Distributed ledger technology (DLT) will have a profound effect on clearing and settlement, but taken too far, it might actually turn the clock backward and reintroduce problems financial markets have been working to alleviate for more than 500 years.
DLT has great potential to enhance the existing system, says Ken Monahan, Senior Analyst for Greenwich Associates Market Structure and Technology and author of Steampunk Settlement: Deploying Futuristic Technology to Achieve an Anachronistic Result. But in reality, the technology is evolutionary, not revolutionary, and attempting to replace the clearing infrastructure with this technology is to carry the system not into the future, but into the past.
Some DLT enthusiasts argue that the new technology should replace, not enhance, the existing clearing system. They contend that cryptographically enforced contracts can make secure settlement instantaneous and default impossible, thus avoiding the need for posting collateral and the existing system altogether.
Yet by any measure, the existing system is extraordinarily efficient. While its true that this efficiency would not be wiped out entirely with a real-time gross settlement associated with DLT, it is not an exaggeration to say that it would save billions of dollars in reserve funds at the cost of requiring hundreds of billions in prefunding, creating a burden on money markets that participants have spent over a century developing systems to alleviate.
This is precisely the lesson the Venetian Senate learned in 1584 in a strikingly similar way, says Ken Monahan. By substituting a payment system for a credit system, they sucked liquidity out of the economy. Unlike the Venetians, who really did blaze a new path, we have the benefit of learning from history, and this is its lesson: DLT has a big role to play in improving the quality of the settlement infrastructure, but it cannot replace it entirely without imposing the very costs it was designed to reduce.