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By Alexander Osipovich 

Technology from the bitcoin world is coming to the trillion-dollar plumbing that underpins the U.S. stock market.

Last week, the Securities and Exchange Commission gave the green light to a pilot project in which blockchain -- the technology behind cryptocurrencies -- will be used to settle trades in stocks like General Electric Co. and AT&T Inc. Paxos, the blockchain startup leading the project, hopes to construct a faster and cheaper way to process stock trades, ultimately reducing costs for Wall Street banks and investors alike.

The project will be limited to a tiny slice of the U.S. stock market and there is no guarantee that it will succeed. Still, it could eventually bring change to the world of clearing and settlement, which has evolved slowly since the current system was created in the 1970s.

Settlement is the delivery of securities from sellers to buyers, while clearing is the process of handling trades from when they are initially agreed upon to when they are settled. Today, the standard time it takes to settle a stock trade is two business days -- which is why investors must typically wait several days to get cash from their brokers when they sell shares. Paxos's initiative is aimed at settling trades at the end of the day in which they are agreed upon, or even sooner.

For decades, an organization called the Depository Trust & Clearing Corp. has had a monopoly on the clearing and settling of equities trades in the U.S. Owned by a financial-industry consortium, DTCC traces its roots to a 1970s effort to eliminate paper stock certificates and replace them with electronic records. Last year, it cleared an average of $1.3 trillion in stock trades each day.

Now, DTCC is about to face something new: competition. On Oct. 28, the SEC issued a letter that lets Paxos set up an experimental settlement service for stock trades. Paxos, whose other businesses include a cryptocurrency exchange, expects to launch the service by the end of the year. Credit Suisse Group AG and Société Générale SA have said they would use it and Paxos hopes to bring more banks on board.

The appeal to banks is that a faster, more efficient settlement service could reduce costs in their stock-trading businesses, an area where profit margins have shrunk in recent years due to competition and declining fees.

"There has been so much innovation in the way trading happens over the past 20 years, with people trading in microseconds, but there hasn't really been innovation in clearing or settlement," Paxos Chief Executive Charles Cascarilla said in an interview.

DTCC says it welcomes the competition. "That kind of innovation is helpful for the industry," said Michael McClain, the head of its equities clearing and settlement business. DTCC says it has modernized its processes, studied blockchain technology and shifted the U.S. stock market from three-day to two-day settlement in 2017.

That two-day delay comes with various costs. Banks collectively set aside tens of billions of dollars in capital to cover the risk that firms elsewhere in DTCC's network will fail before the trades settle.

There are also separate systems at each big bank, as well as at DTCC itself, that track what different market participants are expected to pay or deliver at settlement time. Bankers say this is inefficient and results in errors when systems disagree with each other.

"We are constantly reconciling that data," said Jeffrey Rosen, a New York-based managing director at Société Générale. "That is hugely expensive. While we've built tools to do it efficiently, it would be better not to do it."

Paxos's goal is to eliminate these redundant systems by creating a unified record of trading obligations using blockchain technology. A blockchain is essentially a database with many copies distributed across the internet that constantly communicate with each other to ensure the data doesn't get garbled or hacked.

With cryptocurrencies, the blockchain records who holds how many coins at any time and it supports the transfer of coins from one person to another. Similarly, Paxos's planned blockchain would let banks exchange digital representations of cash and securities to settle trades with each other.

It would also allow settlement in less than two days. Paxos plans to give participating banks the option of next-day or same-day settlement, or perhaps even to settle trades multiple times a day, Mr. Cascarilla said.

The SEC has put significant limits on Paxos's experiment. Only about 140 of the most actively traded, least volatile stocks, like Exxon Mobil Corp. and Bank of America Corp., are eligible for the project. The number of trades Paxos can settle will also be capped at 1% of average daily trading volume of those stocks, according to the SEC's letter.

Moreover, the electronic records that officially record stock ownership won't leave DTCC but will instead be housed in Paxos's account at DTCC. So while Paxos's blockchain is recording transfers of stocks between the participating banks, the stocks will stay within the existing system -- a measure that will limit disruptions to the market's plumbing.

Still, proponents say the project offers a blueprint for a next-generation approach to clearing and settlement.

"There's an enormous amount of capital trapped in the system to make sure clearing can take place," said Eric Noll, the former CEO of brokerage Convergex and an adviser to Paxos. "The day you can clear a trade instantaneously, or near instantaneously, the need for that capital to be tied up goes away. That should ultimately lead to lower costs for investors."

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Write to Alexander Osipovich at alexander.osipovich@dowjones.com

(END) Dow Jones Newswires

November 07, 2019 08:14 ET (13:14 GMT)

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