DeFi is the Future: Frictionless Clearing and Settlement
There are a number of key DeFi innovations that make the nascent technology the future of global finance in the next 5 -10 years. Those innovations include atomic transactions, data transparency, smart contracts, tokenization as well as frictionless clearing and settlement. In this post I will highlight how blockchain technology used in the context of DeFi can significantly reduce the cost and friction in the all important clearing and settlement process.
Before we go any further, let’s define clearing and settlement. Although the term clearing and settlement are often used synonymously amongst traders, these are two separate functions in the post trade process. Clearing is what happens before the trade is settled by the physical exchange of assets.
Specifically, clearing involves financial institutions sending transaction messages through a payment network to be validated so that money can move safely between member financial institutions where it is finally settled with a physical exchange of assets. In many cases, specialized entities called clearing firms stand between the buyer and the seller in a transaction, guaranteeing that the transaction will reach settlement, and assuming the liability if one side fails to deliver. The actual settlement is the final step of exchanging between participating parties.
DeFi technology is well suited for a compliant and a frictionless clearing and settlement process. DeFi tech can be customized to work within a “right-sized” regulatory framework which can make clearing and settlement much more efficient for all market participants. Here are a couple of bullet points about the underlying blockchain technology that makes clearing and settlement frictionless:
Standardization: all transactions must meet the requirements of the protocol in a deterministic manner or be rejected
Straight Through Processing (STP): blockchains have built-in STP which can make clearing and settlement instantaneous and atomic.
Standardization: how blockchain technology can meet the Exchange Act requirements
DeFi protocols follow a specific set of rules that must be followed in a deterministic manner, meaning that the inputs for on-chain transactions are known entities such as the price, quantity, asset, etc as well as specific ways that transactions need to be packaged.
These deterministic rules can be adopted to meet the legal requirements of clearing agents in the Securities Exchange Act of 1934 where messages such as security identification numbers and necessary trade information to monitor and track the transactions. At the core of its technology stack, blockchains are immutable databases and are well-suited for customizing an exchange’s data model to meet any regulatory requirements.
Built-in STP
Another important innovation of blockchains is that there is built-in straight-through-processing (STP) which will significantly reduce transaction cost. Furthermore, blockchains will reduce settlement time from T-1 (which takes effect on May 28, 2024, currently trades are settled in T-2) to instantaneous. Blockchains are essentially real-time gross settlement systems or RTGS.
RTGS settles transactions in “real-time” and on a gross basis which significantly reduces settlement risk and cost. Currently, clearing agencies such as the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC) use end of day netting which aggregates transactions between brokers at the end of day as part of the clearing process.
With blockchains, the transactions are cleared and settled instantaneously and stored on the blockchain where it can’t be tampered with by malicious actors because of the immutable properties of digital ledgers. This allows for unique risk models that operate on an extremely granular time frame.
Improving Liquidity
“I support this rulemaking because it will reduce latency, lower risk, and promote efficiency as well as greater liquidity in the markets.” ~ Gary Gensler
The SEC in February 2023 announced that it will shorten the settlement cycle for broker-dealers from T+2 to T+1. This significant rule will be implemented on May 28, 2024 and was adopted because SEC Chair, Gary Gensler in his words wanted to “reduce latency, lower risk and promote efficiency.” Because of blockchain’s innovative properties, DeFi could allow market participants to utilize their capital more efficiently.
For example, traders can allocate less capital for minimum requirements within their margin accounts because settlement risk would be significantly reduced allowing traders to use their capital to seize opportunities in the market. On blockchains, once a trade is completed the clearing process is automatically validated and the settlement of assets are exchanged between participating parties which is all backed by the consensus algorithm and the security of the blockchain. This makes for a safer overall financial system.
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