Stablecoins are key to a modern global stock market

Stablecoins have been synonymous with crypto market activities, but it could potentially have a significant role in the international stock markets. What’s the connection? Foreign money exchange.

The stock market timing problem

Since 28 May 2024, the world’s biggest equities markets (i.e. the U.S. stock markets) have transitioned to a T+1 settlement system from the previous T+2 settlement. 

In this system, all stock trades are expected to settle within 24 hours after a trade order has been processed. In the previous system, stock trades were expected to settle within 48 hours after a trade order was executed.

For U.S. investors, trades would happen near-instantly. However, foreign brokers outside of the US border must take a few extra steps to ensure that their clients (i.e. the foreign investors) can securely own their assets through their custodial banks.

The foreign exchange bottleneck

One of these steps involves foreign exchange (FX). For that alone, there is an entire “invisible” industry that moves trillions of dollars of money around the world, and for many decades, the T+2 settlement system poses no problem.

However, now that the time window for US stock settlements has shortened by 24 hours, institutions in the FX industry must also move one day faster. 

The problem is that financial institutions don’t open for 24 hours. Compiled U.S. equity trades usually occur near the New York market close (4 pm in NY, 10 am in Auckland the next day).  

FX transactions can be processed through what’s called the Continuous Linked Settlement (CLS) system. Think of it like a super-motorway that enables FX transactions between companies and institutions across time zones. But it also does not operate for 24 hours. 

Because of the change in the equity settlement rules, it seems that the rest of the world must learn to adapt.

What’s the solution so far (without stablecoins)?

There are several ways for stock brokers to operate in time zones that have a disadvantage when it comes to T+1 settlement for the U.S. stock market. Here are some options:

1. Delegate foreign exchange to custodians

Custodians form a meeting point between where the stock exchange’s assets would be credited to the investors’ account, and where investors’ money from the broker would be sent to the exchange. Because of this, custodians must keep a handful of liquid US dollars to ensure a smooth flow of money traffic from all parties.

The disadvantage is that the custodian would be the only provider of US dollars and brokers couldn’t get the best exchange rates to maximise their revenue.

2. Pre-fund the broker’s or investors’ account.

A common strategy for international brokers is to insist on making investors buy and store (or pre-fund) US dollars to their own account, because only then would they be able to buy US assets. Alternatively, investors would in effect pay extra for forex fees, which will then offset the broker’s risk of holding US dollars for an extended period.

The disadvantage is that the forex fees are felt by users much more intensely than if it were abstracted away within a predictable system. 

3. Set up a US-based operation

Foreign exchange rates may be more favorable to brokers if there’s a branch that directly touches U.S. soil. Of course, this requires a hefty investment and may not even be the best option.

What’s the solution with stablecoins?

Stablecoins are considered “borderless” for one important reason — they can be moved at any time, even on weekends, and bank holidays. 

Trades between a Kiwi stablecoin (NZDD) and US-dollar stablecoins (e.g. USDC) can take place even during the inactive time windows of financial institutions in both countries, which would have been impossible through traditional processes.

Another important factor is speed. Trades between NZDD and USDC is possible because there is deep liquidity for both stablecoins in something called a liquidity pool, a Web3 technology that allows supply-side investors to deposit stablecoins and earn a small fee as a liquidity provider.

So, how would an NZDD-powered brokerage firm enable Kiwis to buy US stocks? Here’s the rough architecture:

1. Investor Action: An investor decides to purchase shares of a US company through a local investment platform.

2. Platform Setup: The investment platform has integrated stablecoin technology into its system. It uses a USD-pegged stablecoin (e.g., USDC) to facilitate FX transactions.

3. Funding the Account: The investor deposits NZDD into their account on the platform. The platform can also convert NZD fiat money to NZDD stablecoin through Easy Crypto. Using liquidity pools, NZDD is converted to USDC at a fair rate.

4. Stablecoin Transfer: The platform transfers the equivalent amount in stablecoins to its partner broker in the US. This transaction occurs almost instantaneously on the blockchain, bypassing traditional banking systems and FX markets.

5. Broker Execution: The partner broker receives the stablecoins, converts USDC back to US dollars, and immediately executes the stock purchase on the US stock exchange.

6. Custodian’s Action: The custodian bank holds the purchased shares and records them in the investor’s name. It also manages any necessary regulatory reporting and compliance.

7. Settlement Completion: Since the stablecoin transaction is settled instantly on the blockchain, it aligns with the T+1 equity settlement cycle. The shares are effectively settled within one business day.

The takeaways

Stablecoins like NZDD offer significant advantages for FX settlement, revolutionising the traditional process. Its ability to facilitate near-instantaneous transfers ensures that FX settlement no longer acts as a bottleneck for international equities market activity. 

The 24/7 operational capability breaks free from the constraints of traditional banking hours, effectively addressing the challenges posed by global time zone differences. Perhaps most crucially, the implementation of atomic settlement on blockchain platforms substantially mitigates counterparty risk by guaranteeing the simultaneous completion of both sides of a transaction. 

These key benefits collectively position blockchain as a transformative force in the realm of foreign exchange, promising enhanced efficiency, flexibility, and security for market participants worldwide.