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the following content is provided under a Creative Commons license your support will help MIT OpenCourseWare continue to offer high quality educational resources for free to make a donation or to view additional materials from hundreds of MIT courses visit MIT opencourseware at ocw.mit.edu today’s a little bit of a discussion about clearing and settlement systems maybe you feel you’ve heard everything you needed from Jeff Sprecher when he was asked a question when he was with us and Jeff runs some of the largest clearing houses in the world at IntercontinentalExchange not only because he started in the energy business but he has big credit default swap clearing houses and energy Clearing House isn’t like and he kind of said well I don’t know about blockchain technology for clearing and settling but I’m gonna try this Bitcoin project that you all know about and he talked about but today we’re gonna try to dig into well maybe there’s there’s something there because there are projects going on and why are there projects they’re mostly permissioned and not permissionless systems but I think there’s something there and this this will be one of the more optimistic you know if you’re judging how often I get to the maximal side I think there is probably something there at least for permission blockchain projects and their clearing and settling I’m going to will of course go through the readings and and these are the sort of topics will go through clearing and settling services I’m gonna try to set the stage as to what this is frankly when I was on Wall Street for 18 years I couldn’t really define what clearing and settling sorry Ross you thought I could define it when I was on Wall Street what’s that well when you’re in the merger and acquisition area you usually don’t think about what it means to clear something and to settle it and frankly even usually when you’re on the trading floor that’s something somebody else takes care of just the nature how many people have worked on trading floors here alright so I’m gonna have seven or eight of you start and you’re you’re on notice now in about 8 to 10 minutes you’re gonna help you you might prove what I just said to Ross that you can’t define what clearing and settling is because somebody else took care of it but we’ll see let’s see and then we’ll talk about blockchain technology applicability some of the projects that are going on and then move over to this there was a reading from the International swap derivatives association is what they’re doing around smart contracts in this space but what I want to do first is a little bit of talking about final projects because we’re at that time of the year and this is to help this is nothing like and I’m gonna go through eight or nine questions that if if you haven’t already thought through your projects these are eight or nine questions that I I would think you’d want to think about which is another way of saying it will probably enhance your performance what else can I say and number one and it’s a little small print I’m sorry or no it’s not too bad is what’s the value creation proposition or pain point if you wish so are you creating value or you’re solving a pain point or as Jeff Sprecher would say what are you doing that’s gonna make something cheaper faster better what’s the value proposition whatever space there’s two or three groups that are doing trade finance there’s one or two doing payments there’s some group doing commercial I mean consumer credit rating or so forth I mean there’s a there’s a wide variety there’s one or two groups that have come to see me that are doing things outside of finance but regardless what’s the value proposition what pain points are you’re addressing or as Jeff would say what are you gonna do better faster cheaper if you can’t kind of answer that you know threshold question shake it loose kick it around or move on to a different use case frankly secondly and nanning you get into like what is this blockchain technology what transactions are data gonna be recorded because this is fundamentally ultimately a database technology even the permissionless systems and and you’ll see a later question is like why this versus traditional database system but what transactions what data whether it’s healthcare records whether it’s consumer credit data supply chain moving a piece of property along a supply chain but what is the actual data and transactions that you’re recording questions what multiple stakeholders need to write and read access to the Ledger’s and I underline the word multiple because really when you think about the value proposition of blockchain technology it’s about immutable records or so-called immutable records that’s verifiable immutable records amongst multiple parties and it cost extra money everything we’ve been studying about in this in this this semester is about there’s more complexity there’s more cost in some way of this decentralized even permission systems decentralized system but you get something for it you get some verification of transactions of data immutability but you also have to have some logic that there’s multiple parties that need to both write and read a distributed database that just has read-only I can read my Bank of America bank account I can see what’s in that you know sort of ledger doesn’t have to be on a blockchain so multiple parties writing why is that important forming consensus in this circumstance which specific cost of verification are networking are you lowering we talked about a lot of the verification cost whether it’s whether it’s privacy censorship resistance whether it’s some direct cost maybe maybe you’re going right at something that’s got a bunch of economic rents in it so there was a series of verification costs we talked about what networking costs are you trying to reduce there’s probably been something in the order of four or five thousand white papers many of them that you can find you can’t find all of them but if you’re going it’s something that you think a white paper has been written about or a blockchain company’s been started on figure out what the competition’s doing and for the two groups and it may be more that are doing something around trade finance and supply chain you know you know you know there’s a bunch of stuff you can read what we were studying at next Tuesday alene give us an example of a networking cost often why people are using a native token but networking costs are how to get to jump start a network now uber jump started a network in a sense without blockchain technology but an example of networking costs or if you walked out of the airport and you didn’t think any drivers are using this this application then you wouldn’t be terribly interested in using it so we cursed across often the cost of building a network can be a tremendous start-up cost so how to start a network often as you go to a bunch of venture capitalists you raise money you advertise and you try to get participants and one of the challenges of healthcare records we don’t have our health care experts inherent today but I was looking around we have two students from Harvard public policy school doing graduate work and sometimes join us but healthcare records for instance you there’s some really interesting