This is a summary of “Blockchain-Based Settlement for Asset Trading,” by Jonathan Chiu and Thorsten V. Koeppl, published in the Review of Financial Studies, vol. 32, no. 5.
Blockchain can plausibly make asset trading settlement faster and more flexible. It can bypass existing intermediaries to speed up the settlement process. The technology also allows time-sensitive investors to complete settlement earlier by paying extra transaction fees. By making careful block size and block time decisions, miners are incentivized to rule out settlement fails and to maintain true records of transactions.
How Did the Authors Conduct This Research?
After briefly reviewing the blockchain technology and its advantages, the authors model a trading environment where buyers and sellers can expect a surplus from trades. To complete the settlement, investors have to pay transaction fees to blockchain miners. The authors then derive the miners’ expected profit mathematically. They assume that investors may wish to revoke the trade because of a randomly distributed preference shock, which provides motivation for them to perform forking. The authors then derive algebraic expressions to show how these constraints affect the optimal block size and block time in order to eliminate the profit from forking.
The authors calibrate their model to the US market for corporate debt using statistics from the Trade Reporting and Compliance Engine (TRACE) reporting system. The optimum block size and block time are calibrated based on real-world transaction size, number of trades, and volatility. Given these parameters, the transaction fee and transaction time can be determined. Based on the benchmark parameter values, the average fee per trade is equal to 0.34 bps ($34 fee per $1 million transaction) and the settlement time per trade is 148 minutes. The authors then calibrate the model with other extreme parameter values and compare the result with that of the existing legacy clearinghouse system.
What Is the Investment Issue?
Asset trading involves settlement risk—that is, the risk that the seller of the security fails to deliver or the buyer fails to pay. To deal with this risk, the settlements are organized through clearinghouses. The process involves fixed time costs of up to a few days.
Using blockchain technology—also known as distributed ledger technology (DLT)—can lead to a faster and more flexible settlement process. The main challenge of blockchain-based settlement is how to eliminate the settlement risk. The system has to set proper block sizes and block times to ensure that “forking” (a system attack that undoes a true transaction record) is economically infeasible. The authors investigate the factors that affect the blockchain setting and evaluate conditions under which blockchain can outperform the clearinghouse system.
What Are the Findings and Implications for Investors and Investment Professionals?
The results reveal that blockchain-based settlement could have advantages over the legacy system by being faster, safer, and more flexible. These advantages, however, are subject to certain constraints that the legacy system does not have to consider.
Because the blockchain system is a distributed ledger, no central record is kept and everyone can change the record. When there are multiple versions of a record because of forking, the system recognizes the one supported by larger mining resources. In other words, blockchain-based settlement requires a lot of active, honest miners to ensure the true record can prevail. Therefore, as illustrated by the authors, blockchain-based settlement is particularly suitable for markets with active transactions, because these markets can generate sufficient fees to incentivize a large number of miners. With honest miners, forking is very costly and thus the block size can be larger and block time can be shorter, making settlement fast and cheap. When an asset has high default risk, however, the benefit of forking is high, and so the system has to set the block size lower and the block time longer to create system congestion, which makes forking costly and eventually makes transaction fees high and settlement slow.
To sum up, the advantages of blockchain-based settlement can be maximized when the transaction number is large, default risk is low, and the number of miners is large.