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How fast should trades be settled on financial markets? If I sell a stock now, how long does it take until I can use the cash proceeds? Until recently, it could be several days. In September 2016, the Securities and Exchanges Commission (SEC) proposed to shorten the U.S. markets' settlement cycle from three to two days. In a market where high frequency traders update quotes every nanosecond, talking about a post-trade infrastructure where delays are measured in days feels like a different era altogether. Trades need to follow a long route, through a central counterparty, custodian banks, and a central securities depository. Blockchain (or, generally, Distributed Ledger Technology or DLT) is poised to change the status quo and bring post-trade infrastructure up to speed. DLT uses a distributed messaging protocol (a "ledger") to create consensus across all counterparties and maintain a unique, authoritative shared record. Regulators agree that with Blockchain, long settlement chains are obsolete (see, for example, some recent reports from European Central Bank, ESMA, or the Fed Board). The decentralized nature of Blockchain allows trades to be validated through market consenus almost instantaneously: that is, immediate settlement. Does this mean we should settle trades immediately? Not necessarily. Fredrik Voss (VP of Blockchain innovation at Nasdaq) envisions a world where we [..] allow participants to select the pace at which they want to settle, which has been challenging to do in the market today. More anectodal evidence that immediate settlement is not always best comes from Moscow, where a reform to implement same-day settlement has been reversed in March 2013: trades now settle in two days, like in most places around the world.
In a new study with Mariana Khapko (University of Toronto), we take a fresh look at the economics of settlement times. The main market imperfection, in our view, is not the length of time-to-settlement per se as much as its rigidity (so far, due to institutional and technical requirements). What Blockchain and DLT bring to the table is the option of shorter settlement times, rather than simply faster settlement. There are two main channels we focus on. First, a long time-to-settlement means that a trader is exposed to counterparty risk for an extended period of time -- and might not actually receive the trade proceeds on the settlement day. However, at the same time longer times-to-settlement could help liquidity. Forcing traders, especially market-makers, to settle immediately is equivalent to asking them to hold (risky) inventories to settle against. If settlement times are longer, market-makers can act as intermediaries and match buyers and sellers without having to hold large inventories. Exactly how large settlement time should be depends on -- potentially time-varying -- (i) counterparty risk and (ii) search costs in a given market. Having the option to adjust time-to-settlement in time and across assets is therefore valuable. Who should exercise the settlement time "option" introduced by Blockchain? One way would be that the exchange sets a fixed time-to-settlement for all trades (in a given security, or on a given day, or both). Another way is to build a "3-D" order book, where traders specify prices, quantity, and preferred times-to-settlement. We find the first option yields the largest welfare. In our model, if market-makers are allowed to choose times-to-settlement, they choose to specialize. Some market-makers offer expensive, but fast settlement, whereas other market makers offer cheap contracts, but with long settlement times and high counterparty risk exposure. Having the option to propose trades with different levels of counterparty risk allows market-makers to relax price competition and earn excess profits. Moreover, such rent-seeking behaviour is more pronounced when counterparty risk is already high, as that widens the scope for specialization. Conversely, if the exchange sets a unique time-to-settlement, it stimulates price competition between market-makers. Whether and how large an impact Blockchain technology will make on financial markets remains an open question. The overarching message of our study is that Blockchain's main value for trade settlement is its flexibility. Market design choices influence which trading stakeholders are best positioned to take advantage of such flexibility -- with important consequences for liquidity and market quality. P.S. The paper is available [here]. Comments are closed.
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