To use radical new technology effectively, you have to be radical – otherwise, all you end up with is a retro-fitted version of the present system.
The benefits of the new technology are watered down or overwhelmed by the need to maintain the practices associated with the old system – many of which only exist precisely because of its inefficiencies. The new technology can even seem less efficient than the old one, simply because it isn’t designed for use with processes from the past.
Blockchain and distributed ledger technology are radical.
Together, they could transform the way finance works, but people in the financial world are creatures of habit and old practices die hard.
So, if these technological advances are to transform finance, they need to be championed by key financial organizations.
It was exciting, therefore, to see a working paper from the Japan Exchange Group (JPX) that seriously examines the potential uses of blockchain and distributed ledger technology in capital markets. In conjunction with six other financial institutions, the researchers conducted two proofs-of-concept (PoC) covering securities issuance, trading, settlement & clearing and cash payment. They also looked at ownership, dividends and stock splits, data ownership and privacy.
From their PoCs, they conclude:
“DLT has the potential to transform capital market structure by encouraging new business development, improving operation efficiency, and contributing to cost reduction.”
Sounds really encouraging, doesn’t it?
The trouble is, anyone can say that. I did, in the second paragraph of this piece. I have produced no evidence to support my argument. And sadly, despite their PoCs, neither have the JPX researchers.
Instead, they noted that business practices have to change, then tried to shoehorn DLT into existing business practices.
Kept in the dark
Transparency is often believed to be desirable in financial markets, but it has serious implications for market structure. Lit markets are less open to fraud, but frontrunning and predatory behavior is common. Consequently, initiatives designed to improve transparency can encourage the growth of “dark markets”.
This causes a problem for DLT. Eliminating the need for trusted third parties – which some would argue is the whole point of DLT – requires a blockchain on which transactions are public.
Unfortunately, rather than considering ways in which transactions could be made public without encouraging the growth of dark markets, JPX decided that a public blockchain was a non-starter. Financial market participants, they believe, would “never agree” to all transaction data being public.
So they compromised. They went for a permissioned DLT with trusted third parties they envision would be the same as the current trusted third parties – CCPs, exchanges and custodians.
I was left wondering what was so great about a distributed ledger when it simply distributes the functions of the present system over multiple computers. True, a distributed architecture would radically improve the system’s resilience, unlike the present system where failure of a key participant can cause the entire network to freeze (think Lehman Brothers).
This is an important benefit of DLT, whether public or private, but I could not see how the claimed cost reduction or operational efficiency would materialize
Sacred cows
Next, JPX discovered that DLT would not work well in trading. So, they decided to concentrate mainly on using DLT for settlement and clearing, though there was also a discussion of ownership registry (which to my mind is a sensible use of DLT).
I’ve worked as a project manager in capital markets, and believe me, you cannot radically change settlement and clearing processes while leaving trading practices untouched. Changes have to be made end-to-end, or you end up with a reconciliation nightmare. Reconciliation differences between front- and back-office are a major source of cost and inefficiency in capital markets.
I can’t see how introducing DLT in settlement and clearing alone would improve this. It could make matters a whole lot worse.
JPX restricted DLT to settlement and clearing because price discovery and order matching isn’t efficient in a decentralized environment, and because traders often cancel or amend trades, which would play havoc on an immutable blockchain.
But why didn’t they question these practices? Are there ways of pricing and matching orders without collecting lots of trades? Would introducing an immutable blockchain encourage better trading practices?
Traders are touchy creatures, but their working practices really can’t be regarded as sacrosanct if there is to be radical change in capital market functioning.
Strange assumptions
A third fundamental problem, which the JPX researchers discuss but don’t really solve, is the trade-off between availability and capacity.
A third fundamental problem, which the JPX researchers discuss but don’t really solve, is the trade-off between availability and capacity.
Centralized systems can handle the speed and volume of transactions on today’s financial exchanges better than decentralized systems, but at the price of loss of resilience. Discarding the public blockchain partially addresses this problem, because proof-of-work as currently conducted is far too slow for a high-volume transaction environment: verification by practical byzantine fault tolerance (PFBT) on a private or consortium blockchain is faster. But fully solving it really requires more technological advances.
JPX identifies potential new bottlenecks in a DLT environment, including the fact that running smart contracts slows everything down – a devastating finding for which they did not offer a solution.
But, the exchange didn’t ask whether bottlenecks in the present system might also apply in a DLT environment. For example, know-your-customer (KYC) anti-money laundering (AML) regulations are currently applied by financial intermediaries. Strangely, JPX assumes that this would not change in a DLT environment, even though a key benefit of the DLT would presumably stem from the elimination of financial intermediaries if it were used for cash settlement.
There are other strange assumptions, too, such as the notion that a central bank might issue a digital currency for use on a private or consortium DLT, but wouldn’t make that digital currency available on its own RTGS system – which would be a competitor to that DLT.
To be fair, this study aims only to prove that the technology has potential for use in capital markets. And although JPX concluded that much more work is needed, they do succeed in this aim, despite the compromises.
Now, there needs to be a second evaluation, which looks at the changes that would be needed to capital market functioning to enable DLT to deliver genuine improvements in cost and efficiency.
The real benefits from DLT will come not from re-engineering capital markets as they currently function, but from re-imagining capital markets for a radically different future.
Boy in a big suit image via Shutterstock