U.S. and European payment systems1 as we fondly know them are notoriously antediluvian. In China, all a consumer needs to do to send money is to input on their phone the beneficiary’s 16-18 digit account number, name, and bank name. Final credit is typically received in 5 seconds – not up to 5 hours, as for a U.S. domestic wire. Nor do Chinese consumers experience the grotesque fees charged for Western Union’s “instant money,” which in most cases still requires a trip to clear physical cash. There is no shortage of U.S. and European-based apps, but general standards and rules have yet to be developed. Simply put, financial infrastructure has vast potential for disruptive innovation. As a result, the European Commission6 has conducted a broad-based review ways to make financial services regulation more efficient, less costly and, above all, more anticipatory, by reducing complexity and “future-proofing” laws.

Clearing comprises all processing from the time the commitment for a securities transaction is entered into until consideration is exchanged in settlement thereof – usually contemporaneously. Advanced clearing systems and legal provisions are needed as the speed of trading by far outpaces the ability to complete each such transaction. The settlement process includes a legal transition: during the time span between trade and settlement, a purchaser’s rights are purely contractual and thus personal. Only after settlement, they become proprietary.

While settlement of equities, bonds, mutual funds and municipal securities in the U.S. is usually required to occur within three business days  after the transaction date (T+3) and by T+1 for listed options, options on futures contracts, and government securities, the European standard and that applicable in forex spot markets is T+2 (except trades between USD, CAD, EUR, RUB and TRY, which settle T+1). However, the target is real-time clearing and settlement8 in accordance with ISO 20022 standards for real-time payments. This objective, stated considerable time ago, requires not only broad-based financial technology but also major investments in financial markets infrastructure and legislative adjustments and harmonization. Of course, even with digitally assisted, ledger-based transfers and digital communications, it is far more accurate to speak of near-real time settlement.

Cost-benefit analysis is controversial in an age of skepticism over further market acceleration: “T+2 is probably one step the industry could find a way to cope with. For T+1, someone would really have to define what the benefit is and what problem is being eliminated.” One problem that would be almost certainly eliminated through real-time or quasi-instantaneous clearing and settlement is counterparty risk: the risk that one party in the chain defaults by virtue of insolvency. Given that subsidiaries of DTCC (the Depositary Trust and Clearing Corporation, the major U.S. clearing house and equivalent of Euroclear and Clearstream) settled securities trades in an amount of $1.7 quadrillion already in 2012,17 and daily turnover in the forex markets exceeded $5.3 trillion18 in 2013, it is easy to see that even 3 minuscule per-transaction savings or expenditures mushroom to substantial figures industry-wide. This summary references legal, institutional, policy and structural issues involved in arriving at real-time clearing and settlement.

While countries strive for near-real time clearing systems, the ambition to arrive at near-real time settlement systems is not keeping pace. This is so in part because it would adversely affect banks’ access to funds technically in transit – a true real time payments system would reduce the negative float19 to zero. This would potentially require banks to keep funds available at all times in order to make final payment in real time, when in reality banks do not have funds available but have to find them to make timely settlement, which they accomplish through a variety of liquidity optimization algorithms20 that allow them to come up only with the necessary minimum of funds to cover payment orders. This is also the reason why Real Time Gross Settlement (RTGS) systems are not scaled toward consumers but currently remain restricted to interbank settlements. To understand the tasks involved, it helps to realize that the task of reassigning and delivering a security consists of several rather complex steps that must be verifiable and traceable at the lowest possible cost[/toogle]

Execution 

The commitment stage matches buyer and seller of a security in a public market through any execution platform,22 be it a stock exchange, an electronic trading system, a brokered market or any other form of matching system, with or without intermediary.

 Clearing 

Clearing consists of several steps: matching the trade compares the records of both buyer and seller as to price, quantity, and other terms. Thereafter, the parties identify the accounts to which a security or payment is to be credited. Risk of failed trades is further minimized by interposing a central counterparty (CCP) between the dealers for either party. The CCP acts as seller to all 4 buyers and vice versa, minimizing failure risk through set-off (netting) buy and sell transactions. Netting substantially reduces the need for actual exchange of funds and securities at settlement.

 Settlement 

Settlement involves the exchange of consideration:24 security against payment. In advanced financial markets, physical certificates are seldom held (as a matter of authentication). Rather, they are held indirectly through a book entry system run by a custodian, typically a central securities depository (CSD), which transfers ownership on its records upon evidence of payment. Taking possession in the settlement of a cross-border trade is more involved: local or global custodians acting for international and institutional investors may establish a link for the investor to the foreign CSD holding the security certificate. Countries also differ in settlement cycles, currencies, legal systems, and by a large number of settlement arrangements used for various types of securities

Blockchain clearing and settlement could be conducted in very near real time. It is based on a fintech first applied by the Bitcoin virtual currency. The name refers to a chain of data blocs that include the entire history of origin of payments made for securities, goods or other assets Following execution of a transaction, all clearing steps are entered into a database that functions like a register for monetary units and their origin, for property rights, securities, commodities or any other asset exchanged for payment, by way of title underlying the exchange. The blockchain enables the buyer to recognize the asset within the limits of identification and registration technology. It significantly increases confidence as to legitimacy of title and provenance. Information regarding the new owner is converted into an encrypted data block that cannot be deciphered by unauthorized parties.

