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2017] M. Geranio: Fintech in the Exchange Industry ... 245
FINTECH IN THE EXCHANGE INDUSTRY:
POTENTIAL FOR DISRUPTION?
by
MANUELA GERANIO*
The recent growth of financial technology ventures involves several types
of financial players, including stock exchanges. Many of them are exploring
blockchain applications to their multiple business lines, focusing in particular
on post trading activities. Potential benefits include the reduction in counterparty
risk and post trading costs as well as the increase of liquidity and transparency.
At current stage exchanges are mainly exploring the technology looking for proofs
of concept, with the exception of some more advanced projects like at Nasdaq
and ASX. The mass adoption will require longer efforts and is expected to come
in a decade, at least. Fintech developments are receiving strong attention also
by regulators and international organizations, given the potential of distributed
ledger technology for both competition enhancement and cyber risk reduction.
A coordination between market players and regulators is essential to guarantee
the effective implementation of new technologies, as their benefits can be delivered
only in presence of a common framework and a proper management of risks.
KEY WORDS
Fintech, Blockchain, Distributed Ledger, Smart Contract, Stock Exchanges
1. INTRODUCTION
In recent years global investments in financial technology (Fintech) have
boosted, totaling more than 24 billion in 2016.1 The “Fintech Revolution” is
expected to have a disruptive effect on the financial intermediation
*manuela.geranio@unibocconi.it, Adjunct Professor at the Finance Department, Bocconi
University, Milan , Italy.
1KPMG. (2016) The Pulse of Fintech Q4 2016. [online] Available from: https://assets.kpmg.
com/content/dam/kpmg/xx/pdf/2017/02/pulse-of-fintech-q4-2016.pdf
[Accessed 1 March 2017].
DOI: 10.5817/MUJLT2017-2-3
246 Masaryk University Journal of Law and Technology [Vol. 11:2
industry, making finance more cost efficient, consumer friendly
and transparent.2 The main sectors involved include banking, payment
services, insurance, asset management as well as stock exchanges, which are
the focus of this contribution.
Fintech developments have attracted potential new players from the tech
field (i.e. Google, Amazon, Apple) as well as from the telecommunication
(i.e. At&T, Verizon, Vodafone) which in the next future could fulfill
the needs traditionally satisfied by banks and other financial players.
As such, also traditional incumbent in the financial industry were forced
to heavily invest and start new ventures to assess the potential of the new
technologies, in order to defend their own business from incoming
competitors.
In the case of stock exchanges, the main Fintech innovation is expected
to come from the implementation of the distributed ledger technology
or blockchain to run market infrastructures in a more shared
and transparent way. According to the World Economic Forum3, more than
25 countries are investing in blockchain, filing more than 2,500 patents
and investing $1.3 billion.4 By 2027, it is expected that 10 % of global GDP
will be stored via distributed ledger technology.
In order to defend their business from new potential competitors
in the tech and telecommunication industry, all major exchanges have been
particularly proactive in exploring blockchain. They are creating start up
to investigate the technology (i.e. London Stock Exchange, Chicago
Mercantile Exchange, Deutsche Borse) and developing applications to build
brand new market infrastructures or partially replace current ones
(i.e. Nasdaq and Australian Stock Exchange).5
Regulators and international organizations are also paying strong
attention to the field, given not only the competition enhancing potential
but also the different exposure to cyber risks possibly associated
with the distributed ledger technology. Indeed new technologies allow
2Economist. (2015) The Fintech Revolution, 9 May.
3World Economic Forum (2015) The Future of Financial Services. [online] Available from:
http://www3.weforum.org/docs/WEF_The_future__of_financial_services.pdf
[Accessed 23 September 2016].
4One of the major developer of the technology is R3, a consortium involving over 80
of the world’s largest financial institutions to develop ground-breaking commercial
applications for the financial services industry.