blockchain technology solutions but the networking challenge is how do you get a bunch of medical providers hospitals doctors and users to actually join the network so that would be an example of network cost is basically adoption often does that help what are the competitors doing I’m not looking for plagiarism but if you’re in a space payments or a supply chain or a consumer credit or some others where there’s three or six or ten white papers out there and maybe somebody’s even raised 20 million or a couple hundred million and an ICO then it would be interesting and you should you should feel free to look at those and maybe you’ll be informed by it and you’ll say yeah I’m doing it better or they got it poorly here or their projects in Estonia and I’m gonna do a digital ID project in the US and our regulatory system is different than a stony ax but I wouldn’t be bashful about looking at the competition in fact I would say that’s where business school you always look at the competition and you see if you can do either what they’re doing better or what they’re doing in a different geography or in a little bit different market back to how a lien likes to define things I’ve not used the term blockchain technology yet on this slide have I but why are append-only logs at multiple party consensus the best solution which kind of goes back to why not just a traditional database but why append-only time stamped verifiable logs with you know they’re connected by cryptographic hash functions but why have these logs and why have multiple parties in essence form a consensus about this state of the ledger time time stamps in essence but what what in essence is innovation of the early 90s and then Satoshi Nakamoto grabbed it was the concept that you take a block of data and you connect it to the next block with a cryptographic hash function and once you’ve done that then it’s committed you can’t amend anything that’s before because it’s a unique hash and traditional databases did not have similar commitment schemes they do have other commitments schemes but not this commitment scheme of taking a block of data having the hash function which that means never shall you amend what hack came before that’s how I understand it do you have a different view and traditional databases is there something new about technology so we knew how to do that and give you an append-only look it’s nothing nothing exceptional yeah there are debates as to where is the where is the border and boundary between a permission blockchain and a traditional database but I chosen to at least for this class a hyper ledger fabric we’ll call that a blockchain project but recognize there’s some we would say well that’s how–that’s unless you have a native token it’s not really blockchain Eric listen this that the Trust is the key attribute that’s not because you can get a multiple I mean multiple pallet consensus doesn’t have value it on its own it’s actually multiple particle censuses it’s actually something you have to come up as a necessity that stems from the fact that we are dealing with a decentralized arrangement in which you’re not trusting any of the parties that intervening in them in the exchange of information right well I agree with the first half that you’ve you wouldn’t even want to use Hyper ledger fabric unless you really need multiple parties writing to the ledger and I think that separated a little bit you could take an Oracle database and allow it to be multiple parties too but I think that separates it where you might be more the purist than I am Eric I I don’t think it has to be completely open where you don’t know all the participants but even in a financial we’ll talk about the Australian Stock Exchange in a half an hour or so and when we talk about that that’s a limited closed loop but they believe that they are actually taking a lot of cost out of the verification side they think they’re getting a lot of they’re lowering verification costs and they would contend they’re lowering networking cost because they don’t have the same reconciliations between multiple databases now you might call that verification cost but I think they would call both verification and networking costs there’s multiple back offices no longer reconciling if your if your final project has a permissionless system with a native token why do you need a native token is it to jumpstart the ico that you want to raise money for I’m not a I’m not averse to that I mean if that’s but but at least fess up and say that’s that’s that’s how we’re crowdsourcing this thing if it’s about that you really believe there’s a some benefit to the token economics that it’s an incentive system to run your new competition to uber or an incentive system for healthcare records or an incentive system for supply chain talk about what that incentive system is and and are you trying to motivate jump-starting the network or maintaining the network later and it could be both it could be either I’m just saying it’d be good to have a discussion is the native token just about a crowdfunding is the native token also about jump-starting this network and in an incentive to maintain the network amongst multiple parties what trade-offs of scalability performance privacy security coordination I’m not asking you to solve them and in fact you can even jump ahead three and five and seven years and sort of assume that some of these things will be taken care of so recognize that in the permission blockchains they seem to have a higher performance a lot higher performance than the native token permissionless systems but if you’re proposing a native token permissionless system I just like you know a short discussion of how much these scalability issues a matter to you particularly when most of the native token permissionless systems can handle much more than a thousand or a handful of thousand of transactions a day I mean it is true that Bitcoin handles quite a bit more than that but you know five or ten transactions a second is that going to work for whatever your solution is I’m not in fact I’d like to see some groups use native tokens I want to have a variety of things I read in December rather than reading all permission systems but and then again kenick permission blockchain or traditional database adequately address whatever use case if you do have a permissionless system yeah thinking about that how can broad adoption be realized are you gonna use a native token to get broad adoption how are you gonna get a bunch of hospitals signed on how are you gonna get a bunch of banks signed on you’re gonna do like Jeff sprecher did and get 50% of his equity away it was that conversation he talked about he had with goldman sachs they realized that was the only way to get his business started in the late 1990s but just you know how are you going to sort of get that adoption what and and to the extent you know this might be a paragraph but what type of customer interface or how might it be better than other customer UI’s so these are just some of the things if you were thinking about a real business and I think that the market is moving towards away from that big frothy bull market where there was money as four or five hundred ICS a Mont and there was raising anywhere from two to five billion a month and now now it’s sort of October was about