Euroclear: You Don’t Need a Blockchain to Fix Securities Settlement

ledger-top

It’s time we better understood private blockchains. Photo: Shutterstock

Euroclear, along with consulting firm Oliver Wyman, has published a great report on the potential for the blockchain in the context of capital markets.

If you’re not familiar with the company, Euroclear provides post-trade settlement services for financial institutions in over 90 countries, which makes it the largest international central securities depository (CSD) in the world.

Overall, the report presents distributed technology in a very positive light, suggesting that the adoption of blockchain settlement could save time and money by eliminating redundant systems and providing a single version of the truth for all market participants.

But it might be a smidge early for private blockchain aficionados to break out the party hats. Because that last statement comes with an asterisk.

As it happens, those potential benefits aren’t unique to blockchain technology. As the report noted, there are “other ways to achieve these benefits.” That includes utilizing “existing technologies” or, better yet, “no actual technology at all.”

Explains the report:

Adoption of blockchain technology will be reliant upon aligning industry standards for the process, data terms, contractual documentation and so on. Regardless of technological innovation, this standardisation can improve settlement times and cut costs even using existing market practices and infrastructure.

A central authority could maintain a single universal source of the truth database recording asset transactions which all participants use as their golden source: essentially an expansion of the role taken by a Central Securities Depository (CSD) in a traditional infrastructure. Likewise, features could be built into the existing market infrastructure, allowing the auto-execution of coded logic embedded into smart contracts. Indeed, smart contracts already exist in basic form. Finally, real-time settlement of asset transactions occurs today in some circumstances. It is a market choice that a settlement cycle no shorter than two days is standard for cash equities in European markets. The industry operates at the speed of the slowest trades.

So why are private blockchains or shared ledgers perceived as a clear panacea for the financial industry?

Today, each bank maintains its own ledger. This means that at some point, they will have to reconcile their version of the truth versus that of their counterparties, which adds significant costs and delays to the system.

In a way, that’s why the idea of a private blockchain intuitively clicks for bankers—by appearing to potentially address that pain point. Having a distributed ledger means that there exists a single version of the truth and every network participant already has a copy. This would conceivably reduce costs and delays and reconciliation and settlement.

But a private blockchain also introduces further complexity to the system in other ways.

For banks, the idea of a shared ledger is problematic because they need to keep their transaction data confidential. That would need to be addressed somehow.

As Euroclear suggests, it’s unlikely the solution will be very straightforward—not to mention additional considerations around the issues of security and authenticity:

Anonymity is a critical requirement for many processes in capital markets. Cryptography could go a long way in protecting anonymity in a blockchain. However, it will require meticulous key management records, maintained separately from the blockchain for each participant, to decrypt and reference back the entries they hold an interest in. Furthermore, the ability to reveal selective information to counterparties for credit assurance, for instance, makes it extremely difficult to prevent errors that result in major data breaches. And overarching all these considerations is the question of how to link cryptographic identities to real world identities.

In other words, half the challenge is sharing everyone’s transaction data. The other half of the challenge is hiding it again. Also notable is the fact that the system touted to eliminate the need for redundant systems is itself a set of redundant ledgers.

Efficient? Unlikely. Elegant? Hardly.

Of course, the unique feature for distributed ledgers is that they theoretically don’t require a central operator, which we’ve discussed in depth in the past.

It might seem like a minor quibble, but matters a great deal in the context of the banking industry. After all, the relationship between competing yet cooperating banks might best be described as “frenemy.” Giving any party power over the rest is less than ideal. The belief then for blockchain is that, lacking a central operator, this is a non-issue.

In practice, the situation will likely be a bit more muddled. Ultimately, someone or some party is going to have to manage the private blockchain—such as when new participants need to be added to the group or if upgrades are required as the platform scales. So in a sense, a form of central operator will continue to exist—although admittedly one that has less unilateral control and power over the network.

And so when push comes to shove, it may turn out that a private blockchain solution starts to resemble the existing infrastructure they’re supposed to replace.

All of which begs the question—would it make more sense to have a centralized system? There wouldn’t be much difference when it comes to functionality and governance. In this scenario, market participants can access the single ledger of truth through an API. Since there’s no need for redundancies, the major difference would be performance.

Still, banks might decide that when it comes to private blockchains, the pros outweigh the cons.

On the other hand, as we’ve noted in the past, we believe this will be the year that people realize that they don’t actually need the blockchain for their use case—like the state of Vermont did last month.

The Depository Trust & Clearing Corporation (DTCC) expressed their blockchain skepticism in a white paper earlier this year.

But what’s most important is that we’re finally having this conversation.

In truth, that’s where the blockchain’s magic lies—the ability to inspire. As the Euroclear report notes, it’s all this “activity around blockchain technology” that is “creating energy for further improvements to the system.”

In the end, that’s what really matters.

Read Euroclear’s full report.