WFE Takes Aim at DLT-Based Settlement

The World Federation of Exchanges (WFE) has taken aim at moves to introduce distributed ledger technology (DLT)-based settlement, arguing the latency that comes with the new technology increases costs and risks.

A paper published by the federation, The Effect of DLT Settlement Latency on Market Liquidity, argues that reduced settlement times would come at the cost of market quality. WFE adds its analysis also finds that when adopting bitcoin blockchain the cost of making a trade increases, and the price reaction to a trade is intensified. For example, it states that a one-minute increase in settlement latency leads to a 1.3% increase in transaction cost and a 1.5% increase in price impact.

“This increase isn’t a rare event, and some of our findings showed that settlement latency can easily vary by over 3 minutes, equating to a 3.9% increase in transaction costs and a 4.5% increase in price impact,” WFE observes. “When there is uncertainty, informed traders will find it more difficult to execute their trading strategies and therefore pricing is less efficient.”

The big challenge from the WFE’s point of view is the “inherent latency” DLT settlement introduces, which brings uncertainty into the process due to factors such as overall mining capacity, which affects block validation speed. The WFE finds that this uncertainty discourages investor participation, resulting in a deterioration of liquidity and an increase in transaction costs.

“The policy implications are substantial, especially in shaping the market design of cryptocurrency infrastructure and, more broadly, for exchanges that are considering different methods of speeding up trading time,” it argues. “DLT, with its promise of decentralised and swift settlement cycles, comes at the cost of introducing uncertainty due to the unpredictable nature of settlement time, which has negative implications for the investors trading on that venue.”

In summary, WFE says policymakers and market operators, from regulated exchanges to crypto platforms, should “carefully consider” this trade-off between near-instant settlement and market quality before introducing DLT. In a statement to promote its members interests, WFE adds the research reinforces the important role of CCPs and CSDs in overseeing and guaranteeing the settlement process and reducing uncertainty in the timing of settlement.

“Whilst much of the finance industry has been focused on how to reduce settlement time, our research – looking at the extreme case – demonstrates the important place CCPs and CSDs have in the process, and the trade-offs that would need to be made if their roles were removed in favour of speed,” says Pedro Gurrola-Perez, head of research at the WFE.

Kaitao Lin, senior financial economist at the WFE, adds, “Implementing DLT in settlement processes presents a dual-edged impact. Our research reveals a trade-off between near-instantaneous settlement and liquidity. Without trusted entity oversight, DLT introduces uncertainty which impedes liquidity. Policymakers must weigh these trade-offs and balance their impacts on different market participants.”