two hundred icos and it was about eight hundred million and I think it’s going to continue to decline partly because they don’t all work but partly because people are now getting more rigorous as to what’s really going on if you are using a permission blockchain you don’t have to tell me whether it’s hyper ledger quarter but if somebody does and you have something thoughtful to say there I’m intrigued to find out you know why this one versus that one I mean it’s really just to show your critical analysis of the subject and if you want to improve yourself when why it’s quarter versus hyper ledger fabric that they’ll be interesting if somebody you know has a point of view but I’m not looking for that level of either computer science knowledge this is from a business perspective think of me as a venture capitalist if I was investing you know how how do you sort of pull it together so any questions on that so we had six or seven people that actually worked in banking who did we have at this table ah so what’s clearing anything else in clearing who else worked in trading it’s somebody back in the back table working they have the assets to be trade well most equity markets trade on transaction date plus two days so somewhere in that two days you have to confirm they have the asset that is correct you don’t have to do it on t plus zero normally buy t plus one exchange knowing what is the net exposure that you had that exposure net exposure very key thing so there’s authentication at some point between execution and transaction you have to actually know you have the security and then net exposure which we’re going to look at in another page this this simple chart of you know two people cutting the lawns but a buyer and seller meet but a buyer and seller meet in an exchange again traditional securities markets through brokers that’s called an inter mediate a taxes in the crypto exchange markets those two brokers in on the left-hand side on the right hand side the sellers and buyers brokers don’t exist in the in the crypto exchange markets basically you have direct access to the market but in the traditional stock exchanges whether it’s London Tokyo New York Beijing where’s the major is it but where’s the exchange in India what’s that Mumbai yeah I forgot 30 years ago I visited it and walked on the floor it was called the Bombay Stock Exchange fact then but regardless of where the stock exchange is there’s some Clearing House separate from the stock exchange doing these functions that we just talked about so three steps execution what’s it mean to execute a trade alpha do you know what it means to execute a trade without reading should I go back yeah it’s like before signing Docs making sure that information is all there so this sounds like it’s about derivatives executing a derivatives contract but what if you’re just buying a hundred shares of Apple stock what’s it mean to execute a trade so we’ll be on the phone on the screen and agree on there you go it’s just you bid a price and somebody hits hits the bed or lifts the offer those are the terms when you’re on the phone I lift your up off or I hit your bed or at least it was when I did it still what’s that still all right question talk to anybody can you go – without talking any money what’s that all right I guess I’m a dinosaur yeah the screens that I used to look at at Goldman Sachs there was it was green yeah you know you know the screens Kelly’s thinking what is he talking about right look it up on the Internet there wasn’t any color on those screens so execution is basically I buy you sell we agree upon a price a price and a volume that’s really what execution is but when when you execute you still need to do a few other things and it’s called clearing and settling when I was on a trading floor I couldn’t have told you what the difference was between clearing and settling that was something somebody else did frankly I’ll admit it they were really terrific professionals but they had their job I had a different job clearing is performing all of these functions authenticating somebody’s there making sure you actually have those securities and importantly this thing called netting how about settlement anybody want to say I know it’s written up there but anybody want to just say what so we’ve talked about Ledger’s for seven or ten weeks now what do you think a settlement really means in the context of a ledger did I see it he end up here yes I did I did see a hand up what settlement right it’s making a final recording on a ledger finally moving something on a ledger you could be moving the ownership of an asset or the ownership of cash and when you do both at the same time it’s called delivery versus payment or DVP it’s just a final change of data record on a ledger in the old days I’m talking about before I was doing it but you know 40 40 years – hundreds of years ago it was physically delivering a physical piece of paper which was a equity security or bond security but it all got dematerialized starting in the 1970s and by the 1990s it was pretty much in this country and in UK has pretty much dematerialized securities that everything’s digitized now in the equity markets in nearly every country that you’re all from and maybe with some small exceptions so execution is I buy you cell volume price we’ve legally agreed to something verbally and billions of dollars can trade on the phone or in the computer legally it’s executed clearing is trying to make sure that you actually have the Securities and I actually have the cash we do some netting we authenticate and settlement is actually moving the data on the ledgers three steps this is the benefit of netting it was just one short that I could find somewhere it’s actually the Australia Stock Exchange had it on their website but if you have multi parties into transaction which is on the left-hand side and these are just arrows of all the different transactions that it could occur in one little example and instead you in interpose a central intermediary you can you can do a lot of netting and look at participants see participants see only has an exposure of selling thirty five of whatever they’re selling some stock versus all these other transactions and this is a very simple case but if you have twenty or a hundred clearing members that are all big brokerage houses and they’re doing thousands or even hundreds of thousands of trades a day you have an awful lot of transactions and the gross transactions versus the net is quite a difference that netting can bring down numbers 90 plus percent or maybe even 99 percent or more so central intermediaries I know this goes against Satoshi nakamoto’s whole concept but central intermediaries came about in the securities market for a bunch of reasons but one of the biggest ones was in the back office of Wall Street from the gross transactions very good question so are we losing information or are we just lessening the lines of counterparty risk in the transactions and the answer is if done properly you still keep the information of all of these and in the real world it’s not this is just eight transactions its netted down to four right so this is a transaction that identifiers usually this is millions of transactions and that it down to tens of thousands or maybe millions of transactions literally