Liqudity and Blockchains: How does settlement time affect real trading?

Question

I am not sure, whether this question is on-topic here, but it is microstructure related, is of concern to practitioners and addresses a question which is often debated in academia.

When it comes to discussing blockchains, I often encounter the argument that blockchains technology helps to improve liquidity, especially as it speeds up settlement time (see for example this paper). I admit that I do not know how settlement of, say, equity trades, is really working on financial markets so I have to relay on what I read in papers and books: - Often it is said, that the settlement of a stock trade in the USA generally requires three business days to pass between brokers and theirs clients and to formally move ownership from seller and buyer. Clearly, recording transactions via blockchains could speed up things extremely (the bitcoin blockchain is updated roughly every 10th minute). However, I am not sure whether this really affects liquidity: Aren't these 3 days to fix the settlement just some form of administration which are not relevant for the trader anymore? Or do these tasks produce such severe costs that fixing everything much faster and elegant via a blockchain benefits the trader?

Answer 1

i am not an expert in equity settlement, but through example you will be able to grasp the idea. there are few separate parties involved - for example client, broker and third party register where equity ownership is registered. let's say client buys equities through broker. now broker needs to collect funds from the client and deliver ownership of asset (register in clients name the asset). broker takes client funds, buys equity and records this transaction in its own books and later transmits information to third party register. what happens here is that information goes from broker to third party register. it might be in paper form or electronic form. then actual funds go from client buying equities to broker and from broker to client selling equities. so currently there is information exchange which is being recorded in one system, transmitted to other etc. also each party will be double checking if transaction is correct.

now let's simplify blockchain, assume that it is just a shared database between some parties. meaning that there is one database, which is shared by client, broker and third party register, each having their own key to access the database and their information. this database is immutable (you can't change information once it is confirmed and approved), all related parties can access information immediately when it is added.

so regarding liquidity, currently funds and ownership are settled in 3 days, meaning funds are locked up for this period of time. with blockchain, paper work is done instantly and funds can be released instantly as well. this increases liquidity as funds are released much quicker. though the benefits are mostly for broker and third party register. they will save up a lot of time and resources needed for record keeping, sharing/transmitting information between each other. settlement becomes almost instant, removes fraud, and all parties involved can access same information when needed.

Answer 2

You are right in your skepticism when you say: "Aren't these 3 days to fix the settlement just some form of administration which are not relevant for the trader anymore?"

Liquidity is the ease with which an asset can be converted into cash and vice versa without affecting its price too much. Post-trading settlement process's speed may hence not be a consideration for the relative liquidity of an asset. Take for example stocks of Apple are extremely liquid (it's important to remember that "liquidity" of an asset is an abstract notion and is usually understood in comparison to that of another asset). Now, how long the settlement process takes is a different issue.

It is actually quite surprising that the paper you quoted misses/confuses the above point.

Liquidity on the blockchain pertains to whether or not there would be enough buyers and sellers in the market such that the market can discover the 'true' price of the asset. Remember that most of the trading in the current markets is done on information asymmetries (read: Stiglitz paradox) so if - in theory - perfect information prevails in a system with a public blockchain as the technological backend, what incentive is there to trade (apart from of course, demands for liquidity for reasons like death, disease, etc)?

While, in theory, freeing up these funds sooner than later is a valid argument for increasing liquidity, I think it fades away in comparison to the volume of trading that goes on in public markets. Can a blockchain-based trading platform match that? Should it?

I think it's an open question.