Gaurav Yadav

@blockchaindude

The Collision of Stock Exchanges and Blockchain

June 25th 2018

Blockchain technology was invented simply as a ledger for bitcoin transactions. But very soon it became clear that its decentralized, immutable, pseudonymous nature could be effectively used in numerous industries. Blockchain technology has been one of the most revolutionary technological concepts over the last few years. Several publications, covering various aspects where the distributed ledger technology can be used to disrupt a change in different markets, have been written. The finance industry is undergoing many seismic changes at present, with fintech in particular proving to be a significant disruptor. Blockchain has ignited curiosity among industries and sectors, especially in finance. Blockchain has often been called “the future of financial services infrastructure” . If we talk about the Blockchain Technology there are very less critics that exist. But recently there is a group of critics emerging from different industries of the world where the distributed ledger technology is being practically experimented to increase efficiency of the current system.

While the financial sector has dominated the headlines over the past couple of years, other industries are beginning to embrace this technology in a bid to democratize markets. The real potential of the blockchain came when innovators and visionaries across industries began to realize that it could be separated from the digital currency and used to revolutionize every other industry. Firstly, its pseudonymous nature could help end identity fraud. Secondly, the decentralized nature of blockchain could help introduce faster payments than two centralized systems could ever manage.

The Current System

It’s not just the banks that are rapidly boosting their exposure to blockchain. Stock exchanges all around the world are now exploring how best they can leverage the technology, invariably as a way to improve costs and efficiency, and to lower risks and tighten security. Today, some of the most prominent stock exchanges are looking at ways to use the distributed ledger technology (DLT) in order to overhaul traditional mechanisms and come up with more efficient available solutions. The working and functioning of a stock exchange involves very hectic and cumbersome procedures which are time consuming , cost inefficient and can be prone to numerous risks. The multi-layered processes — pre-trade, trade, post-trade and custody, and securities servicing is very complex. This makes a case for experimentation with blockchain, thanks to its potential ability to streamline the process.

The old model for the stock market industry has multiple issues that must be resolved at the earliest. Following points highlight the problems associated with traditional market systems.

  • current market systems have a centralized ledger, which stores all the digital assets at a single location. If any data is corrupted, the entire data is lost.
  • Old systems are often tedious to upgrade.
  • A centralized database is expensive, since it requires mainframes. Moreover, a lot of money is wasted to repair the traditional methods, if the need be.
  • The traditional way of investing in stocks requires intermediaries. The participants have to spend a lot of their money for the stock investment processes.
  • A traditional system lacks transparency, where one participant is unable to view the decisions of other participants, resulting in information asymmetry.

The good thing about using blockchain technology is that it would significantly cut transaction costs and bring about a seamlessly efficient system where participants would confirm trades via a decentralised network. Some have alluded that the peer-to-peer network could as well be composed of brokers and dealers, while others believe it could be significantly akin to the bitcoin trading process. However, stock market industry experts have come out with differing opinions about the idea of replacing stock exchanges with a system comparable to the one that bitcoin is traded. Well, Bitcoin has no fungibility which means that one can easily identify transactions that are made and track them for eternity. This might not be applicable when it comes to stock trading.

So in simple words blockchain will:

  • Reduce costs
  • have better security of information.
  • have faster processing time
  • have better information gathering and research

What does Blockchain bring to Stock Market?

Blockchain can be the answer to compatibility, trust and transparency issues in the current fragmented market systems. Stock market participants such as traders, brokers, regulators and stock exchanges are required to go through a cumbersome process (which takes 3+ days to complete transactions, mainly due to the role of intermediaries, operational trade clearance and regulatory processes). Blockchain can make stock exchanges much more optimal through automation and decentralisation. It can help reduce huge costs levied on customers in terms of commission while speeding up the process for fast transaction settlements. The technology can have viable use in clearing and settlement, while securely automating the post-trade process, easing paperwork of trade and legal ownership transfer of the security. Blockchain can eliminate the need of third party regulator to a large extent, since the rules and regulations would be in-built within smart contracts and enforced with each trade in order to register transactions with the blockchain network acting as a regulator for all transactions.

Automation of post-trade events

Applying blockchain and smart contracts to post-trade activities can eliminate the need for intermediaries, reduce counter-parties and operational risk, while providing the infrastructure for faster trade settlement. Financial institutions can settle securities in minutes instead of days, with the major benefits being streamlined real-time settlement, improved liquidity, supply chain optimisation and increased transparency. Blockchain can offer a solution to the post-trade events processing to maintain a single source of truth jointly owned by all participants in the system.

Increased Fairness and Transparency

If implemented, blockchain can act as an online automated surveillance system for each transaction. A blockchain-based exchange can have inbuilt characteristics to track, block and report illegitimate attempt made by anyone on the network, and can provide a robust platform to implement the security policy and standards. Since the blockchain ledger is designed in such a way that all participants have full record of transactions and, therefore, holdings of investors, it can bring in complete transparency and trust in the market.

Cutting out the Middlemen

A key advantage to blockchain technology is cutting out the middle man. In effect, because all transactions on a blockchain are validated by the community based on a mathematical probability, the requirement of a trusted intermediary is unnecessary. Blockchain would allow you to have a decentralised stock exchange, without the need for a brokerage, clearing house, or settlement process.