netted down to if there was a hundred clearing members it would be one hundred transactions because they each have one net transaction per security persecute II and so you need to keep the information of the millions of transactions to properly record for your customers for your taxes for all sorts of other reasons but you’ve netted down for counterparty reasons does that help Shawn’s ask the question what if you’re not dealing with digitized asset but physical assets I think you used the word commodity but I I was presuming you meant physical so some of the innovations of the 19th century relate here when they started to have standardized contracts for commodities that were held in warehouses and they started in essence to facilitate some of this netting was also why central warehouses this Clearinghouse in the middle in physical commodities could be a warehouse that held the gold held the silver how the corn or wheat and if they’re holding that corner we they started to have specifications as to what standards there were in gold and silver it was percent it was called the you know let’s see si I’m trying to remember the word but you know what percent gold or silver it is but in corn and wheat there was a more detailed what’s going into the warehouse to commoditize it so that it was a standard contract if it’s truly physical and and not commodity it’s much harder then you can’t you can’t really net down my house versus Simone’s house they’re two different houses does that help but literally by the late 19th century even in the commodity space running out of Chicago they figured out central clearing houses would lower a lot of counterparty risks so there’s an economic reason we have centralized clearing houses and the biggest economic reason it is is netting and netting lowers something called counterparty risk it’s instead of having literally millions of transactions you have thousands and you’ll have less counterparty risk it also lowers one other things so it lowers counterparty risk and whether the other thing you think it lowers anyway transactions cost because it’s efficient you just you take a lot of line we we used to call it you take a lot of lines off the page so yeah in the old human days you’d have to have fewer humans actually pushing paper or trading disks I do they just go about their day trading everything and then at the end of the day they’re clear or the next day the Clearinghouse tells them okay you made all these transactions yesterday in that case and now looking back to this you are either the buyer or seller and you’re dealing with a broker so if you’re a hedge fund you often enter into an arrangement with a broker and it’s called a prime brokerage arrangement and you might have a prime brokerage arrangement with more than one Wall Street firm but you rarely would have it with more than three so even if I’m doing a trade through Merrill Lynch if my prime brokerage arrangement is at Goldman Sachs Merrill has to give up that I Merrill is going to get a commission but they’re going to give up my prime brokerage arrangements to gomen Sachs and that helps me get me the hedge fund get more netting as well and that’s some that’s a development in the last 20 years this concept of prime brokerage but to answer your question yes I go about my business I trade all day unless I get a phone call or an electronic communication for my prime brokerage saying you’ve hit your lines you know you you do have credit limits and position limits in essence but but your prime brokerage and I might say well I need something moved over I need I need some more credit today or I mean you know so then it but yes you go about your business until your prime brokerage says slow down question says that you know if you’re a lot like LTCM balance sheet of a trillion dollars right I am probably why when a bankrupt is they didn’t want to use one prime broker because I didn’t want to reveal all their trades but then the brokers could not nan out their positions right because I may hold one leg with you and another leg with you right they made the net maybe zero but there’s no way for you to actually reconcile that already thought that risk so it’s a real problem long-term capital management was a hedge fund operating in Connecticut it was founded in the early 1990s by a man named John Meriwether who was a very famous trader from Salomon Brothers and very successful and then he started it with some remarkable finance faculty from here at MIT and elsewhere Bob Merton who’s Nobel laureate I mean brilliant brilliant team of folks but they ran into a little triage for years later they had about a hundred and twenty five billion dollar balance sheet four billion dollars in capital and 1.2 trillion in swaps why do I know the numbers I got the phone call with my one-year-old sitting on my lap and I picked up the phone and I said hello and and the voice of the other line said Treasury operator I’ve got the Treasury secretary for you when I get on the phone I go yes Bob it was Bob Rubin it was the Treasury secretary Bob what’s up it was a Saturday Isabel was on my lap he says do you know anything about long capital management he goes through some of the figures I’ll never forget he says I hear from Alan that would be Alan Greenspan who was the head of the Federal Reserve I hear from Alan that they have over a trillion dollars of derivatives Ramon’s memory he says is that a big number you have to understand above sense of humor was quite you know at that moment you know he knew it was a big number you know so I was I flew up the next day and with somebody from the Federal Reserve Bank in New York Peter Fisher we sat around a conference table looking at these facts and figures and then I got back with the planning and flew flew back to Washington to be with my family the next day was actually Russia shut up Jewish holiday and I wasn’t going to work and I had to call Bob and and and his deputy Larry Summers up and give him my feedback and I said this thing’s going down bear stearns was their prime brokerage and Bear Stearns who 20 years later failed themselves but Bear Stearns and said we’re pulling the prime brokerage account if you can’t post another half a billion dollars by Wednesday well there was no way they could post another half a billion dollars because their four billion dollars of capital we could best figure on that Sunday was somewhere covering around four or five hundred million at that point in time well when you have a lot of leverage you have one point two trillion dollars of derivatives which are all sort of leverage in one way or another and you’ve got 125 billion dollar balance sheet even with the best minds the best finance faculty and and they really are terrific individuals and Merivale Merriwether was quite a traitor sometimes markets go against you correlation risk liquidity rest and so forth so they they pulled the plug the next day basically that’s the long-term capital management story I remember but it’s just because I kind of had to live it but to answer your question you you can trade all day until you’re prime broker kind of says Hugo slow down because they’re extending credit to you and that’s and the prime broker is entered in today and one of the big risks what are the big risk of the financial crisis and and certainly