Adopting distributed ledger technology in the pursuit of faster settlement times could hit liquidity and increase transaction costs, warns research from the World Federation of Exchanges (WFE).
Exchanges and policymakers around the world have been investigating the use of DLT for several years, touting, among other benefits, radically reduced settlement times.
However, the WFE says that inherent latency in DLT settlement introduces uncertainty into the process due to factors such as overall mining capacity, which affects block validation speed. Using DLT, settlement latency can easily vary by over three minutes, equating to a 3.9% increase in transaction costs and a 4.5% increase in price impact, according to the research.
When there is this uncertainty, informed traders will find it more difficult to execute their trading strategies and therefore pricing is less efficient. This uncertainty discourages investor participation, resulting in a deterioration of liquidity and an increase in transaction costs, says the research.
The WFE warns that 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. 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.
Kaitao Lin, senior financial economist, WFE, says: "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."
Read the paper