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In April 2021, Credit Suisse made some US equities trades with the Nomura-owned broker Instinet, using blockchain. While this technology has been used before to verify other kinds of transactions, these trades were considered a “first” because settlement occurred within hours, rather than the two days typically needed with America’s Depository Trust and Clearing Corporation (the industry-owned utility that normally settles stock trades). This particular instance was conducted as a peer-to-peer record of trade or transaction, yet the potential of a digital network for post-trade processing is clear.
This interest in digitised assets by such big players illustrates the potential that digitised assets and distributed ledger technology (DLT) can provide, especially given the fact that all asset classes – from traditional securities to new asset classes such as real estate, art, property and wine – can now be digitised. According to a recent HSBC report, “The financial services industry is waking up to the transformative potential of DLT; it is estimated that US$1.7 billion per annum is currently spent on DLT in financial services globally.”
But how can smaller exchanges, without the deep pockets as per the likes of Credit Suisse and Nomura, likewise take advantage of the tremendous potential of digitising assets, while also ensuring risks such as defaults and anonymity are properly addressed?
A natural evolution of technology
It is widely recognised that there is real value in moving the underlying plumbing of capital markets to digitised products and using ledger technology, especially in the area of settlement, custody and registry. For smaller stock exchanges, however, the prospect of moving wholesale from their existing technology to DLT-based plumbing is an extremely complicated and potentially extortionately expensive one, not to mention the risk of a wholesale big-bang migration. There are two main reasons for this: firstly, because these infrastructure providers are usually using quite old technology which needs constant day-to-day maintenance and are subject to a very busy upgrade schedule. Secondly, the prospect of integrating this old technology with a more modern tech stack is extremely complicated which, because we are talking about their mission critical system of their core business, is an extremely risky proposition.
Test driving digital assets
One way forward is to launch a new initiative on a parallel technology stack. For example, to set up a couple of new digitally-based securities and learn from that experience. Not only do these smaller PoC projects make it much easier to assess the implications of integration and other associated risks, these ‘sidetracks’ are also much faster to build with a much lower initial investment.
Exchanges, interested in gaining hands on experience with digitised assets, need to ask themselves the following questions:
- What type of assets should we start with?: What types of securities are popular at the moment, and what are their competitors providing? Does it make sense to make these assets digital, rather than simply offering them via their existing technology stack, and who wishes to trade them?
- What is the distribution?: What kind of API’s and access points are needed? Should the exchange be looking at App- and website-enabled access, or work closely with brokers to simplify distribution and access to the targeted audience?
- What kind of matching engine is required?: A professional anonymous market will of course need to guarantee privacy, and fair and orderly processing of orders. For instance, if building on ERC-20 (the official protocol for proposing improvements to the Ethereum (ETH) network), the full history of an entity on the protocol can be viewed in some circumstances – and you are potentially open to front-running of your order. In order to truly guarantee a fair and transparent market, this is an important challenge and it can be worth looking at private ledger technologies as an alternative. (You can read more about front-running here, here and here.)
- What kind of settlement cycle, and payment & account structures are most appropriate?: Will they need to be tied into fiat and the traditional economy? If so, how will this be achieved? The targeted audiences and their existing post trade processing will of course also need to be taken into account. If you push through a real-time settlement cycle, but the customer back-office systems operate on an end-of-day or even T+1 cycle, how can you accommodate a mixed environment?
A first step…
The World Economic Forum estimates that up to 10% of global GDP will be stored and transacted via DLT by 2027, and that tokenised markets could potentially be worth as much as US$24 trillion by 2027. It is clear where the direction of the market is heading, so it is now a matter of exchange infrastructures updating their plumbing. And this is where things become really interesting – because if you get that mix right and build a bridge between traditional finance and the blockchain, then you have successfully taken a first step forward in the evolution.
TABBForum link: https://tabbforum.com/opinions/digitising-assets-for-trading-an-evolution-with-revolutionary-effects-for-infrastructure-providers/
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