What’s the Problem?

The market has been promised that instantaneous atomic real-time settlement will eliminate settlement risk and cycles in digital assets, but this isn’t the reality for participants.

While digital assets are presumed to settle on their blockchains (“on-chain”) in real-time, institutional participants typically settle free of payment (FoP) on a gross basis, either through off-chain or on-chain, manual, bilateral processes.

FoP settlement involves trade counterparties sending each other the agreed upon cash and assets on good faith, without any guarantee of receiving what they are owed. Someone must go first, typically the smaller counterparty against the larger, exposing the smaller firm to the risk of not receiving their side of the transaction despite making good on their own obligation.

In addition to offering no guarantee of fulfilment, settling gross transactions bilaterally with individual integrations, whether physical or digital, is costly and operationally complex to manage, increasing settlement and counterparty risks.

The digital asset market also faces unique structural problems, including, but not limited to:

Largely non-interoperable instruments confined to fragmented blockchain ecosystems further limiting settlement processes to within centralised, siloed trading platforms.
No direct integration with banking systems, leading to un-coordinated cash settlement legs for asset/cash trades.
Further complications from fragmentation at the custodian level. For example, if counterparties to a trade each use a different custodian to perform the on-chain movements this will require two FoP transfers to be made between their custodians.
Unexpected costs and delays from transfers conducted directly on blockchains. On-chain transactions are subject to fees (which can increase depending on network congestion), compliance checks, and waiting for confirmation of completion (conducted either through an on-chain scanning tool or waiting for the counterparty to confirm receipt).

These are a few of problems standing in the way of broad institutional adoption of digital assets and market growth. After all, trading cannot scale when each individual trade must be settled on a gross basis in a fractured ecosystem with uncertain costs.

Trading in digital assets occurs largely off-chain, on hundreds of trading platforms not dissimilar to traditional securities markets (TradFi). However, FoP settlement has long been replaced by delivery vs payment (DvP) in TradFi.

Facilitated by a trusted, regulated intermediary called a central securities depository (CSD), DvP is the simultaneous exchange of cash and assets between buyer and seller, which significantly reduces counterparty risks and increases settlement reliability and market security. No counterparty needs to risk ‘going first’ as neither party receives their dues until both settlement obligations have been met.

Furthermore, the depository can accept trades from a virtually unlimited number of trade sources, while also netting-off opposing trades bought at one location and sold at another.

A CSD can also simplify the settlement process by managing the integrations with multiple custodians, simplifying the operational burden by sending out settlement instructions, tracking the state of settlement and feeding this to counterparties in real-time, only requiring settlement for a net obligation.

The end effect is that delivery can be consolidated in one neutral location with one delivery, and receipt can be taken from that one location into the custodian of choice. While this concept has yet to emerge in digital assets, ClearToken will bring these proven economic models to digital assets.

So, How Do We Unlock the Benefits of Netting and DvP for Digital Assets? Using the regulatory and economic frameworks which have solved the same problem in traditional markets – by building regulated financial market infrastructure (FMI): clearing houses/central counterparties (CCPs) and central securities depositories (CSDs).

Clearing houses net down and risk manage a member’s trades for a specific instrument across trading venues to a single position per cycle. A CSD then takes those netted positions and settles the obligations by transferring securities and cash between accounts.

To illustrate, in 2023, the US equities clearing house, NSCC, cleared an average daily volume of 197.1 million transactions: an annual total of around 49.67 billion transactions. However, the US CSD, DTCC, settled just 953 million transactions for the whole year. This netting effect resulted in less than 2% of transactions having to be settled, a significant reduction in operating and settlement costs, complexity, and dependency.

CCPs and CSDs have embedded efficient and standardised clearing and settlement processes in TradFi markets that are completely lost with real-time gross settlement. However, it is both feasible and desirable to repurpose the most efficient clearing and settlement models and establish digital asset CCPs and CSDs.

Today’s technology already supports efficient, risk-managed T+0 settlements, nets down trades to a fraction of the initial volume for final settlement and reduces counterparty risk. This proven infrastructure could bring similar efficiency and risk reduction to digital assets, providing a bridge between traditional and new financial systems.

Re-establishing FoP settlement as the norm is unfit for the complexities of today’s trading environment and denies participants the operational and cost benefits of netting enabled by DvP. Instead, it creates parallels to the problems of the late 20th century paperwork crises from which CSD-enabled DvP settlement was born.

We’ve Been Here Before

In the late 20th century, post-war economic growth and product diversification significantly increased trading opportunities and interest from a growing investor base in the UK. Administrative friction was reduced with stock transfer forms legally replacing third-party witnesses to sanction trades.

The adoption of advanced computer systems and trade automation made trading faster, but settlement remained a manual paper-based task requiring the physical exchange of paper share certificates alongside the stock transfer forms. Paper was routinely transported from broker to broker around the City of London by briefcase and by bicycle to clear and settle trades on a free-of-payment basis.

The system appeared to work until 1986’s ‘Big Bang’: the simultaneous market deregulation and trading electronification which led to a 60% surge in trading volumes in just one week.

This mirrored the US experience, where trade volumes quadrupled from 3 million shares per day in 1960 to 12 million just a decade later due to similar changes. These were unprecedented surges in trading volumes, and though an ocean and two decades apart, both markets exposed the vulnerabilities of manual FoP settlement processes.

The ‘Paperwork Crises’

Back-office teams, drowning in paperwork, struggled to keep pace with the growing backlog of trades and the manual processes and physical deliveries required to individually settle each one.

In response, both the UK and US markets implemented stop-gap measures to support back offices to try to keep up with the mounting backlog: shortened trading hours, weekly market closures for a full day, and extended settlement cycles. Yes, US markets closed on Wednesdays so the back office could “catch up”.

It wasn’t enough. Liquidity and trading slowed down, and risks escalated.

FoP settlement combined with the volume-driven “paperwork crisis” in New York and “paper crunch” in London, created chaos: uncertain stock ownership, illegitimate trades, high counterparty and settlement risk, frequent delays and failures, and even thefts. Brokerages became casualties to the crisis; long-established names went bust.

The paperwork crises were a collective turning point for financial markets, prompting the creation of CSD-operated automated and centralised systems to enable DvP settlement and strengthen the markets.

The Urgent Need for Robust Infrastructure

As we navigate the rapidly growing digital asset space, the critical lessons from the paperwork crises demonstrate that post-trade operations cannot be administrative afterthoughts. Accurate and efficient trade settlement is a foundational to healthy and stable capital markets and cannot be taken for granted.

The traditional market’s previous indifference towards the ‘nuts and bolts’ of post-trade processes soon changed to furious alarm as it fractured under the pressure and demands grew for a robust solution. We have seen that when trading volumes surge, post-trade processes and infrastructure must rise to the challenge to keep the market running smoothly. Or put another way, when post-trade efficiency is prioritised, trading volumes will surge soon and forever thereafter.

As the digital asset market grows through increased institutional participation, the industry must prioritise building resilient financial market infrastructure that can safely handle the pressure of scale to safeguard the future of digital markets, before a crisis forces a reactive overhaul.

The critical need to align clearing and settlement processes and infrastructure with the pace of trading evolution cannot be overlooked.

ClearToken’s mission is to resolve the absence of financial market infrastructure necessary to facilitate clearing and DvP settlement in digital assets, critical to the market’s safety, growth and adoption by financial institutions.