How tokenization can take settlements to the next level
Tokenization is becoming an increasingly popular concept, including in the financial industry. Banks and other financial institutions are eager to learn and implement new technologies faster, such as converting securities into tokens. The main reason is the opportunity to reduce the cost of processing trade transactions, which are now estimated at 27-24 billion US dollars per year. The clearing and settlement niche could indeed be changed dramatically with the help of tokenization and settlement tokens. Today, securities, including stocks and bonds, are stored in electronic accounts in centralized vaults. But in the future, they can all be transferred to distributed ledgers, where each participant would have a synchronized copy. This article will explore how tokenized settlements can improve existing processes in the industry.
How are settlements organized currently?
Securities are tradable financial assets issued to raise funds from investors. Previously, securities were printed certificates, and whoever could present such a paper was considered the security owner. But transactions with paper certificates were risky and expensive, as they had to be physically transferred between traders. Later, central securities depositories emerged to eliminate the need for physical transfers of securities. After a while, the securities were dematerialized; they turned into accounting entries.
To date, most securities and information about their owners are at least partially stored in the central securities depository. In some countries, beneficial owners have individual accounts with the CSD; this is called a direct holding system. But in most countries, the system of indirect ownership is widespread when brokers and other intermediaries hold securities on behalf of their clients in the CSD — because of this, updating information about securities, their owners, and so forth is complicated. In either of these two cases, the securities transfer from the old owner to the new one occurs through a “book-entry” into the CSD accounts or the intermediary.
Financial assets are traded either on centralized exchanges or decentralized over-the-counter (OTC) markets. In the first case, transactions go through an intermediary that interacts with the seller and the buyer. Several intermediaries in OTC markets compete for the right to match buyers and sellers.
What is a settlement cycle?
The settlement cycle is the period between the conclusion of a deal and the final execution of the transaction. Today, most securities settlements occur on a rolling cycle, where the trade is made on day X, and the payment arises later (in 2-3 days). This cycle consists of two processes: clearing and settlement.
After the transaction is concluded, the details are transferred to third parties for approval and confirmation. Also, trading obligations can be offset. This is the clearing process.
The settlement of securities represents the transfer of ownership in accordance with the transaction. The sale of securities, in turn, consists of two phases. The first phase involves the transfer of ownership of the securities from the seller to the buyer. The second phase is the transfer of funds from the buyer to the seller.
How can tokenized settlements improve the market?
Securities tokenization and distributed ledgers can reduce settlement costs and make clearing simpler. Tokenization will not eliminate the main risks associated with the sale of securities, but it can change how they are managed and transform some of them. In addition, tokenization allows you to change the role of intermediaries in clearing and settlement.
DLT reduces costs and makes the procedure easier
Distributed ledger as a single and public ledger reduces the need to reconcile transaction details between back offices, intermediaries, and CSD. A single transparent system where it is easy to see who belongs to whom ensures more reliable compliance with regulatory requirements, shareholder voting, etc. Overall, DLT can eliminate intermediaries and significantly reduce clearing and settlement costs. In addition, many actions are performed automatically following smart contracts. For example, interest and dividend payments to token holders are made automatically in some securities tokenization projects.
Changing risks in clearing and settlements
Risks in securities trading are difficult to eliminate completely, but new approaches can change how they are managed. In the case of clearing and settling securities, there are two main types of risk: replacement cost risk and principal risk during settlement.
Tokenized settlements shorten the cycle, which reduces the replacement cost risk. This is achieved by reducing the number of intermediaries, using DLT, and optimizing the approval processes.
Building links between tokens and accounts
Securities can be settled on the principle of exchanging securities from an account in exchange for cash tokens or transferring security tokens in exchange for payment from an account. Such approaches can be used now, as many banking institutions around the world are doing:
- The Commonwealth Bank of Australia, together with the World Bank, issued security tokens called Bond-i. They are issued and maintained using DLT, but payment is made using cash from accounts.
- The Bank of England also maintains similar mechanisms for its own real-time gross settlement system.
- Finality International introduces the USC cash token to settle transactions with securities held in CSDs.
What could the future securities market be like with tokenized settlements?
Securities tokenization may lead to the spread of securities settlement systems in the near future. To date, securities settlements are monopolistic in every country, as there is no competition between providers. But tokenization can open up new possibilities in this regard.
In a tokenized ecosystem, where tokens represent securities and cash, you can perform fast transactions in real-time. This means reduced risks and reduced time between the stages of the tokenized settlements.
Settlement tokens can become a bridge between conventional money and digital assets, including securities, linking the traditional financial world and the crypto economy. If you want to learn more about the potential of security tokens and tokenize your company, feel free to contact our managers. The first consultation is entirely free.