Ben Bernanke and who is chairing the US Federal Reserve and others had to deal with it in the middle of 2008 is most commercial banks so they’re they don’t have a broker their banks they’re the brokers themselves were extending significant amount of intraday credit to each other that in 2008 wasn’t terribly well measured in the repo markets and in other markets and that’s changed subsequently but you wouldn’t have been a big bank yeah you would have probably been shut down sorry or maybe not so netting is the biggest benefit of clearing but it’s also efficiency and taking down a lot of operating lines of code this is a chart I’m going to spend a lot of time on it but this is right off the Australian stock exchange website and I thought well why not take that they have two million investors the market participants or brokers in a much smaller market than the u.s. in Australia has 77 brokers registered regulated brokers and then they have the Clearinghouse called chess CH ESS which I can’t quite remember what it all stands for but SS is settlement system Clearing House what’s that what’s it thank you is it equity for e they have the Australian Stock Exchange clear and Australia Stock Exchange settlement because they actually put it in two different places two different things the Clearing House is doing what we talked about mostly netting lowering the lines of code and then settlement and basically because we’re in a trade a plus two days on the first day is all the clearing and the netting and you better show up with your securities and on the second day set electronics and technology can make this simultaneous but most market participants like to have some ability to do gross trading against Nets positions so there’s a lot of economics and markets practice and structure behind keeping some delayed settlement and the markets have grown up around that Ross if it’s not delayed if it was instantaneous wouldn’t that get rid of the benefits of net every trade go right right it has to be wait till the end of the day or whatever so Ross just raised the number one reason economic reason why simultaneous clearing and settling is is not that likely to happen the markets have built themselves around the benefits of netting and also stock loan the ability to borrow that security somewhere but you’re absolutely right if if if there were simultaneous execution and settlement which is what the Bitcoin network in essence is supposed to be and blockchain networks can be then you in essence have to pre-fund you have to have your secure every time Hugo trades he’s gonna have to provide his security to trade and and but then Tom would get the security faster it would change the entire prime brokerage model it doesn’t mean markets Ross couldn’t adapt and be structured that way but it’d be fundamentally a different structure this is a hand up so the parvis is really big with derivatives I don’t see it I don’t see what like I don’t see it being a primary issue with like equities so if you were going to apply this deck please do any any sort of like any cash instrument base right yeah I don’t see the huge economic value for and Eddie the huge economic benefit for netting it currently is a lot of operational efficiency sure but if you’re gonna face that with some and then also because there is two day Tanner Party rest you are lowering that to day whatever measure equity volatility to day volatility equity volatility risk usually not collateralized I’m just commenting on the the just commenting on whether this like the you you you said the so the price that you paid for replacing this system right this with the blockchain based one would be that you cannot earn it up I should have said something and the market participants would have to then pre fund their trades I think I think the the larger thing so so if I speak in too much financial technology let me say current markets are you can sell or buy a security without owning the security or having the cash you can buy something and not have the cash you have to deliver the cash in two days and usually by that evening or the next day you have to show you have the cash you can sell a security without owning the security and you only have to really kind of deliver it generally speaking the next day on t plus one if you went to a true simultaneous clearing settling in execution market you’d have to have the cash and the security before you execute and I think that’s the larger piece of it much larger than netting so three or five brokerage arrangement hugo remember has a couple he’s a big hedge fund and he has what’s called a prime brokerage account not at Bear Sterns any longer but you know maybe it’s a Goldman Sachs he’s he’s kind of fancy he’s it’s good then his prime brokerage account in his legal contractual arrangements with them they will find that security for him maybe from some other customer maybe that securities held in somebody else’s what’s called a margin account and they will enter into what’s called a stock borrow but when he executes on the phone he doesn’t technically already have that security he could be shorting it and his prime brokerage account could then go you know find it from the Goldman Sachs Network but it’s not because you have two plus two but it’s because you have a broker yes that’s right combined with t plus two it’s a really good question is this just the system we’ve grown accustomed to or is it beneficial it’s hard to tell it is definitely the system we’ve grown accustomed to over a couple centuries and as we’ve gone from transaction date plus five which most markets were I’m talking about fifty and a hundred years ago maybe it was even t plus ten at some point but T plus 5 2 T plus 3 2 now T plus two we’ve started to challenge that but in the US the Depository Trust Corporation provides same-day settlement and very few accounts asked to do same-day settlement and I think it might be just they’ve grown accustomed to it but I think there’s some benefit in this stock loan stock borrow side but I I stand with what I said earlier I think the market could work the other way but it would be a big adjustment and there are some benefits because then Hugo this hedge fund is being extended credit by his prime brokerage account and and the prime broker is making some money on it but also Hugo’s taking risk in that arrangement pre-funding it would be a different model some argue it would have less liquidity in the marketplace it would make it shorting stocks a little costlier I’m not sure they’re right but their argument is is that I’d have to borrow the securities always a hundred percent and have it off before I sell even if I’m a multi-billion dollar hedge fund that has has some credit worthiness market so what would necessarily be implications for markets would it basically be that people can make trades without having an interface with extensions of credit are you talking about illiquid markets that are centrally cleared or illiquid markets that have no central clearing saying that they’re what would when they’re not the implications so Kelly’s asking I don’t remember that comment because it was in the Australian Stock Exchange why so in in non-cleared markets things that are just so illiquid my house it’s not cleared it’s not centrally cleared certain parts of the derivatives