The capital markets and trading businesses may soon see the introduction of cryptocurrencies for facilitating trading transactions across multiple asset classes. The expected benefits include minimal transaction costs as well as secure and instant transfers. (For more, see: The Future Of Cryptocurrency.)

Goldman Sachs Group Inc. (GS)  was granted a patent for its cryptocurrency by the U.S. Patent and Trademark Office in July 2017. The patent was titled "Cryptography currency for securities settlement."

GS is expected to launch its own cryptocurrency called SETLcoin, which will be used for trade settlement. Built around SETLcoin will be a robust trading system which will offer instant trade settlements, a self-regulatory mechanism based on blockchain technology and other benefits which could make the function of a clearinghouse redundant. (For more, see: What do T+1, T+2 and T+3 mean?)

Here's a sneak peek into how the SETLcoin based trading and settlement system will work.

Today's System

After a trade is made between a buyer and a seller, a clearinghouse like the National Securities Clearing Corporation (NSCC) matches the trade instructions as received from both trading parties. This process of matching is called clearing.

Following the successful matching of the trade details, the clearinghouse initiates the settlement process, which involves the transfer of securities from the seller’s dematerialized (demat) account to the buyer’s demat account, and payment of money from the buyer’s account to the seller’s account. These processes of clearing and settlement can take from one to three business days, depending on the type of security traded.

This lag from the time of trade to the time of final settlement involves risks. One of the parties can default on providing securities or payment, which constitutes counterparty risk. The clearinghouse acts as a counterparty for the buyer and seller, and protects each from counterparty risk, thereby becoming a necessary party in present-day trading business.

The cryptocurrency based system proposed by GS aims to replace the functions of a clearinghouse by offering instant, accurate and secure settlement of security as well as cash.

The Cryptocurrency System

First, let’s break down a basic example of a cryptocurrency transaction. Assume Bob wants to send X bitcoins to Sam. Bob issues the necessary instructions to his bitcoin software to make the transfer from his bitcoin wallet to Sam’s, which in turn generates a transaction, which gets broadcasted to the Bitcoin network.

The network involves a blockchain ledger which records every transaction made on the network. Once the transaction is recorded and verified on the network, the X bitcoins are debited from Bob’s wallet and credited to Sam’s wallet. (For more, see: What Does a Blockchain Record in a Bitcoin Exchange Transaction?)

Under the cryptocurrency based settlement system, GS will introduce a new cryptocurrency called SETLcoin. This cryptocurrency will be similar to the popular bitcoin digital currency and will represent securities and other assets. The underlying system will be based on blockchain, which will host virtual multi-asset wallets to store different kinds of securities like stocks or bonds as well as cash and cash equivalents in the form of SETLcoin.

How Trading Will Work

SETLCoin is an expanded form of any popular digital currency like bitcoin. In addition to facilitating cash equivalent transactions, it will account for transacting in assets like stocks and bonds.

Here's an example.

Bob, the stock buyer, will enter his buy side trade details in his digital wallet, and Sam, the stock seller, will enter his sell side trade details in his wallet. The instructions from their individual wallets use SETLcoin cryptocurrency software. Their actions will generate SETLcoin transactions, which will reach the blockchain based secure network. Once on the network, the actions will be authenticated and matched. That is the clearing process. The transfer of securities and money will occur instantly. That is the settlement process.

The trade will be executed if Bob has sufficient funds to buy the shares, Sam holds a sufficient number of shares and both entered the trade details in their wallets correctly. Once successfully matched by the blockchain network, the trade will be executed. Bob will have the shares in his SETLcoin wallet, Sam will have the funds in his SETLcoin wallet and the trade transactions will get recorded on the blockchain.

 A trader’s wallet can hold multiple securities in the form of SETLcoins. For instance, IBM and Apple shares may be represented as “IBM-S” SETLcoins and “AAPL-S” SETLcoins, respectively. IBM bonds may be represented as “IBM-B” SETLcoins, and USD currency as “USD” SETLcoins.

One IBM-S SETLcoin may represent 100 shares of IBM, while one AAPL-S SETLcoin may represent five shares of Apple. It will be possible to trade five IBM-S SETLcoins for one AAPL-S SETLcoin, or for 1,800 USD SETLcoins.

Essentially, the system allows seamless integration, facilitating multi-asset transactions.

The reliable blockchain technology with efficient self-regulatory mechanism will ensure instant and flawless execution of trades. (For more, see: What Is the Blockchain? - Video)

With the role of clearinghouse becoming redundant and being replaced by a network network-baseded ledger, the cost of trading is expected to come down substantially. Moving to blockchain the recording of all transactions related to trading, clearing, settlement, demat accounts and payment accounts will result in a single platform with unified processing. It should significantly reduce the cost of maintenance and transactions, with the reliable security and robust authentication of blockchain technology.

There have been long-standing concerns with regards to no regulation and borderless transactions being facilitated through blockchain technology and cryptocurrencies. The entry of dedicated systems being built by reputed organizations should allay those fears and mitigate the risks of unfair use.

The Bottom Line

The humongous growth of blockchain based cryptocurrencies has created a parallel economic universe which is outside the purview of any regulators. With leading investment banks like GS and JP Morgan adapting to the concept and building financial systems based on blockchain, this path breaking technology may become the future backbone of the financial system.

The SETLcoin is just the start, and there’s more to follow. (For more, see: JP Morgan's Blockchain Trial Project)