KEY TAKE OUTS
- The current state of the post-trade ecosystem is highly complex and involves a myriad of players.
- Smart contracts operating on a blockchain have the potential to simplify the complex web of players and resolve existing pain points.
- They have the potential to reduce settlement times for trades to near real-time, create efficiencies, reduced fraud and counter-party risk and reduce operational risk.
- To recognise the potential, blockchain needs to overcome scalability issues.
- Legal and regulatory challenges also need to be addressed.
The March edition of HDY’s The Wrap featured an article entitled ‘Blockchain and Smart Contracts: The Dawn of the Internet of Finance?’ which introduced the basic features of blockchain technology and different blockchain systems. In this article, we go one step further, moving beyond the theory to examine, at a practical level, applications of blockchain and smart contracts in the post-trade clearing and settlement processes.
The ‘Blockchain and Smart Contracts: The Dawn of the Internet of Finance?’ article, apart from detailing the basic features of blockchain systems, also examined smart contracts. It detailed how these contracts, if used as an application layer on top of a blockchain architecture, can be a disruptive force - not only in financial services but potentially any industry that involves transfers of value.
In this article, we explore blockchain and smart contracts in greater detail, examining:
- the current state of the post-trade ecosystem and its pain points;
- the ways in which blockchain and smart contracts can improve efficiency and reliability, and reduce transaction risks, within that ecosystem;
- the key technical, legal and regulatory challenges that need to be addressed; and
- what this means for existing players within the post-trade ecosystem.
Current state of the post-trade ecosystem
The current post-trade ecosystem involves a complex web of players. These players include brokers, dealers, custodian banks, the securities exchange, central securities depositories (CSDs) and central clearing parties (CCPs).
Each player in the ecosystem maintains its own systems and ledgers that record each transaction.
To facilitate a trade, messages are exchanged and reconciled between the various players in the ecosystem at different stages of the transaction. The critical success factor is how well information flows between all players.
The high volume of information exchange and reconciliations occurring among the players means that the ecosystem is susceptible to delays, errors and costs.
A successful trade occurs in three stages:
- Execution: This is the pre-trade stage and begins with investors placing buy or sell orders through their chosen banks. The banks send information about the buy or sell orders to the securities exchange - the ASX - which matches the orders, confirms the trades and initiates the post-trade clearing and settlement processes.
- Clearing: The post-trade process begins with clearing the trade. After a trade has been confirmed by the ASX, the custodian banks send trade information to the CSD on behalf of the investors. The CSD validates the trade information and matches all sections of the trade.
- Settlement: After all sections of the trade have been matched by the CSD, information is sent to the CCP which determines the net transactions across all trades and custodian banks, in order to minimise the number of required transactions.
The CCP is responsible for simultaneously transferring equity and cash between the custodian banks on behalf of the investors.
Current state pain points
The following pain points are inherent in the current ecosystem:
- T+3 settlement time: Settlement of the trade takes up to three days after initial trade confirmation.
- Inconsistent data quality: The frequent exchanges of information result in inconsistent data quality. This often requires the CSD to manually validate transactions before settlement.
- Counterparty risk: There is a risk that counterparties may not be able to fulfil their obligations to settle the transaction.
- Operational risk: Due to complexity of processes and high volume of information exchange, there is a risk of inaccurate settlements caused by technological and/or manual errors.
A blockchain and smart contract-enabled post-trade ecosystem
Smart contracts operating on a blockchain have the very real potential to resolve or minimise the pain points identified above.
A smart contract is a computer program that automatically verifies and executes some or all of the terms of a contract on the achievement of certain pre-determined events.
There is no need for human intervention. When the smart contract code recognises the achievement of the pre-determined events, it automatically triggers execution of the transaction and the movement of value.
Smart contracts are trustless, autonomous and self-enforcing creatures.
We set out below how smart contracts operating on a blockchain could work within a future-state post-trade ecosystem:
The processes involved in the pre-trade execution stage remain unchanged; that is, investors and brokers still place buy or sell orders through their custodian bank, which would then send information about those orders to the ASX for confirmation and matching.
The role of the CSD in clearing activities disappears and is replaced with a smart contract. The smart contract automatically validates the trade details provided by the custodian banks and matches all sections of the trade in real time.
The role of the CCP in settlement activities disappears and is replaced with a smart contract. The smart contract automatically:
- determines the “net transactions” across all trades (thereby minimising the total number
- of required transactions);
- simultaneously executes all of the relevant transfers of equity and cash between the custodian banks on behalf of the investors;
- records the transfers on a shared, distributed ledger; and
- ensures each investor is automatically notified as settlement occurs.
Resolving the pain points
The future-state described above has the potential to transform the post-trade ecosystem by:
- Reducing the settlement time for trades: Settlement times reduce from T+3 to real-time (or near real-time), thereby removing friction in the ecosystem and improving liquidity.
- Improving the efficiency of existing clearing processes: Efficiency gains are achieved by allowing trade matching to occur using standardised data fields.
