The World Federation of Exchanges (WFE) published research warning of the risks of adopting technologies, such as DLT, that radically reduce settlement time at the cost of market quality.
The research finds that:
- When adopting technologies, such as DLT, the cost of making a trade increases, and the price reaction to a trade is intensified. For example, a one-minute increase in settlement latency leads to a 1.3% increase in transaction cost and a 1.5% increase in price impact.
- This increase isn’t a rare event, and some of our findings showed that settlement latency can easily vary by over 3 minutes, equating to a 3.9% increase in transaction costs and a 4.5% increase in price impact.
- When there is uncertainty, informed traders will find it more difficult to execute their trading strategies and therefore pricing is less efficient.
Inherent latency in DLT settlement introduces uncertainty into the settlement process due to factors such as overall mining capacity, which affects block validation speed. The WFE finds that this uncertainty discourages investor participation, resulting in a deterioration of liquidity and an increase in transaction costs.
The policy implications are substantial, especially in shaping the market design of cryptocurrency infrastructure and, more broadly, for exchanges that are considering different methods of speeding up trading time. DLT, with its promise of decentralized and swift settlement cycles, comes at the cost of introducing uncertainty due to the unpredictable nature of settlement time, which has negative implications for the investors trading on that venue.
Policymakers and market operators, from regulated exchanges to crypto platforms, should carefully consider this trade-off between near-instant settlement and market quality before introducing DLT. The research reinforces the important role of CCPs and CSDs in overseeing and guaranteeing the settlement process and reducing uncertainty in the timing of settlement. Markets with less uncertainty have increased liquidity and lower trading costs.
Pedro Gurrola-Perez, head of Research at WFE, said in a statement: “Whilst much of the finance industry has been focused on how to reduce settlement time, our research – looking at the extreme case – demonstrates the important place CCPs and CSDs have in the process, and the trade-offs that would need to be made if their roles were removed in favour of speed.”
Kaitao Lin, senior financial economist at WFE, said in a statement: “Implementing DLT in settlement processes presents a dual-edged impact. Our research reveals a trade-off between near-instantaneous settlement and liquidity. Without trusted entity oversight, DLT introduces uncertainty which impedes liquidity. Policymakers must weigh these trade-offs and balance their impacts on different market participants.”