5Rizzo, P. (2016) Ten Stocks and Commodities Exchanges Investigating Blockchain. [online]
Available from: https://www.coindesk.com/10-stock-exchanges-blockchain/ [Accessed
23 September 2016].
2017] M. Geranio: Fintech in the Exchange Industry ... 247
a more transparent and shared accountancy of assets, eliminating the risks
associated with the single ledger approach in use nowadays. At the same
time unexplored sources of risks could also arise, especially from the cyber
environment on which the blockchain is shaped.6
The paper is organized as follows: the second paragraph presents
the blockchain technology, while the third one focuses on potential
applications to the exchange industry. Section four highlights necessary
steps for practical implementation, section five describes early projects
in place, while section six concludes.
2. BLOCKCHAIN TECHNOLOGY
Basically, a blockchain is a public digital register shared by all parties
participating to a distributed network. The blockchain records and stores
every transactions that occurs in the network, creating an irrevocable
and auditable transaction history. Originally developed for Bitcoin
(but different from it) such technology has large potential to be
implemented on several financial fields, including payment systems
and market infrastructures.7
Technically the blockchain is a “chain of blocks” in which each block
contains information about a certain number of transactions and can be
added chronologically to the database (thus forming a “chain”) only after it
has been validated by the computers on the network (“nodes”), together
with a reference to the preceding block.8 A copy of the updated blockchain
is then stored on all the network members’ computers, making it pretty
difficult to change or alter any detail in the “transaction history” by any
single players. Since the master record is shared by all network members,
the blockchain can survive the loss of one node as the registration is always
reported on all counterparties shared registry. The blockchain technology
offers thus a built-in redundancy that prevents from loss or deliberate
alteration of records by one single member of the network.9
6ESMA. (2016) The Distributed Ledger Technology Applied to Securities Markets, Discussion Paper
n. 773, June. [online] Available from: https://www.esma.europa.eu/sites/default/files/library/
2016-773_dp_dlt.pdf (hereinafter referred to as “ESMA, 2016”)
7Stafford P. (2016) Banks struggle to make blockchain fast and secure. Financial Times,
26 September.
8Fico P. (2016) Virtual Currencies and Blockchains: Potential Impacts on Financial Market
Infrastructures and on Corporate Ownership. Available from SSRN: https://ssrn.com/abstract=
2736035
9Differently, in a database managed by a unique central authority an attack to the latter will
automatically damage all the records.
248 Masaryk University Journal of Law and Technology [Vol. 11:2
The “distributed ledger database” enable all the members participating
to the network to know almost in real time assets’ ownership because each
of them has access to the shared registry in which all trades and related
ownership changes have been recorded. It is important to highlight that
the digital ledger attributes each transaction to a public identifier
(i.e. a public key or a code) but they cannot be traced back to a specific
person or institution by anyone other than the identifier’s owner (by the use
of a private key).10 Therefore, on the one side transparency is granted
to the network participants, as they can always be aware of their
counterparties transaction history and holdings, without the need
and the costs charged by a third party certificator (such as a bank,
an auditor or a central counterparty). At the same time data encryption
and the adoption of combined public and private keys allow them
to maintain safety and privacy.11
Blockchains may be based either on a public or private network.12
A public network is an open, peer-to-peer framework, accessible to anyone
that wishes to join. As there is no central authority, the network relies
on the same participants in order to record and verify transactions
according to a certain protocol. Differently, private networks are
permissioned networks, so that only trusted parties that have been granted
access can join them. In addition, different entities may have varying levels
of authority to transact and view data. As such, in private networks
a greater control is maintained over users.
Since many of the problems associated with Bitcoins (fraudulent activity,
money laundering) depend from the circumstance that the underlying
blockchain is a public network, all main implementations of the distributed
ledger for the security markets are currently designed on private
networks.13 Indeed, in a permissioned blockchain model14 data validation
and access to data can be limited to selected members only (such as traders,
10 Cuccuro P. (2017) Beyond Bitcoin: an Early Overview on Smart Contracts. International
Journal of Law and Information Technology, V0, p. 1–17.