markets aren’t centrally clear they’re not quote liquid enough so I don’t know I don’t know the comment maybe see me in class and I look at the comment and try to nail it for you is that all right so I wanted to put this chart up because it was from 2011 I remembered it when I was at the CFTC but somebody at this fat of Chicago made this chart about the u.s. clearing system’s yellow are all clearing houses red the SEC the Federal Reserve New York yeah SEC CFTC and the Federal Reserve but they might have new it New York I don’t even know who New York SP Board of yeah somebody from the Chicago Fed was trying to make the case that our regulatory system in the US was a little bit complicated and I think this was in the midst of the debate about dodd-frank that they thought all oversight of clearing houses should move to the Federal Reserve but I remembered the chart and found it no no we won’t wanted to share it with you but the yellow or all the clearing houses there are a lot of clearing houses in the US there’s one for bonds there’s one for equities there’s multiple ones for derivatives both from cash and interest rate derivatives to energy derivatives to credit default derivatives and so forth there’s once four options so I just I just wanted to kind of lay it out there it is a very finance is pretty complex this is all digitized by the way but in this complexity that’s also where I think there’s some opportunity whether it’s permission blockchain and not fully permission less with tokens and inspired by because in almost the green is the Greeners exchanges and I don’t even think they put a color up for brokers today because then you’d have hundreds there are multiple parties sharing Ledger’s and reconciling their Ledger’s reconciliation means I keep a ledger Tom keeps a ledger it’s both on our database systems and we keep testing and assuring that we have the same records this is a system that by its complexity and by its multiple shared or multiple copies of Ledger’s and reconciliation has a lot of opportunity for greater efficiency and the question is whether blockchain technology maybe permission can bring some of that efficiency that’s that’s the thought and that’s what the chart was just trying but it will be in there by the way that Congress didn’t agree they fed they left the authorities at the SEC and CFTC and those are four stories other times I personally felt it could be a shared Authority and we ended up with some shared authorities but I thought that the CFTC and SEC have domain knowledge and it was really important to keep the SEC involved in securities clearing and the CFTC involved in derivatives clearing for that domain knowledge but that the Federal Reserve also kind of came in under something called title 8 of dodd-frank and they also got authorities so we made it more complicated because now there’s kind of multiple dotted lines for this the Federal Reserve basically has an account with everybody or they have some oversight of everybody so then the question on blockchain technology could you take the Clearinghouse out of the middle and do the thing on the right and my question for you all is do you think the economics I’m not talking about the technology I’m not talking about whether it’s performance if you wish you can go five or ten years down the road and say it’s got all the scalability and performance do you think the technology without something in the middle what’s the economics about that anybody we’re liquid markets because of the netting because yeah I just I can’t see I can’t see a blocking solution working well netting to enjoy the selling and shorting but the question really is can you somehow on the right with you know shared ledger still get some benefit of netting right you’re saying you’re inclined here because you want to get the netting for economic reasons so as a ledger structure can you get the netting here shamone netting is is basically again with caching I’m not talking about to release the waves different as a different issue with cash instruments the only reason why you have kind of Artemis is because it’s not clear it was my understanding correctly is because you don’t have instantaneous state in a settlement if you have a standard seven then you don’t care about it you care because he faced so many transaction fees no but that’s going to be a lot more efficient so what again I don’t do you think read transaction fees are they are big economic issue you yes really intense help how much do you pay per transaction with the Clearinghouse and without maybe the net we give you only 10% of the transactions but the cost of having the Clearinghouse is more than 10 times the economic depends on those numbers I think is that a question so it’s it you go and that’s kind of like netting then you have a second mmm-hmm system on top of that that keeps track of what’s going on throughout the day takes care of so Hugo content you maybe you can get this this economic thing called netting and still have a shared distributed ledger or you could do it off chain I think shamone to your question is this is a big economic thing either because we’ve just grown accustomed to it over a couple centuries or it’s fundamental to how markets trade that we don’t pre-fund its that economics that blockchain technology will challenge but we might stay with a central clearinghouse if the economics or that value of the economics of in essence not pre-funding and and and thus some delayed settlement whereas in the past we always had delay settlement at first because there were so much paperwork we had to have delayed settlement we went digitized and now really in 2018 we don’t need delayed settlement or batch processing so now you sort of exposed we’ll wait what are the economics Tom and then a lead with the blockchain system just by using a smart contract okay yeah absolutely I mean you still yeah I should keep the system that people are accustomed to but do it without the economic read that it there okay yes and that’s what the Australian Stock Exchange says they are using with the digital asset company Blake masters company that’s their outside vendor using the hyper electric fabric and they’re using the code that they call it Donald digital asset machine language I don’t know what the M is but they call it demo lean well that’s if I think you could through smart contracts I think you could find this but this the the challenge with just the picture the picture suggests there’s no central counterparty to do all the netting and so the question is can you have this ledger structure and still find a way to net down all the positions well there’s no need for that like why you get that implicitly by recording everything but if you’re recording all right agreeing with that – but that’s where I get to if you need to do she moans approach which is simultaneous execution and settlement then you need to pre-fund even if that pre-funding is by nanoseconds but you need to pre-fund the post of transaction that says I want to buy a stock and I’m not gonna prove to you that I have money to buy it you recorded being optimistically and later on no but it depends on the word record let me use a different word settle settlement means final legal rights have moved from one party to another so the word settlement has a meaning of it I