has been amplified by the COVID-19 crisis, which has necessitated a non-negotiable economic shutdown. Economic growth has been dealt a crippling blow and the current conditions have undercut activity within the capital markets considerably. This unprecedented crisis has the potential to cause irreparable damage to certain industries. However, companies and traders have proven adept at adjusting to market fluctuations in the past, and will do so again. This might sound overly optimistic, but capital markets have the potential to bounce back to new heights and a wide scale embrace of blockchain technology can deliver much needed efficiency gains.
So where are the gains to be made? Right across the spectrum of trading activity. For one, the cost of a lifecycle of a trade is unnecessarily high, and the T+2 model, which stands for trade date plus two days, brings with it a high level of systemic counterparty risk that can be quite destructive, particularly when there is a fiscal meltdown or a dislocation of credit. Within the traditional T+2 timeframe, financial market infrastructure operators are expected, incorrectly, to guarantee that trades take place, when in fact in the event of a credit dislocation, the taxpayer is charged with resolution. With a litany of centralized counterparties at play including clearers, centralized securities depositories, banks, registrars, and nominees, the congestion becomes visible. Currently, 6% of nominal equity trades in Europe fail. From September this year, CSDs will start to charge fees for fails, or ‘buy-in’ the trade, further squashing margins. In a T instant model, fails and capital posted by market intermediaries with CCPs becomes a thing of the past.
Today’s pronounced risk environment accentuated by COVID-19, underlines the need to address the inherent systemic risk associated with the T+2 model. Blockchain can be deployed to transform capital markets by introducing a breakthrough innovation, a T instant model with no settlement delays. To achieve this level of progress requires some fresh thinking, and bold ideas. The challenge with consensus algorithms is that they may be incongruent with the instant settling of securities given directives such as Settlement Finality. A perspective shift is required. Think of it as Centralized Ledger Technology (CLT), a framework in which operators within a private blockchains can be interoperable. To give an example of what this CLT-based financial world would look like, imagine a client being able to place a buy order in a security on their phone, with complete confidence in achieving the best execution from whatever geographic agnostic exchange was offering the best offer price at that time within the same network. Pan-jurisdictional interoperability dramatically extends the accessibility of capital to investors and issuers alike. Compound this interoperability with reduced trade life cycle costs, zero counterparty risk and zero capital being required to post with CCPs, whilst preserving anonymity, you have a big step forward in the way markets work.
There is wider scope for blockchain to help initiate the mainstream issuance of new tokenized securities representing equity and debt. Like converting Word docs to PDFs, existing publicly listed securities can be digitally wrapped (albeit not as easily!), creating a T instant settlement solution. It is important to note that this would also facilitate a full legal transfer of title at the time of trade, something the T+2 model simply can’t match. Blockchain-powered finance can also help enable regular trading of smart securities based on traditionally illiquid assets like real estate, making the capital markets more accessible, both figuratively and literally.
With reports suggesting the European Commission will be outlining a new set of initiatives to broaden the capital markets union with a view to relaunching the EU economy in the aftermath of COVID-19, the stage is set for a phase of capital markets recalibration, harnessing the latest technological innovations. European officials are acknowledging the pronounced importance of utilizing the resources at their disposal to inject a much needed shot of adrenaline into its economy and indeed, its financial markets. To simplify things, the deployment of blockchain, as part of a Centralized Ledger Technology (CLT) framework would be transformative for the European capital markets, powering a true paradigm shift for how securities are traded and settled, while deepening liquidity pools and alleviating systemic counterparty risk.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.