11 Not everybody agrees that the privacy enabled by the use of private keys and encryption
will be enough (see also Esma, 2016). Indeed in many situations the identity of a market
participant, although technically unknown, could be inferred from its trading patterns
recorded in the system.
12 FINRA. (2017) Distributed Ledger Technology: Implications of Blockchain for the Securities
Industry, January. [online] Available from: http://www.finra.org/industry/blockchain-report
13 For example, the R3 consortium is fully based on a permissioned approach. For further
details see https://www.r3.com/ [Accessed 5 March 2017].
14 See also Cuccuro P. (2017) Beyond Bitcoin: an Early Overview on Smart Contracts.
International Journal of Law and Information Technology, V0, p. 1–17.
2017] M. Geranio: Fintech in the Exchange Industry ... 249
banks or other qualifies counterparties) in order to minimize naive
or fraudulent behaviors.15 Some of the advantages of a pure open system
have been given up so as to guarantee a safe and orderly cyber environment
for financial infrastructures.
A further issue of the blockchain technology is that it facilitates the use
of “smart contract”, i.e. digital, computable contracts where the performance
and enforcement of contractual conditions occur automatically, without
the need for human intervention.16 Such program strings are self-executing
routines that implement a contractual agreement among parties (such
as the payment of periodic coupons on a bond or the execution
of a derivative contract) without the need of a middleman intervention
(such as a bank or a central counterparty). Smart contracts could enhance
the enforcement of contract terms and the automation of back office
processes, reducing in turn errors and legal disputes and possibly
administrative costs.
An example could help to better understand the potential application
of the blockchain technology in the financial markets, namely in the security
clearing. Figure 1 compares the actual process for clearing financial
transactions through a centralized ledger, i.e. the clearing house
of an exchange (on the left) with the possible alternative process enabled
by a distributed ledger (on the right). Traditionally the clearing house is
fundamental to minimize the counterparty risk since once a trade has been
agreed between two counterparties the clearing house will act as the buyer
to every seller and the seller to every buyer. As such the clearing house
centralizes the management of each transaction: registers each trade
on a centralized ledger, nets out opposite positions held by traders if any
and absorbs related risks. Such function facilitate trading and contribute
to liquidity as buyers and sellers do not need to ascertain the credit
worthiness of their counterparty, they just need to trust the clearing house
(typically owned by the exchange in which the transaction occurred). For its
services, the clearing house charge a fee and also requires counterparties
to deposit a guarantee (either in cash or in low risk assets) to prove they will
honor their obligations. Differently, with the distributed ledger technology
(left side of Figure 1) all buyers and sellers can access to the transactions
15 For example, fraudulent activity could consist in recording fictitious transactions
and altering the consensus process (see also ESMA, 2016).
16 Wright, A., De Filippi, P. (2015) Decentralized blockchain technology and the rise of lex
cryptographia. Available from SSRN: https://ssrn.com/abstract=2580664
250 Masaryk University Journal of Law and Technology [Vol. 11:2
history, as recorded and updated trade by trade on a common register
locally held and synchronized among all players in real time. The activity
of a central clearing house becomes unnecessary, since each counterparty
can ascertain the assets ownership while proper routines can automatically
clear out buyers and sellers positions and manage the cash transfers needed
to regulate each trade. Since the system works in real time, the post trading
duration could reduce form actual standards, thus minimizing also the need
for guarantees. Costs and times for post trading activity are therefore
expected to reduce substantially, while transparency will increase without
affecting execution certainty.
Figure 1: The potential impact of blockchain in the clearing activity17
Several benefits are associated with the implementation
of the blockchain technology, including disintermediation, higher quality
of data, reliability and lack of a central point of attack. Transaction are thus
expected to become cheaper, faster but also more reliable and transparent,
as processed on an integer peer-to-peer transmission system (see Table 1).
At the same time many obstacles and challenges need to be addressed
to ensure that all advantages will materialize. From the technological point
of view, market applications of the blockchain are still in their infancy
and need to be verified and tested for both effectiveness and cyber security.
