How blockchain can fix one of Wall Street's thorniest problems

The Big Story

Time to settle up

Crypto company Paxos is taking on the stock settlement business, a relatively unknown but critically important piece of capital-markets infrastructure.

Stock trades still take days to settle, an archaic relic of the days when transactions required the transfer of physical certificates. The SEC has gradually reduced the period from five days to three to the current standard, T+2, or two-day settlement, in 2017. But other assets are traded nearly instantly.

Critics point out that in the intervening time, the risk of a trade not clearing has to be borne by various market participants, adding unnecessary costs and uncertainty to what should be a straightforward and near-instantaneous electronic transaction. No one really likes T+2, but rewiring all of Wall Street is a costly endeavor.

Blockchain technology could be a way to bypass Wall Street's status quo. That's what Paxos is trying to do, and it just won a significant ally in the effort.

• It announced Monday that it has added Bank of America as the fourth participant in its same-day stock settlement pilot, along with Credit Suisse, Instinet and Societe Generale, which it had previously announced.
• Paxos uses a private blockchain using the Ethereum protocol to settle trades between broker-dealers. Essentially, it's a ledger between two broker-dealers, to "bilaterally settle" with no essential counterparty required.
• In 2019, Paxos got a no-action letter from the SEC enabling it to run a pilot settlement test with up to seven broker-dealers.

Robinhood's meme-stock debacle showed the need for reform. The popular online brokerage had to stop trades in GameStop and other meme stocks in January, when it didn't have enough collateral capital on hand to address settlement requirements of the Depository Trust & Clearing Corporation.

• A subsidiary of the DTCC, which handles the transfer of stocks and cash to buyers and sellers, asked Robinhood to post $3 billion in collateral during the volatile GameStop frenzy. Since Robinhood didn't have that cash, it stopped trading.
• Because of the two-day settlement period, collateral is required from brokers while trades are settled. If the settlement window were dropped to one day, those requirements would drop significantly, saving 41%, according to the DTCC.
• The less time it takes to settle trades, the less collateral is required.

Do we need blockchain to fix this? The DTCC has already called for moving from two-day to one-day settlement by 2023.

• The DTCC says it can already handle same-day transactions.
• "This is already done today, using existing technology, and doesn't require new technologies like distributed ledger technology," the DTCC wrote. That's a veiled reference to a key feature of blockchain technology.
• Many trades are made on margin, and some brokers require time to arrange financing for those short-term loans, the clearinghouse points out.

Blockchain advocates don't see the point of waiting. Paxos, which recently raised funding at a $2.4 billion valuation and also provides crypto services for companies such as PayPal, has said it already has the technology to do instant settlement now.

• Under the current pilot, Paxos is still using two-day settlement times but has said it could move to one-day or same-day as soon as clients and regulators agree.
• To that end, Paxos has said it is seeking to apply for a clearing agency license. That would make it the first real competitor to the DTCC.

Robinhood addressed the problem by raising money and negotiating a lower collateral requirement. But volatility in the markets doesn't seem to be going away. That's putting pressure on the industry to settle on a faster fix for T+2.

— Tomio Geron

A MESSAGE FROM FUNDRISE

Relative to a traditional portfolio composed of 60% large-cap stocks and 40% bonds, a portfolio with a 30% allocation to private real estate would have generated a higher return with more annual income and lower volatility over the past 5, 10, 20, and 40 years. Power your portfolio with Fundrise.

Learn more

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Overheard

• "Venmo's privacy failures are already a big problem for everyday folks who use Venmo, and that's been the case for years. All of those problems are magnified when we're talking about a major public figure." —Gennie Gebhart, the acting activism director at the Electronic Frontier Foundation, about how easy it was to find President Biden's Venmo account and his contact list.
• "Memes are the language of the Millennials. Now we're going to have a meme matched with a currency." —Glauber Contessoto, who invested his life savings in dogecoin.
• "Index providers like S&P DJI play a crucial role in the financial markets. When index providers license their indices for the issuance of securities, as S&P DJI did here, they must ensure that the disclosure of critical features of their products as well as the publication of real-time values are accurate." —The SEC's Daniel Michael, on a settlement by S&P Dow Jones Indices for publishing stale data which resulted in $1.8 billion in losses.

3 Questions With...

James Wu, Principal, M12 (formerly Microsoft Ventures)

Why the name change?

We are Microsoft's VC fund. We changed the name to signal we're an independent fund. Today we have only one LP — Microsoft. We see ourselves like a GV or Sapphire in their early days in the sense that we're not a strategic VC.

How do you view fintech as an area of investment?

Traditionally fintech fell into the portion [of our investments] that's less relevant to Microsoft. If you think about defining fintech, tech platforms are trying to disrupt banks. Historically, banks have been a good friend for Microsoft. So that can present some conflicts. We look at outside bank-enabler technologies. From the infrastructure side, it's things like what security or fraud-detection mechanisms can you deliver value to users or what are the compliance tools to comply with GDPR.

What's changing in your strategy now?

Last year we rethought how we think about fintech. We are still very B2B-focused, but we're a little more open to fintech companies to look at and have opened up our aperture. We invested in At-Bay, a cyber insurance company. To us that feels like fintech. Most of our investments are in the infrastructure layer, security, big data, explainable AI and fraud. We have taken a look at banking platforms. We haven't made a bet there just yet, but we're open to it.

Every time we look at fintech, we look at how to more securely move capital as opposed to, "This is a cool interface." Other investors look at it from the angle of: Is this cheapest way to move capital? We think about it from a different angle. That leans on our nature — we are infrastructure experts. With blockchain/crypto adoption we don't think about what gets the most user growth, we think about institutional use of cryptocurrency. That led us to invest in Bakkt.

Need to Know

• Goldman hired an ex-Uber exec. The bank hired Peeyush Nahar, a former Uber engineering exec, to head consumer banking.
• AmEx is planning "buy now, pay later" for travel. The plan would offer installment payments for airline flights.
• Plaid's CEO raised a VC fund. The $30 million fund, Mischief, is run by Plaid's Zach Perret and Lauren Farleigh, CEO of DoteShopping.

Deal Flow

• Amount — yes, that's its name — raised $99 million at $1 billion valuation. The startup helps banks with digital moves.
• Rally raised $30 million. The alternative investing platform's new round was led by Accel.
• Sequoia backed a neobank in Egypt. The VC firm, which made an early bet on Brazil's Nubank, led a $5 million seed round in Telda.

Data Point

$17.3 trillion

That's the projected value of transactions on point of sale terminals in 2026, compared to $14.8 trillion in 2021.

A MESSAGE FROM FUNDRISE

Relative to a traditional portfolio composed of 60% large-cap stocks and 40% bonds, a portfolio with a 30% allocation to private real estate would have generated a higher return with more annual income and lower volatility over the past 5, 10, 20, and 40 years. Power your portfolio with Fundrise.

Learn more