In 2016 Project Jasper started exploring the use of distributed ledger technology (DLT) for clearing and settlement of Canadian securities. Yesterday the participants, Payments Canada, the Bank of Canada, TMX Group, Accenture and R3 published a report on the Phase III Proof of Concept (PoC). The results from the tests prove DLT can enable equities settlement but are somewhat neutral. However, that’s not because of any technology weakness, but instead the result of the current complex interconnected systems which make comparisons difficult.
Hence the report concludes that the scope would need to be significantly expanded to realize full benefits. That would include testing additional processes such as securities lending, derivatives, and fixed-income trades.
- Both securities and cash were tokenized on-ledger to achieve delivery versus payment DvP
- Benefits of DvP undermined because PoC extended credit to brokers, re-introducing credit risk
- Immediately finality is good for liquidity, in theory
- In practice, liquidity optimization is complex so instant settlement benefit less clear
- Liquidity also depends on other activities such as securities lending and derivatives
- Like-for-like comparison with entirely different models is tricky
A fuller reading of the report shows that it’s not about the technology itself. Instead, it’s about seeing which different business processes DLT can enable. And discovering whether or not these new models are more efficient than existing centralized ones. Also, the PoC focused on connecting existing market infrastructures, as opposed to considering whether any of the current central counterparties are still needed.
Digital Depositary Receipts (DDRs) were used to tokenize both securities and central bank money, enabling on-ledger settlement. The report was very optimistic about this aspect and suggested it merits further exploration. Because on-ledger transactions are final, the DDRs could be re-used or redeemed immediately after a transaction.
The critical benefit of tokenization is to achieve immediate finality of delivery versus payment (DvP) which takes away the risk of a counterparty going bankrupt before transaction completion.
However, brokers are not members of the payments system. So to enable access to cash on-ledger, brokers received credit from a credit extender, which is how it works in the current system. But using this conventional process re-introduced credit risk, thereby undermining one of the significant benefits.
Hence the report stated: “DLT-based models that experiment with more fundamental departures from the current settlement process and market infrastructures ecosystem may be more likely to demonstrate operational cost savings and reduced back-office reconciliation efforts.”
Immediate finality means that both the cash and equities can be reused straight away. While that seems beneficial, in practice the comparison to the current system is quite complex.
Today participants pledge collateral to eliminate intraday cash requirements. And net settlement positions take account of existing securities positions.
The report notes that to assess liquidity accurately, it would need to accommodate securities lending and derivatives. For example, in some cases, a transaction cannot complete because the equity isn’t available since it’s pledged to a lending arrangement that unwinds later in the day.
The PoC used some specific models which may have made comparison harder. For example, the PoC required participants to pay in their net cash requirement at the beginning of the day. Settlement was immediate. That compares to the current model of intraday collateral-backed payments, with end of day settlement.
One thing not mentioned in the report is the potential benefits of finality in a crisis. The intraday collateral issue complicates crisis situations which are much more straightforward with immediate finality.
Also, it’s taken a long time to evolve the existing system. So there’s a need for experimentation with the new opportunities that DLT offers. Hence the report suggests “a more ambitious re-imagining of clearing and settlement in a decentralized form”.