just want to come back to means I’m recording on a ledger that I no longer have legal rights to this alpha has legal rights to it and I think you wouldn’t have to pre-fund if you’re doing true settlement Ledger’s seems like you could simulate the Clearing House in this picture they’re clearly how to just distribute it I think you’re right that you could but if you’re going all the way to where shamone is like Bitcoin and you’re doing final settlement final settlement record ation then I think you have to pre-fund a couple questions over here Eric even be done during the nanoseconds but it has to be done before you move the settlement and that’s that’s what’s called clearing so it’s a question of whether you have simultaneous execution and settlement or you still have execution clearing settlement even if separated by Seconds but still literally get granular I apologize this stuff is that granular I mean but that’s that’s what back here and then I’m gonna move on just did I shouldn’t sound that way it’s just that for a couple hundred years we’ve had delayed settlement and so I’m saying if you’re a proponent of a system that has simultaneous execution and settlement you just have to deal with that you’re changing the economic models that have been so common in the capital markets and when you take that ore and you just have to think through what are the economics of that shift from in essence a delayed settlement thus modest but real counterparty risk that Hugo’s got a prime broker and he’s got that and moving to this new model in capital markets so I shouldn’t come across as negative but I’m saying that’s a at least it’s a hurdle that you’ve got a you’ve got an adoption curve that’s gonna be a challenge I think at a minimum DTCC when I first spoke to them and I’ve have a lively Gordon going dialogue with the folks they’re on occasional basis this was the biggest issue they raised they said they looked at blockchain technology starting several years ago they talked to their customer base and they couldn’t find that their customer base really wanted to go to simultaneous execution and settlement they have same-day settlement but it’s end of day settlement so they’re still you know several hours but they said we don’t have a lot of customers that really want simultaneous execution and settlement now that that was commenting on the demand side it’s another question whether you could adopt this lower cost do something and change your capital market so this is another look at it I’m gonna this is also from the Australian Stock Exchange I think website if I remember but maybe there’s another website the question is could you take out these two middle parts this is like blockchain architecture for clearing central counterparty and the central securities depository because there’s also somebody who’s got the central registry and that central registry or the two things could you take this out completely that was the kind of question in a sense so here are the projects that are actually live or being explored and we’re going to talk a little bit about Australian stock exchange in a few minutes we have left but this Australian Stock Exchange project started in 2016 a bunch of requests for proposals they hired digital asset holding there you’re actually actively working on it it’s a 25 year old system and Jeff Sprecher said it too he said you know they had a legacy system that needed to replace they decided to go with the new technology of the day but Jeff wasn’t convinced they had to but they feel that it was the right thing to do to go to with that new technology of the day they believe and and they’ve put out reports as recently as several weeks ago they believe they’re on the right path in that 15 or 20 years from now every Clearing House will be using what they would consider a permission blockchain solution because it will so significantly lower the back office costs for their market participants who are now holding records each bank those was it 77 members from an earlier yeah each Bank has to hold records it can be held in a shared ledger and they would lower the reconciliation cost and they believe the second advantage is using smart contracts now are they exactly the smart contracts like on the etherium network no because they don’t have a native token they don’t have a DAP in a native token but it’s still automating certain processes automating certain I’ll call it back office processes so they’re very committed to it and they’re gonna roll it out in 2020 and then for 12 months run it simultaneous with their legacy system so they’re cut over for for you know assuring that it’s resilient is a 12-month test most major market infrastructures that roll things out do not roll simultaneously for 12 months but they all roll simultaneous whether it’s a month whether it’s 90 days you can’t do a major you can’t cut over the back office in the new york stock exchange and just test it for one day or what you can it just kind of choppy in a big risk good question are they going to use a stable point to to settle it how are they gonna sell their collections see how you use your security as digitally but you cannot issue caps it’s very good it’s very good so all of these clearing houses can they are the final custodian for the security securities are dematerialized meaning they’re all digital and so those digital assets are held on a ledger and the what’s called the golden record this is the words used in the securities business the gold record or the golden record meaning it is the legal verifiable thing you can go to in court of law and it says this is who owns this alpha’ owns it not Hugo sorry you’re you’re working with goldman sachs though right is that that golden record is there for securities who has the golden record for cash central bank or the fractional banking system their commercial bank sub-ledger clearing houses around the globe would like to be able to have direct access to central bank money and they currently do not in any of the major jurisdictions that I know I think so what Australia does now this is what they do now they met everybody down they get to t plus two they’re on that second day everything’s netted down and they’re about to do the whole closing out one second before they do the security settlement they do the cash settlement they call this delivery versus payment DVP but they’re a clearinghouse and they do not want to take risk with the central bank they take all the money and settle all the cash with the Royal Bank of Australia RBA I guess do I have the right name or is it different there’s RBA one of the banks in Australia but they settle all the cash and just within a second they said all we think of it as DV pay but it’s actually technically not inside their clearing systems they have a form of Australian dollars that is effectively digitally in their system digital money in essence what they’re doing is clearing their internal digital money versus Royal Bank money sorry so these other projects Estonia the tool in stock exchange is exploring proxy voting and registration what’s interesting who runs the Estonian Stock Exchange NASDAQ Nasdaq so Nasdaq runs it and they’re doing this project Nasdaq announced and and went live in 2015 on an illiquid so Kelly you asked me about a liquids earlier Nasdaq started a