Moreover, a relevant increase in computational capability is needed,
as distributed ledgers require substantial amounts of computer power
17 Stafford P. (2016) Banks struggle to make blockchain fast and secure. Financial Times,
26 September.
2017] M. Geranio: Fintech in the Exchange Industry ... 251
to validate transactions. As for the regulatory environment, it just started
to cope with the new paradigm and thus it will need time to design
an appropriated regulatory framework and integrate it with current laws.
The practical adoption will require also a cultural change for users
and operators, as they need to familiarize with the new technology, shifting
practices to a decentralized network, and to integrate existing systems
to the new one. This would require time for learning and also substantial
investments in the short run, even if on behalf of future savings.
Benefits Challenges
Disintermediation & trustless exchange
Two parties are able to make an exchange
without the oversight or intermediation
of a third party, strongly reducing or even
eliminating counterparty risk. Users are
in control of all their information
and transactions.
Nascent technology
Resolving challenges such as transaction
speed, the verification process, and data
limits will be crucial in making blockchain
widely applicable.
High quality data
Blockchain data is complete, consistent,
timely, accurate, and widely available.
Uncertain regulatory status
Because modern currencies have always
been created and regulated by national
governments, blockchain face a hurdle
in widespread adoption by pre-existing
financial institutions if its government
regulation status remains unsettled.
Durability, reliability, and longevity
Due to the decentralized networks, blockchain
does not have a central point of failure and is
better able to withstand malicious attacks.
Large energy consumption
The Bitcoin blockchain network’s miners
are attempting 450 thousand trillion
solutions per second in efforts to validate
transactions, using substantial amounts
of computer power.
Process integrity
Users can trust that transactions will be
executed exactly as the protocol commands
removing the need for a trusted third party.
Control, security, and privacy
While solutions exist, including private
or permissioned blockchains and strong
encryption, there are still cyber security
concerns that need to be addressed before
the general public will entrust their
personal data to a blockchain solution.
Transparency and immutability
Changes to public blockchains are publicly
Integration concerns
Blockchain applications offer solutions that
252 Masaryk University Journal of Law and Technology [Vol. 11:2
viewable by all parties creating transparency,
and all transactions are immutable, meaning
they cannot be altered or deleted.
require significant changes to, or complete
replacement of, existing systems. In order
to make the switch, companies must
strategize the transition.
Faster transactions
Blockchain transactions can reduce
transaction times to minutes and are
processed 24/7.
Cultural adoption
Blockchain represents a complete shift
to a decentralized network which requires
the buy-in of its users and operators.
Lower transaction costs
By eliminating third party intermediaries
and overhead costs for exchanging assets,
blockchains have the potential to greatly
reduce transaction fees.
Cost
Blockchain offers tremendous savings
in transaction costs and time but the high
initial capital costs could be a deterrent.
Table 1: Main benefits and challenges of blockchain technology18
Given its characteristics and products (immateriality of goods traded,
electronification of trading, high level of information asymmetries,
commercial relations involving often unknown counterparties) the financial
sector became one of the first and more natural context for the development
and launch of blockchain applications. Early examples involve
cryptocurrencies, such as the Bitcoin, which registered mixed results.19 More
recent projects concern the payment system (such as Ripple, a distributed
ledger for international payment which is collecting growing attention
by traditional banks), crowdfunding and issuing platforms, and clearing
and settlement services providers.
3. POTENTIAL APPLICATIONS
OF BLOCKCHAIN FOR EXCHANGES
From their foundation in the early 1600s stock exchanges provide a safe
and reliable infrastructure that facilitates the transfer of financial resources
between savers and borrowers (equities and bonds) as well
as the distribution of risk according to preferences (derivatives).
The exchange industry expedites such exchanges by reducing information
asymmetries and transaction costs.20 Moreover, exchanges perform
18 Deloitte. (2016) Insights: Blockchain technology. [online] Available from:
https://www2.deloitte.com/nl/nl/pages/innovatie/artikelen/blockchain-technology-9-
benefits-and-7-challenges.html [Accessed 5 March 2017].
