DLT can cut across systems, processes within internal firms and corporate boundaries, and existing market structures. The adoption of DLT was once viewed as having the potential to remove financial intermediaries and give clients or regulators-controlled access to real-time data and eliminate the need for reconciliations.
The reality is quite different. As the initial excitement surrounding DLT subsides and credible DLT implementations emerge, it becomes clear that the outcome can be materialized fully in instances such as when operating within the DLT or for some specific functions. DLT provides one more option to process the trade but cannot replace the existing financial market infrastructure over the next three to five years. Trade processing under classic market infrastructure and DLT need collaboration for broader market adoption. Thus, DLT will continue to coexist with classic technologies to bring the transformational potential of DLT in the next five to 10 years. Financial institutions will adopt DLT in various forms and in parallel with other initiatives such as adopting cloud technologies, outsourcing trading activities, standardizing messaging interfaces, and integrating existing technology platforms to ensure smooth data flow across their businesses to strengthen existing operating models supporting classic assets.
Forms of securities and methods of payment
There are three forms of securities representation in the classic and DLT models:
Classic: These are the classic securities traded on the market or in the off-market and then settled at custodians or with depository institutions.
Tokenized: This is a model in which the original form of the securities is held at a custody bank and an equivalent representation of the securities is made on the DLT platforms.
Native to blockchain: The original form of the securities exists only on the DLT platform on which it is issued, and there is no equivalent representation of the securities at the custody bank.
There are four methods of payment representation on the classic and DLT models:
Fiat currency: These are the currencies issued by a country’s central/reserve bank and widely exchanged over the existing banking network.
CBDC: These currencies are issued by central banks in digital formats without physical notes or coins.
Stablecoins: These coins are backed by a basket of underlying holdings comprising cash equivalents and securities.
Cryptocurrencies: These currencies are issued solely on the blockchain and are not backed by any reserves.
A matrix of three forms of securities representation and four methods of payments leads to 16 different operating models. See Figure 1. Each model has its level of maturity based on market adoption, scalability, and viability.
The movement across the operating models is best made via horizontal and vertical movement instead of a diagonal jump from one operating model to another. Thus, DLT adoption and development of a solid business process around the operating models demand various considerations. These considerations will make the business process sustainable and scalable.
DLT applicability to an asset class
The applicability of innovative technology, such as DLT, has a cost of adoption and a potential benefit. The cost of adoption includes the cost of potential change in the current infrastructure, including process, people, and technology. The potential benefit comprised savings, revenue, and reduction in risks. Figure 2 highlights the cost of adoption and the potential benefit of DLT applicability across asset classes and key functions.
Market View
In the equity market, DLT applicability is observed most in settlement and post-settlement functions, and much less in equity issuance and trading. Fixed-income benefits are significantly under issuance, settlement, and post-settlement functions. The benefit of DLT in private markets is evenly spread across all functions and is observed most under the post-settlement activities, such as collateral management for derivatives. DLT has a high potential under FX settlement and post-settlement activities. For the commodities market, the benefit is more in issuance, trading, settlement, and post-settlement.
Function View
DLT adoption occurs most frequently and maturely under post-settlement activities, followed by issuance, settlement, trading, and clearing. The recent experience of ASX CHESS validates that clearinghouse, and clearing members do not expect a significant benefit from adopting DLT in the clearing. However, there are significant benefits if DLT can change the clearing models (e.g., Paxos) for the equity market.
Conclusion
DLT is not for everyone: DLT, as a solution, works for specific functions supporting an asset class, such as equity trading. It is not an optimal solution for all trade processing functions. The complexity involved in DLT adoption, combined with the drive to maintain existing market infrastructure, creates significant pressure on business functions to support additional and often parallel daily activities.
Need for a bridge to connect all operating models: Efficient securities and cash movement are critical to completing trading activity obligations. Individually, the market infrastructure provides significant benefits but needs a seamless bridge connecting all market infrastructures.
Need for challenging use cases with buy-in from stakeholders: DLT has provided an opportunity to solve long-standing problems in securities issuance and processing. DLT implementation is complex, so the challenge is to identify the relevant business use cases and functions where it can be deployed industry-wide. All relevant stakeholders should support the initiative to make the use case valuable and viable.
Transformational efforts are required to support classic and Digital Assets: Financial institutions need to transform their business, operations, and technology models to support existing (classic) and Digital Assets. Transformation efforts must align the various functions performed in operating models and address the challenges of maintaining the operating model over the next five years.
What the industry learns in the next two years will shape the next 10 years of settlement evolution: The knowledge base created today to achieve integration between the classic and DLT markets will create the foundation for the next phase of trade processing. The next phase of automation will rely on technology but will need additional focus on risk management processes.