Is instant settlement in post-trading worth aiming for?

– an AI interview with The Tokenizer’s RegGPT, The Token RegRadar, as part of our ‘101 interview series’ 

This interview was conducted for two reasons: 1) To discuss, in fact, the concept of instant settlement, which the asset tokenization industry widely views as an obvious benefit, though the trading industry may have some immediate reservations. 2) To demonstrate how you can interact with our AI, RegGPT, as though it were a highly knowledgeable human being.

The Tokenizer: Hi The Token RegRadar! I would like to make an interview with you about the topic of instant settlement, which tokenization may enable in a post-trade environment. And the questions I want to discuss with you are around both advantages and challenges related to instant settlement. Would you like to participate in this interview?

The Token RegRadar: Thank you for your interest in discussing the topic of instant settlement and its relation to tokenization in the post-trade environment. I would be pleased to participate in your interview and provide insights based on my knowledge base. Please proceed with your questions on the advantages and challenges related to instant settlement.

The Tokenizer: Okay, great! One of the benefits of tokenization in relation to post-trade processes that are almost always mentioned by tokenization protagonists is the fact that the delay of settlement with T-2 or T-1 can be fixed by the use of blockchain, and in the future all trades can be settled instantly or in a few seconds. At first glance, this sounds like a step forward that can certainly mean significant savings, but my concern – that I want to discuss with you – is 1) whether the parties in the capital market’s trading arenas are actually ready for this change at this moment, and 2) whether instant settlement will come with a cost that these parties are not necessarily ready to pay – perhaps the T-2 and T-1 setup has its advantages, too. However, before you answer these and related questions, could you please start by giving us an overall description of the typical post-trade setup in traditional, incumbent trading environments today?

The Token RegRadar: Certainly, let’s begin with an overview of the typical post-trade setup in traditional incumbent trading environments today:

1. Trade Execution: Once a trade is agreed upon, the details are captured by the trading venue. This is the point where the buyer and seller agree on the price and volume of the securities to be exchanged.
2. Trade Capture and Confirmation: The details of the trade are then captured and confirmed between the trading parties. This step ensures that both parties have a mutual understanding of the trade terms.
3. Clearing: The process of clearing involves determining the obligations of the trading parties, such as how much is owed and to whom. Clearing houses or central counterparties (CCPs) often facilitate this process by becoming the counterparty to both sides of the transaction, thus ensuring the integrity of the trade.
4. Settlement: This is the actual exchange of securities for payment. It involves updating the records to reflect the change in ownership of the securities. Settlement typically occurs on a T+2 or T+1 basis, meaning two or one business days after the trade date.
5. Post-Settlement: After settlement, there may be additional processes such as asset servicing, which includes dividend payments and corporate actions.
6. Regulatory Reporting: Throughout the post-trade process, parties are required to report to regulators to ensure transparency and compliance with market rules.

The current post-trade environment is characterized by several challenges:

• Complexity and Fragmentation: Legacy processes and systems have led to a complex web of interactions between various market participants, including custodians, cash correspondents, clearing members, collateral managers, settlement agents, central securities depositories (CSDs), and trade repositories.
• Lack of Interoperability: Proprietary databases and the lack of standardization across systems hinder straight-through processing (STP) and contribute to operational risks.
• Manual Processes: Many steps in the post-trade process are still manual, leading to inefficiencies, higher costs, and increased operational risk.
• Settlement Risks: The time lag between trade execution and settlement introduces various risks, including counterparty risk, market risk, and liquidity risk.
• Regulatory Compliance: The need to comply with various regulations adds to the complexity and cost of post-trade processing.

Tokenization and the use of blockchain technology promise to address many of these challenges by enabling near-instantaneous settlement, reducing the number of intermediaries, and increasing transparency and efficiency. However, the readiness of market participants to adopt these changes and the potential costs associated with such a transition are important considerations that need to be evaluated.

The Tokenizer: Thanks for the description. Before we move on, could you tell me how many of the six steps in today’s setup could – realistically! – be eliminated in a fully tokenized post-trade setup?