19 Swan , M. (2015) Blockchain Ed. O’Reilly.
20 Geranio, M. (2016) The Evolution of the Exchange Industry. Springer.
2017] M. Geranio: Fintech in the Exchange Industry ... 253
a regulatory function that guarantees the selection of participants (either
listed companies or trading members), the orderly and fair execution
of trades and the fulfillment of the related post trading activities
(i.e. clearing and settlement operated by a central counterpart).
Blockchain has the potential to further reduce such asymmetries
and costs and to replace the central counterpart with a peer-to-peer
mechanism. As a consequence, stock exchanges represent one of the major
fields that the new technology is expected to impact. Hence it is not a case
that all major stock exchanges are already investing to get a better
understanding of the blockchain prospective and to implement first
applications.
In order to appreciate the possible impact of the distributed ledger
technology to an exchange it may be useful to briefly recall the main
activities that sequentially compose the life of a security, that is issuing,
trading and post trading.
The issuing or primary market phase involve the issue of equities
(or bonds), the offer and distribution of securities among the public
and the collection of funds from investors. Such activities are completed
by the issuing company, usually assisted by banks, legal consultants
and providers of administrative services. If the offer is proposed to the large
public of investors relevant regulatory and transparency duties have also
to be fulfilled, together with obligations of the exchange in which
the security is eventually expected to get listed. Indeed, listing activity
implies that the entity where the issuer is seeking to be admitted conducts
due diligence to assess that the latter is adequately fit and has the attributes
investors are looking for.
Trading or secondary market phase involves matching and executing
orders received from buyers and sellers either on an official exchange
or on an alternative trading system (ATS). Nowadays, trading is fully
electronic: orders reach the matching engine of the exchange or ATS
via dedicated transmission lines that guarantee maximum speed21
(in the order of microseconds) and minimum costs (given the strong
competition among official exchanges and ATS). Smart order routers assist
traders in deciding which market is best to execute each transaction
by collecting and combining information on available order books
21 More than 5000 trades can occur in a second!
254 Masaryk University Journal of Law and Technology [Vol. 11:2
and automatically send the order. It is estimated22 that more than 50 %
of trading is nowadays put in place by algo trading, i.e. software programs
that do not require human intervention to implement the trading strategy.
Post trading involves several activities, namely clearing, settlement
and custody services. In the clearing process, trades are registered
and aggregated to establish the respective obligations of the buyer
and the seller. Each counterparty’s position is netted out by summing up all
their buy and sell orders in order to reduce settlement values. Details
of the deal such as security identification code, the settlement date
and venue, and so forth, are prepared to enable settlement. Clearing houses
might also offer other services, such as acting as central counterparty
(the buyer to every seller and the seller to every buyer). In doing so,
a clearing house replaces the original bilateral contract with two bilateral
contracts and guarantees the trade. This aspect takes on special value
in the case of derivatives contracts, where no cash flow is due
from counterparties before maturity. To cover this risk, the CCP requires
traders to post a certain amount of collateral. Settlement is the process
by which the legal ownership in the traded asset is transferred
and the corresponding payment is made. Giving the existence of network
externalities and economies of scale generated by custody activity,23 often
settlement services are offered jointly by the custodian, using a vertically-
-integrated structure to perform both activities. Custody is carried out
by a depositary, which acts as a “securities bank” that holds physical
securities in custody as well as accounts of their ownership. Many
depositories offer registration as an additional service (i.e. notary services,
proxy voting, information on corporate actions, etc.). At the moment this
function is a natural monopoly because regulation requires that
the shareholders’ register for each security shall be kept at a single
institution, which is usually selected by the issuer.24 As a consequence,
equity custodians are typically based in the same country where the shares
are listed.25 Overall, post-trade services are highly regulated and major
changes in the industry are typically the result of regulator intervention.
22 World Federation of Exchanges and Iosco. (2016) Financial Market Infrastructures
and Distributed Ledger Technology, August. [online] Available from: https://www.world-
exchanges.org
23 Linciano, N., Siciliano, G., and Trovatore, G. (2005) L’industria dei servizi di regolamento delle
Operazioni in Titoli Quaderni di Finanza Consob, n. 58, May.
