Will blockchain replace clearinghouses?
A case of DVP post-trade settlement
This article sheds light on the application of blockchain technology to the existing financial market infrastructure, namely to post-trade settlement. We show how blockchain technology can facilitate trustless delivery vs. payment (DVP) settlement without any intermediary. Moving settlement processes entirely on decentral technologies makes the settlement process more efficient since it decreases the associated transaction costs and reduces involved risks. Hence, the blockchain-based multichain atomic swap technology will become a peer-to-peer alternative to a central clearing counterparty that normally facilitates the DVP settlement of financial assets.
Blockchain technology is more and more applied to financial sector use cases, in particular digital assets. With the term “tokenization”, all kinds of assets can be mapped on blockchain-based systems. In Europe, there are tremendous ongoing efforts to tokenize securities as well as accommodating asset classes such as real estate, art etc. In addition, the regulation of such blockchain-based digital assets gets more and more clear. In Liechtenstein, an own “blockchain law” has come into force. Similarly, in Germany, a law that outlines the regulation for DLT-based debt instruments has been proposed and is expected to come into force in 2021. All these initiatives show that regulatory uncertainty related to blockchain-based assets is decreasing. Thus, blockchain-based financial assets are likely to be used on a global scale in a few years.
One of the greatest benefits of using blockchain technology for digital assets is substantial efficiency gains within the settlement process. In this article, we discuss the application of blockchain technology to the post-trade settlement of financial assets and show how blockchain technology can facilitate trustless delivery vs. payment (DVP) settlement without any intermediary. This move of settlement processes to decentralized technologies makes the settlement process more efficient as it decreases the associated transaction costs and reduces involved risks. Please note that in this article we use the terms blockchain technology and distributed ledger technology (DLT) interchangeably.
Issues of the current system: Inefficient settlement
Today, assets are mainly settled in the form of a so-called free delivery. Under free delivery, a trading Party A first needs to either deliver an asset — in case of a sell trade — or pay for an asset — in case of a buy trade — while Party B pays or delivers accordingly only after the receipt of assets or funds from Party A.
The main disadvantage of this form of settlement is settlement risk as well as counterparty risk, i.e., the risk that the parties can default on their obligations. These risks should not be underestimated as a default of an involved party can lead to substantial financial losses. Therefore, several financial intermediaries are involved in the settlement process to mitigate these risks.
An alternative to free delivery is DVP. A typical DVP process involves the simultaneous delivery of an asset to a trading party in exchange for the receipt of the respective payment from this trading party. Usually, DVP settlement is facilitated by an independent third party such as a clearinghouse, e.g., Clearstream or Euroclear. Although DVP settlement manages to reduce settlement and counterparty risk, it also has drawbacks:
- First, there is still a counterparty risk on the clearinghouse involved, although the risk is relatively low compared to the case of free delivery.
- Second, involving additional intermediary results in increased settlement (transaction) costs. Only members or clients of members of clearinghouses can benefit from the clearing service and DVP settlement. -
- Third, various assets are cleared through various clearinghouses that imply more complex and less efficient liquidity management. In such a situation, a treasurer needs to optimize cash flows among a number of clearinghouses and constantly monitor sufficient funds.
How can blockchain technology improve settlement processes?
Blockchain technology can improve settlement processes substantially. First, using a blockchain makes it possible to decrease counterparty risk as it enables a trustless settlement process that is similar to DVP settlement in a way that the delivery of an asset is directly linked to the instantaneous payment for the asset.
Therefore, atomic swaps enable direct “barter” operations when one tokenized asset is directly exchanged for another tokenized asset (delivery versus delivery). Here, “directly exchanged” means that the technology guarantees that both transfers have to happen. It is technologically not possible that only one transfer is executed if the other transfer is interrupted for whatever reason. Besides, if a blockchain is used for settlement, a third-party intermediary that helps to facilitate settlement in the case of a conventional, not DLT-based DVP is no longer necessary. This implies peer-to-peer settlement that leads to substantial cost savings for the settlement. In addition, cross-chain atomic swaps cover more complex cases such as trustless settlement among more than two parties. Using atomic swaps, operations can be executed in a trustless manner:
- One example for a cross-chain atomic swap is the trilateral case when Party A needs to deliver Asset 1 to Party B while Party B needs to deliver Asset 2 to Party C while Party C needs to deliver Asset 3 to Party A.
- A real-life example is a three-party agreement among a crypto payment processing company, crypto liquidity provider, and a merchant such as an online shop. Nowadays, the processing company accepts digital assets from an end customer, sends them to the liquidity provider that converts digital assets to fiat currency, and sends it to the merchant that, in turn, provides a service or delivers a good to the customer.
How does the blockchain-based settlement work in detail?
