As we contemplate a system in which securities transactions settle on an accelerated basis through blockchain networks, we must also consider the end of “cash” and “credit” as distinct forms of funding. This is the end game imagined by Bitcoin, and the ultimate vision of a financial system based on blockchain.
In last year’s Finadium report on blockchain in securities finance, we described a hypothetical industry-wide credit hub that would allow credit providers to know in real-time their customers’ credit utilization across all counterparties. We offered the supposition that if credit utilization could be ascertained and known with such efficiency, access to counterparty credit could become far less of a limiting factor in securities finance (and beyond).
What is less apparent is that such a credit network would be a prerequisite to any form of instantaneous transaction settlement within the industry – with some intriguing possibilities for the collateralized financing industry. Here’s how it would most logically play out:
In today’s system, CCP’s, CSD’s and clearing entities provide intraday credit to participants, assuming the daylight credit exposure, for which they are on the hook until all participants pay their settlement at the end of the day. Settlement is financed by cash providers, who – upon payment of their customers’ settlement – are now the party at risk. As we have described it in the past – daylight settlement exposure is transformed into counterparty credit risk once settlement occurs. In “blockchain/Bitcoin” terms, the clearing entities are the credit intermediaries – like a Visa or a Pay Pay in the consumer world – who are made unnecessary by the blockchain.
Today, the ultimate credit providers, their customers and third parties then must have recourse to securities finance markets and other forms of collateralized financing in order to fund the clearing entities. If they are down cash, they need to raise it; if they are up cash, they need to invest it. In both cases, the primary mechanisms used are some form of securities finance.
In our current T+ x environment, virtually all parties involved have some macro ability to project cash needs based on projected settlements – any inaccuracies or changes in reality versus projections are generally minor, and within the margin of error baked into credit lines. In the on-demand settlement world, there is no longer any projection – cash must be instantly and synchronously settled, which means credit must be instantly and synchronously available. The distinction between cash and credit becomes essentially academic – they become functionally interchangeable and identical.
If the line really becomes that blurred, the likely outcome would be a securities finance market in which collateral was provided directly against the big credit blockchain. Remember, the blockchain is a closed system, which operates almost identically to today’s CCP’s and clearing houses. The aggregate net at the end of every transaction is exactly 0, a zero sum game in which only the holder changes. Securities Finance Transactions would settle through the identical mechanism as the underlying trades it funds. Collateral in exchange for credit, and credit in exchange for collateral – skipping the cash altogether. Cash would no longer be king – it would only become another type of collateral used as a mechanism to purchase credit within the blockchain.
