Legal risks and potential issues transpire from an unclear legal basis. Settlement finality needs to be addressed before blockchain technology becomes a viable distributed Financial Market Infrastructure.
This article discusses the concept of settlement finality, what it is and why it is an important feature for any digital security blockchain infrastructure. It further touches on the current state of finality in permissionless blockchain systems and the requirements from the financial markets.
Digital securities (synonym for: security tokens) are regulated financial assets, or instruments. The underlying operations of the chosen blockchain infrastructure needs to be closely linked to applicable legal frameworks. In example, the operational finality of transactions on the blockchain need to align with the applicable legal finality requirements of the applicable legislation (DTCC, 2019).
What is settlement finality?
Settlement finality is a conceptual construct often used in statutory, regulatory, and contractual literature. Finality of settlement ensures that transactions made over payment networks will, at some point, be complete and not subject to reversal even if the parties to the transaction go bankrupt or fail. It is the assurance that even in times of financial system uncertainty, turmoil, or crisis the transaction being undertaken will go through (ECB, 2005; BIS, 2012).
Why is it important?
Considering the above, uncertain transaction finality introduces uncertainty about the status of a transaction, and its potential for reversal. The associated risks are categorized as counterparty, liquidity and legal risk and if there is a mismatch between the operational and legal finality of an infrastructure, operated within a given jurisdiction, it can result in an unclear legal basis. Finality of settlements, in congruence with global standards, eliminates these payment related risks and moreover reduces systemic risk in the imminent market for digital securities.
Financial markets are currently operated by Financial Market Infrastructures (FMIs). In the near future, market infrastructures based on blockchain technology could be established, these are referred to as distributed Financial Market Infrastructures (dFMI). dFMI’s, just like FMI’s should attempt to adhere to a set of global principles that are laid out by the Bank for International Settlements (BIS) “an FMI should provide clear and certain final settlement..[…]..or preferable, an FMI should provide final settlement intraday or in real time.”
In Europe, TARGET2 is a well-established Real-Time Payment System, which is a type of FMI. Generally speaking it performs the following:
- a validation process (checking account existence and availability of sufficient funds);
- provides clearance and settlement of transaction, and;
- delivers assurance of payment to the payee (through messaging that provides immediate payment information to the beneficiary).
This entire process should ideally be completed in real-time, which in practice means it takes approximately 2–15 seconds to reach finality (Capgemini, 2017).
Finality in the context of blockchain technology
In the context of blockchain technology, settlement finality is an abstract measure of time required for the transaction or block to become probabilistically immutable. Bitcoin and other platforms utilize a flavour of the Proof-of-Work consensus to secure the blockchain, meaning that the probability of a block remaining in the main chain increases as more blocks get added on top (hence why most services require a depth of 6 blocks before confirming a Bitcoin transaction).
Without going deeper into much of the details, protocols based on the classic BFT (Byzantine Fault-Tolerant) protocols, offer instant finality, meaning that the block cannot be “orphaned” after being added to the chain.
“Orphaned blocks are valid blocks (containing valid transactions) which are not part of the main chain. They can occur naturally when two miners produce blocks at similar times or they can be caused by an attacker (with enough hashing power) attempting to reverse transactions.” — Blockchain.com
dFMI nailing the details
Players from all over the world are attempting to establish dFMI’s and attract institutional adoption for digital securities. However, complying with applicable legislation on highly visible items such as restriction management, identity verification and data protection are only one side of the coin. Addressing the nitty gritty demands, such as a clear legal basis as a result of well implemented settlement finality, will be the major differentiator.
Dusk Network — A distributed Financial Market Infrastructure?
Dusk Network’s consensus algorithm SBA★ is partly based on the BFT family of consensus algorithms. It is fork-resistant and statistically guarantees immediate operational finality of transactions. Dusk boosts block confirmation times between 5 and 20 seconds. At its current performance Dusk Network is nearing real-time settlement finality. A feat that would put Dusk in the league of real-time systems such as Target2. The tech team is currently working on block compression techniques that will further improve settlement finality times.
Dusk — Technology for Securities
Dusk streamlines the issuance of digital securities and automates trading compliance with the world’s first programmable and confidential securities.