24 Ibid.
2017] M. Geranio: Fintech in the Exchange Industry ... 255
Given the above discussed phases that occurs during the life
of a security, blockchain applications for exchanges are expected to focus
mainly in the post trading field and possibly in the issuance of new
securities, while small room is left in the issuing and trading business.
Indeed the distributed ledger technology does not allow to reach, at least
at the moment, levels of speed and efficiency comparable to those already
in place in the trading platforms of exchanges and ATS. In addition, since
with the blockchain possession of assets is a pre-requisite for transacting,
short selling and margin finance26 may be no longer feasible. Also algo-
-trading and in particular high frequency traders27 may find it difficult
to develop their strategies, since they will need to wait (for even just a few
seconds) for each settlement cycle before they can transact again and this
would give rise to a substantial slowdown in their rate of activity.28 So far,
applications of the distributed ledger including the trading activity have
been developed only for less traded securities (such as the SIX platform
launched for bonds29) or new born shares (such as T0 platform in the US30).
Differently, post trading is expected to be the most important area
for the implementation of fintech in financial market infrastructures.
On the one side the new technology will allow a true redesign of current
procedures for clearing, settlement and custody, no more anchored
to the presence of a central counterpart. On the other side, up to now post
trading field has been the least exposed to competition in the exchange
industry, as it could benefit from a sort of natural monopoly granted
by available technology and regulation. Blockchain could disrupt such
monopoly, promoting higher efficiency, shorter duration and cost reduction
in post trading processes.31
25 For example the Central Security Depositor (CSD) in Italy is Monte Titoli, in France
Euroclear Paris, in Germany Clearstream and in Spain Iberclear. See Chan et al. (2007)
The Securities Custody Industry, ECB Occasional Paper Series No. 68, August.
26 Trading strategies typically employed by hedge funds.
27 High frequency traders use sophisticated algorithms to place orders on several markets
at the same time, taking advantage of the extreme speed in order execution.
28 Euroclear and Oliver Wyman (2016) Blockchain in Capital Markets. [online] Available from:
http://www.oliverwyman.com/our-expertise/insights/2016/jan/blockchain-in-capital-
markets.html.
29 SIX. (2017) SIX Securities Services Develops Distributed Ledger-Based Bond Issuing Solution
[online] Available from: https://www.six-securities-services.com/en/shared/news/2017/dss-
news-170322-distributed-ledger.html [Accessed 31 March 2017].
30 Tzero. (2017) Distributed Ledger Platform for Capital Markets [online] Available from:
https://tzero.com/ [Accessed 31 March 2017].
31 Pinna A. and Ruttemberg W. (2016) Distributed ledger technologies in securities post-trading,
ECB Occasional Papers, n. 172, April.
256 Masaryk University Journal of Law and Technology [Vol. 11:2
Nowadays the post trade process can be expensive and slow: commonly
it takes 2 days to process through a number of intermediaries. Blockchain
has the potential to overcome such frictions and provide alternatives
to improve management of clearing, settlement and custody (see Figure 2).
The adoption of a distributed ledger among market participants could allow
a real time clearing for cash transactions, eliminating any manual process
and related errors and avoiding the intervention of a central clearing house
(and related costs and risks). Indeed, both sides in a transaction will have
access to pre-trade transparency details that their counterpart will be able
to meet the terms of the deal, and settlement will happen almost instantly.
This in turn will eliminate collateral requirements, being the settlement
instantaneous (from T+2 to T+0). Efficiency will improve, as cash and assets
transfers will be recorded on the same ledger. Differently, for derivatives
contracts a clearing mechanism will still be needed for the whole length
of the contract, but the new technology will allow to optimize netting
procedures, reducing counterparty risks, facilitating a more efficient use
of collaterals and diminish capital requirements for clients.
Custody services will also be simplified, thanks to higher transparency
and process automation made available by the distributed ledger
technology. New services, including proxy votes and collateral
management, could be offered to clients.