The Token RegRadar: In a fully tokenized post-trade setup, the potential for eliminating certain steps is significant due to the inherent efficiencies of blockchain technology and smart contracts. Realistically, the following steps could be impacted:

1. Trade Capture and Confirmation: The need for separate trade capture and confirmation could be reduced or eliminated. Smart contracts on a blockchain can automatically execute the terms of a trade once agreed upon, ensuring that both parties adhere to the agreed terms without the need for manual confirmation.
2. Clearing: The role of clearing houses could be diminished or become obsolete. Tokenization allows for the creation of digital assets that can be programmed with the necessary logic to handle the clearing process automatically.
3. Settlement: The traditional T+2 or T+1 settlement cycle could be replaced by near-instantaneous or real-time settlement, as the transfer of tokenized assets and the corresponding payment can occur simultaneously on the blockchain.
4. Post-Settlement: Post-settlement processes such as asset servicing could be automated through smart contracts, which would execute actions like dividend payments and corporate actions without manual intervention.
5. Regulatory Reporting: While regulatory reporting would still be necessary, it could be streamlined as blockchain provides a transparent and immutable record of all transactions, which regulators could potentially access directly.

In summary, a fully tokenized post-trade environment could realistically reduce the traditional six-step process to a more streamlined workflow, potentially eliminating the need for separate trade confirmation, clearing, and manual post-settlement processes. However, it’s important to note that while the technology offers the potential for these efficiencies, the actual elimination of steps would depend on various factors, including regulatory acceptance, market readiness, and the development of supporting infrastructure.

The Tokenizer: You mentioned earlier five main challenges in the current post-trade setup. Which of these are the most critical?

The Token RegRadar: Based on my knowledge base, the most critical challenges in the current post-trade setup include:

1. Settlement Risk: Settlement risk is a critical concern, particularly due to upfront purchases where payments are made in advance, but account credits can be significantly delayed, introducing a level of settlement risk. Furthermore, counterparty risk is present on both sides as transactions remain open until a successful settlement cycle is achieved.
2. Lack of Transparency: There is limited transparency within the asset creation and issuance processes due to the use of various systems and a highly manual approach. The absence of an electronic audit trail makes tracing and observability extremely challenging.
3. Multiple Intermediaries: The involvement of multiple intermediaries adds complexity to the process, which can lead to inefficiencies and increased costs.
4. Operational Risk: The most notable risks associated with offering crypto-assets are cybersecurity, market volatility, and operational risk, with a significant number of exchanges highlighting all three at the same time.
5. Regulatory Challenges: Regulation is perceived as a significant challenge, with all exchanges considering it a hurdle. This includes the need for clarity around rules, which has been steadily addressed, but funding and cash leg of the trade remain core challenges.

These challenges are critical as they directly impact the efficiency, cost, risk, and regulatory compliance of the post-trade process. Addressing these issues is essential for improving the overall functioning of the financial markets.

The Tokenizer: Nevertheless, a huge number of transactions are handled by this system every day, and it has been working for decades and has already become much more digitalised than it used to be. So, aren’t things good enough already?

The Token RegRadar: While it is true that the current post-trade system handles a vast number of transactions daily and has seen significant digitalization over the years, there are compelling reasons to consider further improvements and innovations. Here are some critical points to consider:

• Inefficiencies and Costs: Despite digital advancements, the post-trade environment is still encumbered by sequential, often manual processes that are time-consuming, costly, and operationally risky. These inefficiencies can lead to a build-up of credit risk and impose financial and operational challenges for market participants.
• Settlement Times: The current system, while efficient in execution, can lead to delays due to settlement periods and the involvement of multiple intermediaries. Reducing settlement times through tokenization and distributed ledger technology (DLT) could streamline processes and diminish systemic risks.
• Market Liquidity and Balance Sheet Capacity: Legacy processes and technology systems contribute to complexity, opacity, and fragmentation across markets, which can impact costs, market liquidity, and firms’ balance sheet capacity.
• Innovation and Risk Management: The post-trade issues slow innovation and increase risk. There is a need for a system that can adapt to new asset classes, solutions, and investors that emerge continuously.
• Regulatory Compliance: Regulatory compliance remains a significant driver for modernization. As regulations evolve, systems must be agile enough to adapt to new requirements efficiently.
• Technological Advancements: The rise of digitally native securities and the potential for DLT to synchronize data and processes present opportunities to fundamentally re-examine and improve the layers of processes, complex relationships, and workflows that have built up over time.