Thus, blockchain technology provides for legitimate transactional anonymity. Mirrored versions of the blockchain exist on numerous computers connected globally via internet. They all verify the new data block representing the transaction. Because ex-post-facto ‘corrections’ of prior data blocks on a single system will not be accepted by the rest, they will ignore the doctored version and the transaction going forward. This built-in stumbling block substantially elevates the complications and cost of forgeries or manipulations. The current transaction can be added to the blockchain only upon global validation of its history. One of the technology’s many advantages is that it renders it impossible for one seller to convey the same asset to more than one party.
Blockchain technology is also capable of documenting, transmitting and securing entire contractual relationships. It is at the brink of revolutionary breakthrough – only very recently, Newsweek Europe devoted a major feature article33 to its potential. It is considered a central element of “smart contracts.” When used in conjunction with distributed ledger technology and blockchains, smart contracts are capable of revolutionizing key cost and risk factors, specifically by:

1. Delivering cost savings through streamlined back office processes

2. Verifying identity and certifying transactions

3. Providing an indelible record of transaction history

4. Enabling strangers to trade directly with each other without need for a trusted third party intermediary

5. Automating buy, sell and supply transactions on a B2B and B2C basis, including combinations with the internet of things

5 years ago, blockchain technology was still in its infancy; it neither permits netting of transactions nor ex-post-facto corrections or amendments, nor does a legal standard exist for relevant aspects relating to the passing of property rights within a blockchain. Banks have not accepted dependency on a system where third-parties (including competitors) are processing their data and may be gathering intelligence as to transactions processed by individual financial institutions, raising issues of confidential trading. A broad range of legal implications and technical issues remains challenging aside from ownership and netting, including creating uniform standards, data security, and assignment of liability and risk, securities lending, foreign exchange, allocations and confirmations, fractional ownership and handling physical securities. Similar technological challenges remain in the areas of custody, institutional sell-side and retail brokerage. In any event, blockchain technology goes a long way toward the vision of a Consolidated Audit Trail (CAT) with which, once operational, it has to be closely integrated. The level of transparency will have a critical impact on whether people will use blockchains for clearing and settlement. Equally unclear is their use for collateral management. Blockchains fundamentally reorder the mechanics of financial transactions in ways we did not envision some years ago, while as yet unidentified data risks and concerns53 they may create have not surfaced to date. As a matter of principle, it would be the first quantum leap of innovation not susceptible to abuse.
But the revolution is not limited to business application: blockchain technology will also transform how government works in a wide variety of areas of supervision and approval not limited to the financial sector. It may simplify and render reliable authentication for election processes, opening the door to practicality for direct democracy in more areas than are commonly envisioned for its application to date. At a minimum it opens the door to a hybrid combination of direct and indirect democracy dubbed “liquid democracy,” not only in elections, popular propositions, referenda or petitions conducted by different levels of government, but also in shareholder’s meetings. This will permit devolution of competences of deliberative bodies to parties directly affected by decisions

In the EU, blockchain technology will be affected by a wide array of regulations, including the E-Money Directive (Directive 2009/110/EC, but only to the extent an “issuer” is identified pursuant to art. 2.2), the Payments Services Directive (Directive 2007/64/EC58), and the MIFID-Directive (Directive 2004/39/EC59 and Directive 2008/10/EC60). Characteristically, one of the first considerations in the context of new technology in the EU was its utility for levying financial transaction taxes.61 But the regulation with the greatest impact on European fintech to date is the Second Directive on Payments Services62 (PSD2, Directive (EU) 2015/236663) compelling banks to open their systems to fintechs, allowing them to act as intermediaries between bank and customer.
The EU Commission, the Bank for International Settlements, the World Bank, the United Nations, Europol, ESMA, the UK Treasury, the Bank of England, Nasdaq, as well as startups Blockchain and Epiphyte, hosted a non-commercial roundtable on cryptocurrencies and blockchain in 2016 to educate MEPs and set the stage for future regulatory initiatives.65 The EU Parliament intends to hold off on regulation for now to monitor technological development, and the U.S. CFTC concurs with this Hippocratic “do no harm” approach. However, and regardless of the deficiencies of the legislative and regulatory process on a national as well as international scale, the perception of blockchain’s potential is very clearly reflected in investment trends