Figure 232: Possible impact of blockchain in post trading activites
32 Santander Innoventures, Oliver Wyman and Anthemis. (2015) The Fintech 2.0 Paper:
Rebooting Financial Services. [online] Available from: http://santanderinnoventures.com/
fintech2/
2017] M. Geranio: Fintech in the Exchange Industry ... 257
Overall, the reduction in time, expenses and counterparty risk associated
with blockchain adoption in post trading should result in relevant cost
cutting: equity analysts33 estimate a 25% reduction in post trading costs,
equivalent to a 7% decrease in aggregated costs of European exchanges.
The Australian Stock Exchange, which is implementing a blockchain
solution for their clearing services, estimated it will lead to a 15% reduction
in total exchange costs. In addition, further positive side effects are
expected, such as a possible increase in liquidity and transactions motivated
by the most effective management of counterparty and market risks.34
Higher transparency and auditability of the transaction history is
strongly welcomed also by financial regulators and supervisors (ESMA,
2016), which could be granted special access rights to the distributed ledger
in order to better exercise their duties. At the same time, the supervision
of a network could be more complex than that of central market
infrastructures. Moreover, legality and enforceability of the records kept
on the blockchain also need to be carefully considered, in the light also
of differences in securities and company laws across countries.35
As for the issuing activity, the distributed ledger technology could
provide new solutions for issuing securities in cryptographically secured
digital form, breaking down some of the barriers to entry in financial
market for small and medium enterprises (mimicking the impact that
crowdfunding had on smaller ventures). This in turn could also facilitate
at a second stage the development of a secondary trading market
via blockchain, given the limited scope and liquidity of the securities
involved. Some examples are already under construction, as reported
in the fifth paragraph.
4. STEPS FOR BLOCKCHAIN DEVELOPMENT IN CAPITAL
MARKETS
The adoption of blockchain in capital markets requires several steps
and time. Mass adoption is not expected before 2025, even if it is estimated
that in 2027 10 % of global GDP will be stored on blockchain.36
33 JP Morgan Cazenove. (2016) Blockchain: A Revolutionary Technology Too Important to Ignore,
Europe Equity Research, 23 May.
34 Ibid.
35 See also ESMA, 2016.
258 Masaryk University Journal of Law and Technology [Vol. 11:2
First, the technology requires further exploration and proofs of concept,
with initial investments to explore effective capabilities, scalability, data
privacy, performance, identity management and standardization formats.
Such phase is already under way, thanks also to the large venture capital
involvement in the field, but common procedures still need to be agreed.
To guarantee robustness and fair performance very high standards need
to be set for the blockchain, together with reliable protocols for integration
with existing non-blockchain systems (i.e. risk management platforms).
Security issues deserve a special attention, as the risk of intentional security
breaches could have unknown consequences. Indeed, if the distributed
nature of the ledger does provide some protection (hacking the system
would require collusion across the network), it also multiplies the possible
points attacked or damaged by an external hacker (i.e. through
the execution of an intentionally broken smart contract).
The implementation of smaller scale applications is the second stage. It is
needed to allow appreciation of costs, benefits and risks as well as to raise
awareness of economic benefits to a wider arena of players. In the case
of exchanges, the use of blockchain has already been applied to asset classes
with limited trading volume. Projects like Nasdaq Linq and SIX bond
market are first examples in this direction.37
The third step then will imply the involvement of regulatory authorities,
which in many cases already started to investigate the technology to assess
its impact also in terms of audit and compliance benefits. Strict
collaboration between regulators and the industry will be fundamental
to update the legal framework and grant regulatory approval to the new
infrastructures. New principles may be needed where blockchain
technologies become an integral part of the market infrastructure,
and where consensus protocols are run through an international network
of participants. Given the global nature of financial services, the agreement
will be required across different jurisdictions. A special issue concerns
the immutable nature of transactions registered on the blockchain: some
technical solution should be identified to allow amendment of wrong
registrations caused by errors or fraudulent behaviors, given the wide
systemic impact they would otherwise have on all the network participants.