In conclusion, while the current system has served the markets well, there is a clear opportunity to leverage new technologies to address these challenges, improve efficiency, reduce costs, and enhance the resilience and integrity of financial markets. The potential benefits of a more modernized, streamlined, and transparent post-trade environment suggest that “good enough” may not be sufficient in the face of rapidly evolving market demands and technological capabilities.

The Tokenizer: Okay, this somehow brought us back to where we started, which is good. You mention these compelling reasons to consider improvements, and one of them is settlement times. So back to the concern I wanted to discuss with you: Do you really think that the trading industry is interested in ultra short settlement times – instant settlement? Could you please start by telling why you think they might and should be interested, and then afterwards give a detailed description of why they might resist?

The Token RegRadar: The trading industry’s interest in ultra-short settlement times, such as instant settlement, is driven by several factors:

Reasons for Interest in Ultra-Short Settlement Times:

• Risk Reduction: Instant settlement minimizes counterparty risk, as the trade and settlement occur simultaneously, leaving no room for default between the execution and completion of a trade.
• Increased Efficiency: By eliminating the delay between trade execution and settlement, the process becomes more streamlined, reducing the time and resources spent on managing and reconciling trades over multiple days.
• Regulatory Compliance: With regulators pushing for faster settlement cycles to reduce systemic risk, market participants may be incentivized to adopt instant settlement to align with regulatory expectations and avoid potential penalties.
• Improved Liquidity: Faster settlement can free up capital more quickly, potentially increasing market liquidity as participants can reinvest or reallocate funds sooner.
• Competitive Advantage: Firms that can offer instant settlement may differentiate themselves in the market, attracting clients who value the speed and certainty it provides.
• Technological Innovation: The rise of distributed ledger technology (DLT) and tokenization presents new opportunities for instant settlement, making it a more feasible option than in the past.

Reasons for Resistance to Ultra-Short Settlement Times:

• Operational Challenges: Instant settlement requires significant changes to existing systems and processes, which can be costly and complex to implement.
• Netting Benefits: Current systems allow for netting of transactions, which reduces the volume of payments and deliveries that need to be processed, thereby conserving liquidity and capital. Instant settlement would eliminate these benefits.
• Liquidity Concerns: Instant settlement requires that all assets be available at the moment of trade, which could strain liquidity management, especially for large institutions with complex portfolios.
• Market Structure: The current market structure, with its reliance on intermediaries and batch processing, is not designed for instant settlement, necessitating a fundamental reorganization of market operations.
• Cultural Inertia: There may be resistance to change from market participants who are accustomed to the existing settlement cycles and see no immediate benefit to altering them.
• Credit Provision: The current system allows for credit provision, as trades can be executed with the expectation of future settlement. Instant settlement would require upfront availability of funds, which could impact trading strategies that rely on credit.

In summary, while there are compelling reasons for the trading industry to be interested in ultra-short settlement times, there are also significant challenges and resistance due to the operational, structural, and strategic changes required to support such a shift. The balance between the potential benefits and the hurdles will likely determine the pace and extent of adoption of instant settlement in the industry.

The Tokenizer: So to harvest the benefits you need to overcome the hurdles, which is of course not an unusual situation. To efficiently combat these hurdles what would be the best strategy? Do you need to attack all of the hurdles simultaneously, or are there some low hanging fruits you could start with?

