Financial technology companies are working to improve behind-the-scenes market functions, such as exchanging securities and making lending decisions, saying the use of new technologies could help markets recover faster than they did in past financial crises.
New York-based Paxos Settlement Service last month became the first firm to use blockchain technology to settle U.S. stock trades, the process by which securities are exchanged for cash after two parties agree to a trade. The settlement process is more complicated than it sounds for big firms, where large amounts are being moved continuously.
And Fundbox, a tech firm in San Francisco, now uses big data to quickly evaluate potential small-business borrowers, saying it can make a lending decision within about three minutes, getting money to those who need it in a crisis. It recently launched a service that some described as PayPal for business credit.
The companies say these types of innovations will be crucial for helping financial markets in the U.S. and the world recover from the effects of the COVID-19 pandemic.
Paxos will handle deals directly between two major brokers, Credit Suisse AG and Instinet LLC. It’s an initial step that could presage a larger market adoption of the technology. The brokers using Paxos are able to settle trades instantaneously from the opening of a trading day until 4:15 p.m., whereas traditional systems allow instantaneous settlement only up to 11:30 a.m., the company says.
Using blockchain to do this “is the future,” Paxos co-founder and CEO Charles Cascarilla told CQ Roll Call. Blockchain is a digital ledger of transactions run on a network of computers with no centralized governing or regulatory authority. The technology is increasingly being explored for its potential to improve the effectiveness of payment systems while cutting costs.
The Depository Trust & Clearing Corp., which is owned by big banks, has long been the dominant player in settling trades. But the organization says it supports the move to so-called distributed ledger technologies like blockchain, even as companies like Paxos are using it to encroach on its territory.
“We’re big proponents,” said Michael McClain, the organization’s manager of equity clearing and settlement.
He said he doesn’t think new technology will make the organization obsolete because much of the financial world relies on the clearinghouse system. Central counterparty clearinghouses ensure that trades are completed, even if one party defaults, by serving as the counterparty to the buyer and the seller. A participant in the trade doesn’t have to worry that the person on the other side can’t honor the contract. DTCC owns the main clearinghouse for stock trades.
The brokers who use the clearing services have to provide cash to protect against loss, and this protection might be lost without such a system, he said. His organization is owned by its users, who have an incentive to monitor how it’s working, he added.
Paxos says its settlement service is the first example in the modern era of stock trading that will take place outside of the clearinghouses. It argues that the traditional system has become a central point of risk in the years since the financial crisis, now that financial markets rely on them more heavily to protect markets from defaults.
Even as lawmakers and regulators leapt to repair the damage from the last financial crisis, there were no real fundamental changes to clearinghouses, Cascarilla argues. The Dodd-Frank Act gave much more responsibility to clearinghouses in protecting markets for financial derivatives. While their role increased, the underlying technology hasn’t advanced considerably, he says.
Paxos’ clearing between two parties is called bilateral clearing. In the past, bilateral record keeping was cumbersome, and it was hard for entities to quickly figure out the identities of various parties. Unwinding transactions proved very difficult, he said. But Paxos is able to use blockchain to determine “who owns what when,” in Cascarilla’s words.
Paxos contrasts his organization’s technology with the systems used by some trading firms that still run on outdated software written in nearly dead computer languages like COBOL.
Another big issue is the access to cash to fund vital business operations during a crisis. Regulators responding to the last financial crisis turned to solutions like the Troubled Asset Relief Program when they were worried businesses would be unable to pay workers and meet other basic business costs.
Fundbox’s top legal officer, Todd Hamblet, told CQ Roll Call that the company’s technology and its three-minute lending decisions could aid businesses that don’t have a lot of time on their hands. Quickness is important because small businesses on average have enough cash to last about 30 days, he added. Hamblet previously served as the top lawyer at Uber Technologies Inc.
Hamblet said the challenge is getting funds to those in need quickly, especially as business drops because of the slowdown due to the coronavirus. Fundbox directly provides business loans and lines of credit, and it also facilitates lending from a Utah bank insured by the Federal Deposit Insurance Corporation.
Smaller businesses will find that fintech firms provide cash more quickly, he said. They are also able to work with smaller amounts. While a large bank may only consider loans of at least $100,000, Fundbox averages about $15,000, he said.
Paxos, meanwhile, is moving to expand. Its current operations are limited by the Securities and Exchange Commission, which is allowing it to work with no more than seven brokers in real time. It is applying for clearing agency status, which would allow it to work with all brokers. Cascarilla said he’s optimistic that Paxos will receive the SEC’s approval next year.
Paxos has the goal of offering its services in an open market. In addition to Credit Suisse and Instinet, it is also working with Societe Generale Group and anticipates adding clients.
He also expects that in six months or so, as the industry considers lessons from the response to the coronavirus, the move to new technology will increase.