A common example of a two-asset swap, i.e., exchanging one asset to another, works as follows: Party A sends an initial settlement instruction and Party B sends a matching settlement instruction. In a blockchain world, a settlement instruction is a smart contract that includes relevant information such as asset 1, asset 2, quantity 1, quantity 2, blockchain addresses of both parties etc. Atomic swaps allow the execution of two smart contracts in a way that Party A receives an asset from Party B only if Party B has received an asset from Party A (and vice versa). In such a setup, the task that is typically conducted by clearinghouses is solely implemented by a computer program without any possibility to interfere with the execution. Consequently, a reconciliation conducted by a financial organization is not necessary anymore.
Figure 1 visualizes the settlement process step by step. A tokenized euro in the form of commercial bank money and a tokenized asset such as a tokenized stock are used as an example:
- Party A creates an initial settlement instruction in the form of a time-locked smart contract on Blockchain 1, which includes the address of the receiving Party B, and locks a tokenized stock;
- Party A sends the hash from the private key to this smart contract to Party B;
- Party B creates a matching settlement instruction in the form of a time-locked smart contract on Blockchain 2 with the same hash to lock the pre-agreed amount of tokenized euro; there are now two transactions on two different blockchains that are locked with the same hash;
- If Party B does not create the second smart contract, the first smart contract will expire after a specified time T and a tokenized asset will be returned to Party A;
- If Party A does not execute the second smart contract, the second smart contract will expire after a specified time t and tokenized euro will be returned to Party B;
- Party A knows the hash and unlocks, i.e. reveals its secret key to the public, the second smart contract and receives the amount of tokenized euro;
- As a next step, Party B sees the secret key and can unlock the first smart contract. Even if a third party unlocks the smart contract, a tokenized asset will be sent to the address of Party B anyway, which is specified in the smart contract.
Despite the great potentials of such blockchain-based settlement, the practical implementation often faces unforeseen problems. However, there are projects that are close to having blockchain-based settlement in production.
As a prerequisite, there must be a non-custodial trading platform such as Finery eFX that allows subscribing to market data streamed by liquidity providers, defining peer-to-peer trading limits, executing orders as well as clearing (i.e., calculation of the net aggregated positions per asset per counterparty). Besides, such a platform must provide an API that allows communication about the post-trade settlement to automate the process. A software system such as Jelly Swap must be in place to facilitate the trustless exchange of the supported assets using smart contracts and time-locked transactions.
However, before fostering wide adoption of blockchain technology for post-trade settlement, associated risks must be identified and analyzed thoroughly. Some of them are listed below:
- Counterparty risks. Party B is given a limited amount of time to confirm the transaction. As market prices are volatile, Party B gets, in essence, a free-of-charge option with a very close expiration time that can be executed at the expense of Party A.
- Operational risks. The software that connects to the blockchain must be up and running 24/7. Thus, power outage, internet outage or hardware problem may result in the temporarily unavailable service.
- Software-related risks. These risks may include bugs in smart contracts and should not be underestimated. With more complexity in smart contracts and with interconnected smart contracts, the risk significantly increases.
Using blockchain technology for DVP settlement substantially decreases counterparty risk that is typically one of the most expensive risk factors. Therefore, lower counterparty risk increases the efficiency of settlement processes significantly, thereby reducing costs for various business processes. Such blockchain-based DVP settlement can be applied not only in the context of financial assets but rather for all DLT use cases where assets such as immovable property, goods, or services are bought for money or exchanged with other assets. With this, basically, all consumption and trading processes are covered if they involve digital goods, services or assets. In particular, costs associated with high-volume payments such as real estate will be significantly reduced.
As regulatory treatment of digital assets gets more and more clear, companies should now analyze the merits of tokenization of physical assets and should consider DLT for their industrial use cases. Furthermore, efforts tokenizing the euro in the form of commercial bank money, e-money, or central bank money should be intensified, since a digital euro is necessary to enable efficient blockchain-based settlement.
About the authors
Prof. Dr Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). In 2018 and in 2019, he was ranked as one of the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Further, he belonged to the “Top 40 under 40” — a ranking by the German business magazine Capital. Since 2017, he is member of the FinTech Council of the Federal Ministry of Finance in Germany. The expertise of Prof. Sandner includes blockchain technology in general, crypto assets such as Bitcoin and Ethereum, the digital programmable Euro, tokenization of assets and rights and digital identity. You can contact him via mail (firstname.lastname@example.org) via LinkedIn or follow him on Twitter (@philippsandner).
Jonas Gross is a research assistant at the University of Bayreuth and project manager at the Frankfurt School Blockchain Center. His research focuses primarily on central bank digital currencies (CBDC) and stablecoins. You can contact Jonas by mail (email@example.com), LinkedIn, and Twitter (@Jonas__Gross).
Ilia Drozdov, CFA, has a master degree in financial economics and is a co-founder of a fintech startup Finery Tech that is a technology vendor focusing on creating non-custodial trading solutions, which provide for reduced execution costs and lower counterparty risk. You can contact Ilia on LinkedIn.