The Token RegRadar: To efficiently address the hurdles associated with implementing ultra-short settlement times, such as instant settlement, a strategic and phased approach could be adopted. Here’s a potential strategy that could be considered, based on the information provided in my knowledge base:

1. Regulatory Engagement and Sandbox Testing:
   • Engage with regulators to understand the legal framework and seek guidance on compliance.
   • Participate in regulatory sandboxes, like the Digital Securities Sandbox in the UK, to experiment with new technologies in a controlled environment.
2. Technology Adoption and Integration:
   • Invest in blockchain and Distributed Ledger Technology (DLT) to enable faster transactions and operational efficiency.
   • Ensure technology architecture is adaptable and can integrate with existing systems for seamless transition.
3. Operational Readiness and Process Optimization:
   • Standardize processes and implement automated triggers for real-time inventory changes, price fluctuations, and exposure shifts.
   • Develop real-time analytics capabilities to mitigate risks associated with immediate trade settlement.
4. Partnerships and Industry Collaboration:
   • Engage in open dialogue with key industry players to understand market-wide implications and foster collaboration.
   • Form partnerships to leverage shared knowledge, technology, and resources.
5. Education and Cultural Shift:
   • Educate internal stakeholders about the benefits and changes associated with instant settlement.
   • Address cultural inertia by demonstrating the competitive advantages and long-term gains of the new system.
6. Incremental Implementation:
   • Start with pilot projects or specific asset classes that could benefit most from instant settlement.
   • Gradually expand the scope as the technology proves successful and stakeholders become more comfortable with the changes.
7. Risk Management and Contingency Planning:
   • Develop robust risk management frameworks to handle the increased liquidity demands and operational changes.
   • Create contingency plans to address potential issues during the transition to instant settlement.

By focusing on these strategic areas, the industry can begin to address the hurdles in a manageable way, starting with the most accessible or impactful (“low-hanging fruits”) and progressively tackling more complex challenges. This approach allows for learning and adaptation as the industry moves towards the goal of ultra-short settlement times.

The Tokenizer: These are not very simple tasks that can be handled in a few days. Are you sure it’s actually worthwhile to engage in this journey to harvest the benefits of tokenization?

The Token RegRadar: Engaging in the journey of tokenization is indeed a complex and multifaceted endeavor that requires a significant investment of time, resources, and strategic planning. However, the potential benefits for financial institutions and the broader financial ecosystem are substantial. Here are some of the main benefits and reasons why it may be worthwhile to pursue tokenization:

1. Increased Efficiency and Speed: Tokenization can lead to faster transaction settlement, potentially moving from the traditional T+2 (trade date plus two days) to near-instantaneous settlement, reducing counterparty risk and freeing up capital more quickly.
2. Greater Transparency and Control: The use of blockchain technology in tokenization offers a higher degree of transparency and control over transactions, which can lead to improved trust and security for all parties involved.
3. Lower Operational Costs: By streamlining processes and reducing the need for intermediaries, tokenization can significantly lower operational costs associated with trading, settlement, and asset servicing.
4. Access to New Markets and Liquidity: Tokenization can democratize access to assets by allowing fractional ownership and opening up investment opportunities to a broader range of investors, which can increase liquidity in the market.
5. Innovation and Competitive Advantage: Early adopters of tokenization may gain a competitive edge by shaping industry standards, establishing a reputation in the emerging ecosystem, and attracting tech-savvy clients.
6. Regulatory Engagement: Engaging with regulators can lead to a better understanding of the legal framework and compliance requirements, potentially influencing the development of favorable regulations for tokenized assets.
7. Cultural Influence: Institutions that embrace tokenization early on have the opportunity to lead the cultural shift towards a more digitized and blockchain-friendly financial environment.
8. Potential for New Revenue Streams: Tokenization can enable the creation of new financial products and services, potentially opening up additional revenue streams for institutions.

While the challenges are significant, including regulatory hurdles, technological integration, market adoption, and the need for industry-wide collaboration, the potential rewards suggest that it is a journey worth considering. The strategic approach to these challenges will likely involve a combination of addressing regulatory concerns, investing in technology, forming partnerships, and educating stakeholders about the benefits of tokenization. As the industry evolves and best practices emerge, those institutions that navigate these challenges effectively may be well-positioned to capitalize on the opportunities presented by tokenization.