- Reducing fraud and counter-party risk: Fraud and counter-party risk is reduced as a result of the smart contract’s ability to automatically verify and enforce trades.
- Reducing operational risk: Operational risk is reduced by the reliance on smart contracts to simultaneously transfer equity and cash, avoiding the errors (both technological and manual) present in the current ecosystem.
- Ensuring timely and reliable notifications of settlement to investors: This is achieved by virtue of storing trade confirmations on a distributed ledger.
To recognise this potential, there are a number of practical, legal and regulatory challenges that need to be addressed.
First of all, in order to maintain its decentralised nature, the blockchain needs to be able to scale. This means:
- Transaction throughput: Throughput of millions of transactions per second (or even higher) will need to be achieved. By way of comparison, this far exceeds the performance of the current Bitcoin network which is only capable of processing just 1 transaction per second on average (with a theoretical maximum of seven transactions per second).
- Minimum latency: Blocks of transactions in the blockchain need to be processed in seconds (at similar levels to the Visa or MasterCard network). By comparison, each block on the Bitcoin network takes about 10 minutes to process.
- Maximum network bandwidth and storage capacity: There needs to be high levels of bandwidth in order to download the increasingly growing sizes of blocks on the blockchain.
Scalability is an ongoing and evolving challenge, and not all of these issues can or will be resolved ahead of time. For now, the focus is on designing blockchain systems that meet the needs of the particular solution such that they operate within current network and computing power capacity, constraints and limitations.
Secondly, because much of the transformative nature of the technology lies in the ability of smart contracts to automatically execute processes that then bring about changes on the shared ledger, we need to be able to deal with the legal and regulatory challenges which smart contracts present. These include:
- Legal status of smart contracts: We need to ask how smart contracts fit within our common law understanding of contracts. To be an enforceable contract at law, the elements of contract formation still need to be satisfied – there needs to be an offer, acceptance of the offer, consideration passing and an intention by the parties to enter into the contract.
A “smart trade” may well be capable of satisfying these elements and being considered an agreement at law.
The requirements of the Electronic Transactions Act 1999 (Cth) are, generally speaking, also likely to be satisfied in the case of validly formed smart contracts.
- Inflexibility of code: A smart contract is “smart” in terms of self-executing upon the occurrence of events coded into the contract. But what happens if all possible scenarios have not been properly coded for?
In such circumstances, the smart contract may have unintended consequences for the parties. How would this be addressed, particularly if the smart contract otherwise purports to be complete?
- Coding errors: Smart contracts are written in software code - something which, by its very nature, will often contain bugs or errors. If there was a coding error, how would that be identified and by whom? Which counterparty would be legally required to fix it? What are the legal consequences on the rights and obligations of the parties in that scenario?
- Liability and risk allocation: At a pure smart contracting level, the code should simply deal with liability through performance. This is a somewhat simplistic view, however.
The reality is that smart contracts still need to be considered within the context of our existing and established legal frameworks. For example, it is conceivable that the law of mistake could apply if the code did not accurately reflect the trade that the two counterparties had understood they had entered into.
In other words, smart contracts do not exist in a vacuum, and it is possible that the law could mandate an outcome which is different to the outcome programmed into the smart contract code.
If that were to arise, how would a smart contract transaction on a blockchain be unwound? And what would that mean for the downstream transactions that have already formed on the blockchain? Will there be a need to legislate for “kill switches” in times of high stress?
- Confidentiality and security: This is a huge challenge. Smart contracts operating on a blockchain result in massive repositories of data. This raises concerns about the ability for someone to gain unauthorised access to the information. And, while some will point to the cryptography underlying the technology, there is always the risk of a user’s private key being inadvertently disclosed.
- Privacy: Smart contracts formed on a blockchain are much like a cloud solution, in that they do not respect borders or boundaries. This gives rise to significant cross-jurisdictional privacy issues, particularly where trades involving individuals may be capable of being tracked and analysed.
- Auditability: Interestingly, the flip side to the confidentiality/privacy debate is that the availability of the data provides an audit trail and a much more efficient way for regulators to view the information they need to ensure regulatory compliance.
- Jurisdictional issues: Smart contracts also raise interesting jurisdictional issues. Because blockchain operates as a decentralised ledger, it means that smart contracts - and, indeed, “smart trades” - can be formed and accessed across the globe. They do not reside in any one location; yet our laws are jurisdiction-based.
If there is no express stipulation of the governing law and jurisdiction, what law and jurisdiction would apply?
The differences in laws across jurisdictions, including things as basic ownership laws, can also be highly problematic.
- Regulatory and policy settings: These settings will need to be considered in greater detail. How are regulators to police smart contracts? And what opportunities exist for parties to use the technology to potentially side-step the law by hiding the identity of the parties and the governing jurisdiction of the contract? How are cross-jurisdictional issues of taxation, national security and anti-money laundering to be managed?
Blockchain and smart contract technology is still only in its infancy. But these are some of the challenges that players in the ecosystem will need to grapple with, and which will require further attention as the technology continues to evolve and become part of the fabric of the post-trade environment.