Why is it… that trades can now be executed in less than a millisecond, yet it still takes three full days for those trades to settle? The most likely answer is some combination of inertia, cost, and competing priorities.
– SEC Commissioner Luis A. Aguilar1
Each of us at Neosho can trace our financial careers back to the days of timestamping trade tickets and handing them to another firm employee locked in “the cage” to begin the trade settlement process. Striking the bargain, then as now, merely starts the process of shares trading hands for cash. We share Commissioner Aguilar’s frustration that clearing and settlement continues to operate in a quasi-analog manner while trade execution is fully digital and makes use of artificial intelligence and speed of light communications. As such, stock trades settle no faster than two days in Europe and three days in the U.S., no matter how liquid the stock.
Almost all of this time lag is caused by the need to bring, at the minimum, three party’s internal ledgers into agreement that the right shares in the right numbers can be exchanged for the right amount of cash.2 Despite the demise of the physical time stamp, many other forms of “handcrafting” are undertaken by clearing and settlement employees using emails, phone calls, private messaging, and faxes to communicate the information in each of their self-contained ledgers.
It should not surprise you that this clearing process for stock trades is neither slick nor seamless. Errors and failed trades occur with enough frequency that there are reams of regulations and thick sections in Compliance Manuals dedicated to solving failed trades. Clearing houses require participating firms to post large amounts of capital to make sure all players can make good on their trades. And the clearing and settlement departments in brokerage and asset management firms across the globe employ tens of thousands of people at a significant expense which must be covered, thus adding a hidden cost to the process. Clearing is the very definition of a “frictional cost” that we all learned about in Econ 101.
Why should you care? From the perspectives of most market participants, clearing and settlement looks fairly automatic and these participants never see “how the sausage is made” and nor do they wish to. But when the Financial Crisis took down Lehman Brothers, days seemed like years as many anxiously awaited to see how Lehman would resolve billions of dollars in trading liabilities.
Furthermore, the implied costs of managing the clearing process must be borne by someone and the sums involved are not inconsiderable. Let’s just assume that the frictional cost of clearing amounts to only 1/100th of 1%, or 1 basis point, an almost certainly low-ball estimate, but bear with us. If we then take the value of all equity trades in the United States in 2014, which amounts to $41 trillion, this results in total frictional clearing costs of $4 billion annually.
This lowball estimate does not include capital costs of holding qualifying balances at clearing houses nor the cost of failed trades stemming from clearing mistakes. That $4 billion, every year, has to be paid for by wider bid-ask spreads embedded in the trade. The buyer is paying more and the seller is getting less, thanks to frictional clearing costs stemming from an antiquated clearing process dependent upon the reconciliation of the silo’d ledgers of multiple parties.
Enter Blockchain, the cryptographic underlying “distributed database” that drives Bitcoin. To over-simplify, Blockchain creates blocks of records that instills confidence among participants by linking Bitcoins to their present and past owners without a third party intermediary. We believe it has the potential to cut through the Gordian Knot of securities clearing and settlement by lowering operating and capital costs, as well as having the ability to speed up and increase the reliability of settlement.3 Yes, we remain skeptics as to the longevity and utility of Bitcoin (see our January 2014 commentary) and we are not alone in that conviction: even key figures within the Bitcoin community have declared it a “failed” experiment and sold off their trove of Bitcoins.4
Regardless of its fate, the key innovation of Bitcoin, a “distributed ledger” shared by all network participants, can theoretically solve the problems associated with making multiple, unconnected, individual ledgers in the chain of clearing and settlement because each party is using the same Blockchain ledger. In a theoretical Blockchain world, the trade is the settlement and there is no need for a clearing function in the middle of those two actions.
Of course, theoretically a lot of things are possible in this world and Blockchain has a long way to go in terms of speed, scale, and security before any of us will trust trillions of dollars of financial transactions to be stored and accessed on a ledger database which no one really owns. Right now all sorts of ridiculous claims as to the power of Blockchain are floating about in the techno-sphere, such as “Blockchain tech can eradicate corruption in Asia” or that all middlemen, middle offices and clearing houses will all go the way of the dinosaur.5 This is the same pie-in-the-sky that we all heard back in the mid-1990s about the internet and while the internet has been revolutionary and did make shopping and research fantastically easier, it did not produce the “flat” society many advocates envisioned or lead to the overthrow of many governments.