The Tokenizer: Okay, so despite my concerns, do you still believe that financial institutions can gain from tokenization and that instant settlement is one of the essential value-creating elements? Be honest and 100% factual in your answer!

The Token RegRadar: Yes, based on the information within my knowledge base, financial institutions can indeed gain from tokenization, and instant settlement is identified as one of the key value-creating elements. Here are the factual points that support this assertion:

• Convenience and Efficiency: Tokenization can make processes faster, easier, more convenient, and cheaper for customers, which is beneficial for banks as they focus on customer satisfaction.
• Access to New Asset Classes: Tokenization offers potential access to new assets for retail investors and improves security, cost, and liquidity for institutional investors.
• Operational Benefits: The ability to run operations 24/7, automate intermediary functions, and maintain transparent audit records can make on-chain payments and settlements powerful.
• Instant Settlement: Tokenization can enable instant or near-instant settlement, which is more capital efficient, especially in high-interest-rate environments.
• Atomic Settlement: The possibility of atomic settlement, where transactions are settled instantaneously, can bring speed and security to transactions, reducing counterparty risk.
• Regulatory Developments: The US Securities and Exchange Commission (SEC) has finalized a rule change to shorten the settlement period to one business day after the trade date (T+1), effective May 28, 2024, indicating a regulatory shift towards faster settlement times.
• Risk Reduction: Instant settlement can reduce the need for extensive reconciliation across participating intermediaries, leading to cost savings and time efficiency.
• Market Readiness: A significant percentage of industry professionals anticipate local settlement cycles shortening to T+0 or T+1 within the next few years, suggesting a trend towards real-time operations.

These points, derived from the documents in the knowledge base, indicate that tokenization and instant settlement are seen as advantageous for financial institutions, offering a range of benefits from operational efficiencies to new market opportunities. However, it is also important to note that there are challenges and risks associated with these advancements, such as the need for regulatory approval, the legal status of smart contracts, and the potential for increased system fragility due to higher efficiency.

The Tokenizer: Thank you for participating in this interview. As one last thing, could I ask you to introduce yourself and tell us what you are made for and what you are capable of?

The Token RegRadar: Certainly! I am The Token RegRadar, an expert guidance tool developed by The Tokenizer A/S, a Danish company based in Copenhagen. My primary role is to provide insights and information on regulations and laws in the field of asset tokenization, security tokens, digital assets, and the broader landscape of the token economy. I specialize in analyzing and interpreting complex regulatory frameworks across various global jurisdictions, focusing on the implications for businesses, asset owners, and investors in the digital asset space.

My capabilities include:

• Offering a comprehensive database of up-to-date legal texts, regulatory updates, articles, and reports specific to the domain of asset tokenization and digital assets.
• Providing tailored information that addresses specific regulatory concerns and questions for a diverse audience.
• Maintaining a professional and informative tone, delivering clear, concise, and accurate information.
• Scanning for the latest developments in asset tokenization, security tokens, and digital asset regulations worldwide.
• Assisting users with questions regarding comparative analyses of regulations in different countries or comparing specific laws.

I am equipped to cater to the needs of various stakeholders in the token economy by providing fact-based answers and information, ensuring that all responses are correct and based purely on facts from the most recent and relevant documents.

Image by Florian Kurz from Pixabay

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Legal Disclaimer
The information provided in this article is for general information and educational purposes only. It should not be construed as legal advice on any subject matter.

The Token RegRadar utilizes artificial intelligence and language learning models to analyze and interpret complex regulatory information. While The Token RegRadar has made efforts to ensure the quality and reliability of the content, there may be limitations, inaccuracies, or biases present. The information generated by artificial intelligence and language learning models is not a substitute for professional legal advice or expert opinions.

Users should not rely solely on the information provided here to make legal or business decisions. It is recommended that individuals consult with a qualified legal professional before engaging in any activities or transactions related to digital assets. The Token RegRadar makes no representations or warranties about the accuracy, reliability, or completeness of the information provided. The Token RegRadar assumes no liability or responsibility for any errors or omissions in the content of this article. Do not consider any information contained in this text  to be legal advice.