Adopting distributed ledger technology (DLT) to achieve faster settlement times may negatively impact liquidity and raise transaction costs, according to research from the World Federation of Exchanges (WFE).
Exchanges and regulators across the globe have been exploring DLT for several years, highlighting significant reductions in settlement times as one of its primary advantages. However, the WFE points out that the inherent latency in DLT settlement introduces unpredictability into the process, affected by factors such as overall mining capacity and block validation speed. The research indicates that settlement latency can vary by over three minutes, leading to an estimated 3.9% increase in transaction costs and a 4.5% increase in price impact.
This level of uncertainty complicates the execution of trading strategies for informed traders, leading to less efficient pricing. Consequently, this unpredictability can deter investor participation, resulting in reduced liquidity and higher transaction costs.
The WFE advises that policymakers and market operators—ranging from regulated exchanges to crypto platforms—should carefully weigh the trade-off between rapid settlement and market quality before integrating DLT. The findings underscore the crucial roles that Central Counterparties (CCPs) and Central Securities Depositories (CSDs) play in managing and safeguarding the settlement process, thereby minimizing uncertainty in settlement timing.
Kaitao Lin, senior financial economist at WFE, stated, "Implementing DLT in settlement processes presents a dual-edged impact. Our research reveals a trade-off between near-instantaneous settlement and liquidity. Without the oversight of a trusted entity, DLT introduces uncertainty which impedes liquidity."
For further details, you can read the full paper here.