Higher liquidity

Blockchain can reduce the inefficiencies through automation, which also leads to reduction in cost and thus lowering entry barriers resulting into increased market base. For people, who could not access the markets due to cost barriers will be able to participate, ultimately increasing liquidity and investment.

Lower Transaction Costs

Blockchain transactions are faster, as trade confirmations are done through smart contracts by peers instead of any intermediary. As the intermediaries in the system get minimised, costs associated with them, like trades record keeping, audits and trade verifications also get eliminated or reduced.

Mechanism for risk containment

Through blockchain technology, margining system and payment of margin can be done instantly and the frequency of valuation of securities deposited as capital can be done daily compared with the weekly process prevalent now, minimising the risk.

Challenges

While transparency is generally a good thing for the market, it might do more harm than good in some situations. There are mega hedge funds, mutual funds and even private equity firms that sell large positions on a gradual basis for prolonged periods. Allowing the public to identify such transactions could trigger a major market collapse or a rally that’s driven by what, under normal circumstances, would have been insider information. This could destabilise the market and thus serves as one of the top challenges that exchanges might face should they choose to overhaul the traditional systems and implement blockchain-based exchanges. The implementation of blockchain also brings along the risks of maintaining security standards across a decentralised database, legal and regulations and concerns around scalability. Blockchain looks to combine elements of trading, clearing and settlement but current legal and regulations ascribe them separately.

Another concern around is that implementing a clearing system using blockchain will introduce a new type of fee. In the Bitcoin blockchain, miners process Bitcoin transactions by solving optimisation problems and get rewarded by newly created Bitcoins and settlement fees offered by Bitcoin users who wish to have their transactions processed. Miners prioritise the order of transactions to be cleared based on the fees offered and the difficulty of the problems to record the transaction in a block. if stock exchanges while using blockchain equires investors to include transaction fees in order for their transactions to be cleared. If this is to happen, investors will have to compete against each other to have their transactions cleared faster than those of others. The financial market ecosystem is currently uncertain about the extent to which blockchain, particularly as applied to capital markets, will live up to its promise.

Major Limitations of Blockchain are:

  • Complexity
  • Network Size
  • Security Flaw
  • Storage Constraints
  • Unsustainable consensus mechanisms

Here’s a look at what some of the exchanges are doing:

Nasdaq has been at the forefront of the blockchain revolution. At the turn of 2015, Nasdaq unveiled the use of its Nasdaq Linq Blockchain Ledger technology to successfully complete and record private securities transactions for Chain.com — the inaugural Nasdaq Linq client. In May, Nasdaq and Citi announced an integrated payment solution using a distributed ledger to record and transmit payment instructions based on Chain’s blockchain technology.

Australian Stock Exchange (ASX) began to evaluate replacement options for the Clearing House Electronic Subregister System (CHESS) in 2015. Eventually, ASX selected U.S.-based blockchain startup Digital Asset Holdings, LLC to develop distributed ledger based solutions for clearing and settling trades.

Japan Exchange Group (JPX) and International Business Machines Corporation (IBM) are working towards testing the potential of blockchain technology for use in trading in low transaction markets. JPX is embracing a proof-of-concept that is investigating how blockchain could be used to create new systems for the trading of low-liquidity assets.

Korea Exchange has launched Korea Startup Market (KSM) with Blocko’s blockchain technology to enable equity shares of startup companies to be traded in the open market.

Deutsche Börse Group has been making substantial investments in the development and introduction of ‘state-of-the-art’ blockchain services. Recent developments include a solution for cross-border securities transfer in cooperation with the Liquidity Alliance. The German exchange is working on several prototypes related to blockchain technology and DLT.

India’s National Stock Exchange (NSE) conducted a blockchain trial involving country’s leading banks — IDFC, Kotak Mahindra, ICICI, IndusInd and RBL, as well as HDFC Securities collaborated on a know-your-customer (KYC) data trial, testing blockchain technology.

Moscow Exchange (MOEX) successfully conducted e-voting for bondholders via blockchain at the National Settlement Depository (NSD).

The London Stock Exchange, part of the PDTL group, is involved in ways to improve the post-trade space using the blockchain technology.

The Luxembourg Stock Exchange has already introduced a blockchain-enabled security system, where the officially generated Signature by Appointed Mechanism (OAM), along with document type and document URL are stored in the blockchain ledger.

Santiago Exchange is among the latest stock exchanges exploring the blockchain technology to be applied across Chile’s financial sector. Built by IBM and Chile’s Santiago Exchange.

The Toronto-based TMX Group, operator of the Toronto Stock Exchange, announced the development of a blockchain based prototype to ‘power’ a new service of offering from Natural Gas Exchange (NGX).

Conclusion

Given blockchain’s decentralised and undiscriminating nature, it is clearly encouraging to observe the technology being almost uniformly adopted across the entire length and breadth of the world. Whether blockchain completely takes over to form the backbone of stock trading on exchanges remains to be seen at this stage, especially given the scalability issues that many blockchain projects are currently trying to tackle. The path to its adoption will require resolving issues such as scalability, common standards, regulation, and legislation. Despite the hurdles that lie ahead, it is widely believed that DLT could revolutionize the core infrastructure systems of capital markets around the globe, thereby bringing in greater transparency and efficiency.

Connect with me on Linkedin: https://www.linkedin.com/in/gauravneuer/

Sources: https://www.nasdaq.com/, https://economictimes.indiatimes.com/

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