One of the most touted benefits of distributed ledger technology (DLT) for securities is atomic settlement. This is the blockchain equivalent of delivery versus payment (DvP) – the securities and cash are exchanged simultaneously, preventing either of the parties from being out of pocket if the other side defaults. However, it’s also known to impose higher cash or liquidity requirements on the counterparties, eliminating the benefit. A new research paper argues that if settlement is delayed for as little as ten minutes to an hour, with netting it’s possible to achieve most of the benefits of a one or two day settlement window.
Atomic settlements versus netting
In the crypto world, atomic settlement often infers instant settlement, but doesn’t have to. The atomic exchange rather than the immediacy reduces risk most. In 2019 the DTCC wrote a paper arguing against instant settlement using DLT.
The rationale is if you made ten buy and sell trades with various counterparties during a day, you might need to come up with $10 million in cash at different times with atomic settlement. In contrast, netting the settlement at the end of the day might only require a $500,000 payment. In today’s traditional finance (TradFi) markets, the DTCC is the biggest central counterparty operator providing netting capabilities or deferred net settlement.
Meanwhile, one of the feedbacks that Ledger Insights has regularly heard about atomic settlement is the advantage of timing certainty in the future rather than needing to be instant.
The net settlement study
Dennis McLaughlin, the former Head of Financial Risk at LSEG, authored the paper “The Trade-off Between Shorter Settlement Times and Multilateral Netting Benefits.” With the U.S. and Canada moving from two-day (T+2) to one-day (T+1) settlement, there’s a natural question of how far it can go.
The author acknowledges that intuitively, the longer the netting period, the greater the benefit. However, he had a surprising result using NSCC statistics for the U.S. equity markets. “For the network as a whole, there is no theoretical loss of the multilateral netting benefit for a settlement window of length no less than 1 hour,” he wrote. In fact, after ten minutes, it’s possible to achieve 90% of the potential netting benefits.
McLaughlin’s paper discusses the pros and cons of implementing a one hour settlement window. We only saw the paper’s abstract, but some challenges are intuitive. For example, the U.S. equities markets are extremely high volume. How does the model adapt to slightly slower markets? Does the optimal netting for the network as a whole disadvantage some actors?
Other issues have been explored elsewhere. Securities lending has a major impact on settlement. The ability to return securities in time for settlement is a huge issue and one of the key challenges for the move to T+1. Major securities lending platform Equilend is exploring DLT, which will help with speed issues. Another paper argued that tokenization requires transparency, but traders could use the data against each other, the so-called ‘hold-up’ theory.
Meanwhile, institutional crypto platforms in the U.S., such as EDX Markets have started using central clearing.
