Blockchain: A Conundrum for Clearinghouses and Financial Institutions

Centralized financial intermediaries are a cornerstone for trading, settling, and clearing securities. Large institutions manage the individual accounts at the front end of these activities, while the Depository Trust & Clearing Corp. (DTCC) settles and clears most transactions. Though a puzzle to many, blockchain is a technology solution that could replace some of these functions, although for this to happen, changes in current legal requirements or interpretations will likely be required.

Present day, investors generally must maintain an account with a financial institution that is either registered as a brokerdealer or exempt from such registration, in order to trade securities. Financial institutions trade stocks, mutual funds, the securities underlying annuities, and other investments on an “omnibus” basis, meaning that all investor assets and trades are pooled into one “omnibus” account, under the name of a single financial institution that acts as custodian. The financial institution maintains records of the investors' interests in their respective individual accounts, and it holds an appropriate amount of securities in the omnibus account for their benefit. With omnibus trading, trades are netted out internally prior to the financial institution going into the market to purchase or sell securities. The financial institution receives a fee for maintaining the omnibus account and record-keeping of each investor’s interest in the securities.

The clearing process validates the availability of purchase funds, records the transfer, and delivers the purchased security to the purchasing financial institution, which then allocates the security to the appropriate investor. Trades are typically settled one business day following the trade. Outsourcing settlement functions to a trusted third party, like the DTCC, is intended to minimize the risk of a seller not receiving payment and increase efficiency.

Are blockchains a possible replacement for the omnibus trading and clearing model?

Unlike the centralized trading process currently in use, a blockchain is a decentralized method of tracking ownership records that can be both secure and transparent. Envision a linked chain of blocks, each containing transaction data, a time stamp, and an identifier called a “hash.” This chain, which is commonly referred to as a “distributed ledger,” is akin to a list of transactions that would typically be stored on paper or digitally, except that each block contains a copy of all the previous trades, in addition to the most recent trades. Specialized computers, called “nodes,” solve challenging puzzles to cryptographically validate all transactions on a blockchain, eliminating the need for a trusted third party.

Were securities to be tokenized (traded like cryptocurrency) on a blockchain, a clearing agency like the DTCC would in theory be unnecessary, because the cryptographic method used to validate transactions, and the immediate settlement, eliminates the need to use an intermediary to settle and clear trades. All the assets are shown continually on the distributed ledger. Nodes never take possession of an account holder’s funds during any step of a transaction. Rather, the transaction happens between the buyer and seller and is immediately reflected by an updated account balance as represented on the blockchain.

Thus, the usual current one-day settlement delay would be eliminated. Also, with tokenized securities, anyone can in theory directly purchase or sell assets without an intermediary, which would lessen, or in some cases eliminate, any need for financial institutions that currently trade securities on an omnibus basis.

Financial institutions are already puzzling out how to respond. For example, on November 18, 2024, Goldman Sachs announced it would spin off its digital assets platform to create an industry-owned company. Large financial institutions and the government could use such a neutral platform to issue, trade, and settle tokenized assets. Under this model, financial institutions could retain their role as financial intermediaries, while still achieving efficiency advantages from adopting blockchain technology, which may very well become a mainstream part of securities trading.