blockchain technology platform in 2015 on private securities which were not they certainly weren’t lik liquid I don’t know enough about what they did there as to how illiquid they were but they felt all right this is a place we could do this and and and it’s still gone live it so it’s very it’s got very little use but it’s still there and they say they’re gonna try to do it for mutual funds when you and I can just buy interest in mutual funds and Nasdaq is gonna offer that to mutual funds partly because mutual funds aren’t in DTC say from what I understand the others are just really some tests Japan has done the Japan exchange group for the Tokyo Stock Exchange has done some tests they’ve written papers they’re sort of interesting papers the last one was earlier this year they’re really trying it just on post trade matching one of the securities firms in Japan I can’t remember is really pressing the Tokyo Stock Exchange to do this so there’s some local commercial politics that are going on can’t remember which exchange is not exchanged one of the brokerage houses is pushing them to do it all permission systems no no for to my knowledge permissionless systems let’s talk about is de just for a few minutes derivatives common domain model one of my former commissioners colleagues Scott Amalia runs is de and he’s he’s that’s a international trade organization it’s largely largely dominated by the sixteen big banks around the globe that probably transact 98 or 99 percent of derivatives around the globe and it was started the 1980s to do all the forms all the forms to enter into the legal contractual obligations called swaps and over the years it’s it’s it’s transitioned it’s also an advocacy group and it lobbies various regulators in in Europe and the US and Asia but they’ve a year or so ago said wait a minute we could take a lot of the back office of swaps particularly swaps that are not going into clearing houses so it’s called the non-cleared or uncleared swaps and maybe we can create smart contracts to automate a bunch of contractual terms so that’s the second bullet point and they contracted out they put out a request for proposal basically for somebody to come up with machine readable standard representation call it code a scripting language I can’t remember if it’s oh it’s written in JavaScript so written and Java and JavaScript a standard machine readable code of various events if it’s a 20-year swap that’s gonna pay every quarter 880 quarterly payments each of those quarterly payments fixed versus floating payments is somehow put into machine readable code and and Scott and is this view was if we could get a broad consensus and publish that machine readable code that everybody agrees on maybe that machine readable code could take the place of legal contracts insta for 30-plus years it’s been in the one of their lines of business is creating those legal contracts maybe we can get a step ahead of this and get consensus amongst these 16 big banks there’s there’s about a hundred thousand users of swaps when you say all the customers it’s not measured in the tens of millions I doubt anybody in this room personally has a twenty year or a ten year swap but I don’t want to embarrass it maybe somebody does but it’s a institutional product largely that’s their product and and it covers new transactions rate resets partial terminations as I’ve listed up there questions one and it’s definitely very much inspired by etherium and and and smart contracts and apps but in essence it’s not really blockchain technology it’s it’s it’s you it’s inspired by it in essence they think they can have more specificity and certainty about what the contract needs by writing it in contract and importantly importantly efficiency to automate that which humans are still doing even if it’s in written contract so it’s also automation that’s inspiring them so but you’re absolutely right it’s taking legal contract getting into machine readable JavaScript code getting consensus and what that code is giving some courts to recognize it and then you won’t even need to write some of this a rate reset or a partial termination into the contract you’d be referencing this the longer term objective is to say maybe we can put even more of it right into money somewhere looks like we’re tired right that’s a correct execute itself we don’t have to be a pool of money that you might have to you’d have to pre-fund or sell find or something let me go back here and then up it can’t be they call it a blockchain project but it’s just it’s it I think I’ve tried to crap sure the essence of what I think they have here it’s definitely blockchain inspired I just not sure it’s really stored on a blockchain because if you look at credit default swap you have the reference of credit waiting somewhere digitally and wherever that’s reference digitally someone makes a mistake that’s a transaction occurs based on that mistake and it’s big so what’s raised is what about if it’s wrecked if it’s referencing some Oracle referencing some price source and there’s an error I believe is I understand that they’re writing some of that into the the code as well so if it’s referencing a price off the New York Stock Exchange how it does that what open API it references how it pulls it and and and they’re trying to say let’s make sure that it’s what’s really verifiable there’s one more slide on this that will help this is their steps this is their publicly disclosed five steps this was in an October paper it wasn’t part of your reading but select the parts of derivatives contracts for us automation would be worthwhile they’re effective it’s efficient let’s find something we can automate Ross that’s that’s their key driver then try to express the legal terms in a more formalized way get some standardization about the law get that be represented as functions meaning computer code so where can we be efficient in automate where can we take the legal words and get agreement put it into code combine that into templates I think some of this is referencing Oracle’s and then validate that the templates actually work and and ultimately even get some courts of law to accept them that’s kind of their game plan huge implications beyond efficiency right because take your Treasury yeah Eric Goldman Sachs signs a contract with someone at Orange County right the ability of their ability to assess what is actually written in the 30 page contract that the percent what minimum will be minimal but but it’s a lot easier to do kind of risk management or assessment if it’s if you could just be there’s an API right and you have now outside companies visit you providing you with risk analysis right where’s I agree with that we’re still very much at the early days but I think this is kind of an interesting real-life thing that there’s a lot of money behind this it’s a the markets are hundreds of trillions of dollars if my former colleague and is to pull this off they’ll probably drive some efficiency automation they might lower some counterparty risk and event risk or crisis risk I think you could embed these into true blockchain technology but I’m not sure it’s dependent upon it the automation of a smart contract next Tuesday next Tuesday there’s a couple extra readings we swapped out some readings it’s trade finance thank you [Applause]