Conversely, there are those who say that Blockchain cannot be used for trade settlement because in its purest form, as expressed by its mysterious and pseudonymous creator “Satoshi Nakamoto”, Blockchain is supposed to be purely “peer to peer” with no entry fee, no vetting, and no central entity. We reject both those extremes and envision an invitation-only, peer-to-peer Blockchain network of greater speed and security than the Bitcoin version. It will not be an open system, but a member based system more akin to DTC, SWIFT and other industry-maintained systems that presently facilitate securities settlement. The “peers” would be the usual suspects of global, regional, and large national brokerage firms, perhaps ultimately numbering in the few hundred. While there will still be frictional cost, it should be several magnitudes smaller than the current clearing systems.
Toward that end, over a billion dollars of so-called “fintech” venture funding has been directed towards 13 high profile Blockchain start-ups over the past two years since we have last written on this subject. Investors include the likes of the Bank of England, NASDAQ, NYSE, Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), Visa (NYSE:V), Citibank (NYSE:C), Barclays (NYSE:BCS), UBS (NYSE:UBS), Santander (NYSE:SAN), Credit Suisse (NYSE:CS), HSBC (NYSE:HSBC), Wells Fargo (NYSE:WFC), Alphabet (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), and IBM (NYSE:IBM), and many others have invested over $1 billion in venture funding into Blockchain research and pilot projects in the intervening period. Even if another $2 billion or $3 billion of venture funding for research and testing is needed to make our “invitation-only Blockchain network” a reality, given that we estimate a minimum of $4 billion in annual frictional clearing costs, the investment will be worth it since the annual savings will still be larger than the initial capital outlay.
That said, there are very significant hurdles, technical and regulatory, that must be crossed before Blockchain can ease Commissioner Aguilar and our angst over clearing: speeding up current Blockchain technology from a 10-minute ledger refresh to something more akin to a 10-second refresh, the level of consensus that must be reached between all members of that Blockchain network (51%, 99%, 100%?) before a block is verified, and the creations levels of privacy within a block while still preserving its efficiency. And it is inevitable that Blockchain technology can and will be hacked. Any claims of Blockchain’s invulnerability should be ignored: all cyber-networked systems are hackable with enough effort. However, the potential for a significantly safer and more secure settlement system via invitation-only distributed ledger technology does not seem farfetched.
In the final analysis, much like the California Gold Rush of 1849, the real wealth to come out of the Bitcoin phenomena will not come from Bitcoins themselves, but will be in the forms of billions of dollars in annual cost savings for global financial institutions and the death of traditional centralized databases, both thanks to Bitcoin’s underlying distributed ledger technology. Just as it was not Sutter, on whose property that first California gold was found, who struck it rich, but rather Stanford, Crocker, Huntington, and Hopkins, the gold field shopkeepers and later railroad pioneers, who ultimately ended up the big winners.6
Neosho Capital LLC
- The Benefits of Shortening the Securities Settlement Cycle, by Commissioner Luis A. Aguilar, United States Securities and Exchange Commission, July 16, 2015
- At the minimum, there is a buyer’s Broker/Custodian, a clearing house (e.g. Depository Trust, Euroclear, etc.), and a seller’s Broker/Custodian. We have been involved in trades where there are 6 or more individual parties confirming a transaction prior to settlement, including intermediary local brokers or firms who clear through other firms.
- Rather than belabor you with a verbal explanation of Bitcoin, here is a very succinct two minute video.
- Bitcoin: Is the Crypto-Currency Doomed?, BBC News Online, Chris Baraniuk, January 19, 2016
- Blockchain Tech Can Eradicate Corruption in Asia, August 20, 2015
- Past performance is no guarantee of future results and there can be no assurance that the results presented herein can be achieved. Actual performance for client accounts may be materially lower than the results shown. Information provided reflects Neosho’s views as of the date of this presentation. Such views are subject to change at any point without notice. Neosho obtained some of the information provided herein from third party sources believed to be reliable but it is not guaranteed and we are not responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not warrant or guarantee the accuracy or completeness of the information requested or displayed.. Information contained herein is for informational purposes only and should not be considered a recommendation to buy or sell any securities. Nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. Neosho has not taken into account the investment objectives, financial situation or particular needs of any individual investor. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
Neosho Capital LLC
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.