Another day and more news about blockchain, this time in the wholesale financial markets. I’m presenting at a conference later this week, and the organisers asked me to think about collateral management. This is a subject that has been perplexing our capital markets group in London, as EMIR (the European Markets Infrastructure Regulation) mandated that firms provide collateral against trading in real-time. Tough call when most markets have operated at T+3, which means settling three days after the trade.
The uncertainty of settlement is written into the Markets in Financial Instruments Directive (MiFID) and is a key risk in all investment markets. Will the counterparty pay?
When the Lehmans crisis exploded, the loss of trust between counterparties is half the reason why the rug was pulled on so many banks. Washington Mutual and RBS had highly leveraged their capital base through wholesale funding and the inability to roll over those leveraged contracts is the key to what caused their downfall.
So now we move to a world where everything is becoming real-time and near free, and the blockchain is a key driver of this future. The expectation that banks can build a trusted shared ledger between counterparties is a core focal point for the future. This is why UBS are developing a settlement coin.
In an announcement last month, UBS and Clearmatics are developing the concept of a settlement coin that could reduce settlement from T+3 to immediate real-time clearing. The interesting thing here is that just a few months ago, Clearmatics said that such a move was unlikely. In a blog entry titled: No, Bitcoin is not the future of securities settlement, Clearmatics CEO Robert Sams makes clear that Bitcoin is not the future. His view is that Satoshi Nakamoto’s white paper attempted to solve two problems:
Avoiding a third party deleting a transaction, and so reversing history; and
A third party censoring a transaction by refusing to enter it into the ledger (the blockchain).
In writing about how bitcoin achieves this, Robert notes:
If an attacker wished to maliciously replace part of the “sequence of events witnessed” by the network (eg, one where he made a big payment to someone) with an alternative version of history (eg, one where he didn’t make that payment), he would have to redo the latest work of the longest chain, and do this work at a faster rate than the rest of the network. Hence, he would need to control over 50% of the network’s CPU power.
And that, in a nutshell, is Bitcoin’s security guarantee. If you’re comfortable believing that an attacker is unlikely to ever pull together more than half of the network’s computing power, you can trust the veracity of the blockchain’s record of transactions.
What Robert says in his lengthy blog update is that the bitcoin experiment created by Satoshi Nakamoto is brilliant but that it is an experiment that would be unsuited to the trials of the securities markets, where security is key. It is worth reading as it will tell you a lot more about the UBS Clearmatics’ Settlement Coin, with perhaps this paragraph providing the clearest implications:
It takes days to settle trades in book entry assets. This fact is only puzzling to those labouring under the mistaken assumption that custody accounting in the financial system is somehow centralised. It’s not. Records are distributed throughout the system by thousands of different institutions, each maintaining their own siloed accounts and constantly reconciling against each other to come to agreement on the global state of who-owns-what, or who-owes-what-to-whom. It is, in a sense, a form of distributed consensus: consensus-by-reconciliation. And consensus-by-reconciliation is very slow, expensive, and hard to automate. It is this technological infrastructure of consensus-by-reconciliation that the bankers, quite rightly, see being replaced by distributed, shared ledgers. This is a different problem from the one Satoshi tried to solve, as a careful reading of Satoshi’s abstract alone makes perfectly clear.
Regardless, we are seeing the blockchain use cases expand rapidly and the confusion arises between a blockchain and a bitcoin blockchain. What Robert and others are saying is that the blockchain technology capability is a key development for overhauling the financial system to operate in a real-time, low-cost structure. That is the key, and that is why UBS and others are starting to work on making this happen but, to make it happen, is critically underpinned by an agreed shared ledger on the blockchain. That is what the UBS settlement coin is all about.
As the announcement of the Settlement Coin says: UBS “does not plan to issue the digital coin itself. Instead, UBS will work with other market participants such as buy-side firms, regulators and market structure providers for an industry-wide product.”
The thing is, if we have a real-time settlement system, what happens to TARGET2 for Securities (T2S), the Correspondent Central Banking Model (CCBM) and other similar central bank inspired collateral and settlement systems? Have we just wasted a decade of effort to replace them all with something far more efficient using the 21st century technologies of the internet?