Ever since the invention of the Internet, the market has seen every digital project as the next big thing. Blockchain emerged just a few years ago in the context of Bitcoin, the cryptocurrency, but is now growing almost daily in popularity. The use of blockchain in securities settlement is a particularly hot topic.

Distributed Ledger Technology (DLT)

DLT, the technology behind blockchain, operates as a distributed electronic ledger which records ownership information and transactions in a structure spread across multiple computers. This record is permanent and – allegedly – secure. DLT is used as a basis to develop and provide various blockchain models. Bitcoin is the very first blockchain and the best-known example of this application.

What is really innovative about blockchain is the way its distributed structure creates trust between parties who do not know each other. This trust is largely due to the use of cryptography, which enables the creation of a decentralised digital currency via hash functions and digital signatures. Among the key benefits of a distributed accounting system is the prevention of duplicate transactions with different recipients (known as double spending).

Proof of Work

The validation process in the Bitcoin blockchain is based on the Proof of Work (PoW) protocol. PoW allows anonymous blockchain participants chosen at random to propose the next block once they have solved a complex mathematical puzzle. The new block is then incorporated into the blockchain, provided that it is validated by the remaining participants by way of a consensus-based protocol. It is also possible for a block to be attached to a block that is not the last block in the chain, which results in forking of the blockchain. This problem is solved retrospectively by considering the longest chain to be the valid one.

Fintech boom and private blockchain

Securities settlement based exclusively on a public blockchain in which anyone can participate (and where there are generally no contractual relationships between the individuals involved) is not yet possible using the technology available today. In its current form, the PoW-based validation process in a Bitcoin blockchain is also unable to produce the immediate finality required for securities transactions.

However, at least in a private blockchain there is no need to implement a PoW system because the parties know each other and the relationship between them is governed by a contract.

There is therefore increasing euphoria around the use of private blockchains in the financial sector in particular. This trend is being supported inter alia by the formation of many new fintech companies operating in this space.

The activities of these fintechs include developing securities settlement platforms which offer their clients the prospect of lower costs on the one hand and higher profits on the other, based on eliminating some or all of the often extensive – and expensive – back-office operations needed at present.

Back-office activities related to data checks and processing during securities settlement currently still take several days, and in some cases involve confirmations sent by fax.

Securities settlement via blockchain, by contrast, could significantly accelerate these time-consuming processes by distributing data to the various participants and providing all blockchain participants with a synchronised copy of the transaction history. Intermediaries could even become superfluous.

Smart contracts

Another aspect is the use of smart contracts in a blockchain context. More recent blockchains, such as Ethereum, can contain instructions in computer language which are often referred to as smart contracts. Having said that, smart contracts are not contracts in the proper legal sense. In technical terms, they are computer protocols that can be programmed in such a way that they translate simple, specific contract provisions into code and execute the code automatically when the corresponding contractual conditions are met.

Applying these technical possibilities to transactional reality would enable delivery-versus-payment settlement in the legal sense via smart contracts. However, other legal issues arise here in relation to any potential implementation:

  • How can contract provisions be turned into algorithms?
  • How can preambles and imprecise legal concepts such as “in good faith” be replicated in computer language?
  • How can the securities themselves, their delivery and the corresponding payment be mapped in the blockchain to enable real-time settlement?

There are currently no clear solutions in any of these areas.

Innovation

The issuing of a promissory note by Daimler is just one high-profile example of the many companies that are hoping to reap the benefits of using blockchain and “trialing” issuance as part of pilot projects with banks (in Daimler’s case, with Landesbank Baden-Württemberg).

A consortium made up of Commerzbank, KfW and MEAG was similarly successful. The participants mapped the process for settling euro commercial paper using the R3 Corda platform. R3 Corda is built on a private blockchain in which no ownership structures are recorded in the ledger and transactions are only validated by the parties involved in the individual transaction.

Settlement exclusively via blockchain was not, however, possible in either of these cases.

Further developments

How could the switch to blockchain be handled from a legal viewpoint?

Any attempt to answer this question leads to a wide range of theoretical scenarios, from gradual implementation through to a “big bang”. Among the many technical, civil law and regulatory issues involved, the future of securities themselves is up for discussion.

One option would be for new securities to continue to be issued in the traditional manner, with the roles of the parties involved remaining as we know them today. Only cash settlement would be executed via blockchain.

At the other extreme, issuance could take place entirely in digital form using blockchain technology.

A potential halfway house would be for existing securities to be represented in the blockchain by digital tokens. A trusted entity with functions similar to those of a central securities depository would be essential in this situation, though, in order to guarantee that the number of securities in circulation exactly matches the number of tokens.

These various alternatives have yet to be fully explored and resolved from a legal perspective. As such, this aspect of blockchain development remains extremely exciting.