36 See also World Economic Forum (2015) The Future of Financial Services. [online] Available
from: http://www3.weforum.org/docs/WEF_The_future__of_financial_services.pdf
[Accessed 23 September 2016].
37 As discussed in paragraph 5.
2017] M. Geranio: Fintech in the Exchange Industry ... 259
Once main regulatory issues will have been resolved,
the implementation in mainstream asset classes and services will be
feasible. At the beginning this will be done in parallel with existing systems
(e.g. in clearing), while only after technology has been fully assimilated
and tested in practice mass adoption will follow.
Two aspects, out of the numerous operational ones needed to support
the effective blockchain implementation, appear particularly relevant.38
On the one side a robust cash ledger should be put in place to overcome
failures of existing cryptocurrencies (such as the Bitcoin). Indeed, in order
to achieve full “Delivery Versus Payment” in settlement (as in actual post
trading systems) the blockchain should be able to process central bank
money. Some players39 are yet investigating in the field in order to either
create a digital alternative to fiat currency or find a way to use commercial
bank money systems.
On the other side, given the global nature of the financial markets, it will
be necessary to establish standards to allow interoperability between
different blockchain networks that will be promoted by various market
players (stock exchanges, clearing houses, custodians) and for different
asset classes (equities, bonds, derivatives). Cooperation among players
become thus fundamental to gather full benefits from the new technology
implementation. In addition, as distributed ledger technology is expected
to expand in progressive steps, interoperability with the existing systems is
also important to allow the diffusion of the new protocols without altering
market operations. In the long run, interoperability could also foster
interconnections among financial markets in different countries, facilitating
international trading and diversification not only among most developed
financial centers but also in those emerging markets that are willing
to adopt the technology and reshape their regulatory framework
accordingly.
Given the large impact expected on clearing and settlement,
consequences can be expected on the business models used by exchanges
to manage the post trading activity.40 Currently, some exchanges adopt
a vertical model (“silo”)41, in which post trading activity are integrated
38 See also ESMA, 2016.
39 Such as the Bank of England.
40 Mainelli M. and Milne A. (2015) The Impact and Potential of Blockchain on the Securities
Transaction Lifecycle, Swift Institute Working Paper n. 7.
41 For example Deutsche Borse.
260 Masaryk University Journal of Law and Technology [Vol. 11:2
and performed by the same stock exchange in which trading occurs. Other
marketplaces rely on a horizontal model42, in which the customer can opt
for different providers of postrading services. It is not easy to forecast
if the blockchain technology would clearly favor one out of the two models.
On the one side the use of a distributed ledger evokes a more open and thus
horizontal approach, which would largely benefit from the interoperability
among different networks. On the other side, the application of blockchain
will imply both high investments and smaller margins for exchanges that
provides post trading services. As such incumbents might try to maintain
strict control on their permissioned distributed ledgers, at least in the first
years, in order to assess the reliability of the network but also to defend
their own financial results.
Overall the path to effective implementation of distributed ledger is still
long and uncertain.43 In addition to main hurdles identified above
(technology, regulatory and legal barriers, lack of safe cryptocurrencies,
interoperability with existing systems), the presence of vested interests
in the preservation of the existing system could delay the adoption
of the new technology. Incumbents in the market infrastructure industry
(exchanges, central counterparties and depositors, traders and investment
banks) could indeed lose their market position and margins
from the introduction of the blockchain. The pressure exercised by new
entrants in the field is relevant but probably not enough to induce a definite
and fast movement of main market players towards the distributed ledger
philosophy. A concurrent action by regulators and public authorities could
therefore definitely be necessary to support the concrete adoption
of the new technology, as it historically happened with other major
innovations in the financial field.
5. RECENT EXPERIENCES
Despite its quite recent development, first application of blockchain
technology started to appear in latest years. Here’s in the following some
of the main examples.
In late 2015 Nasdaq launched the Linq blockchain technology dedicated
to the issue and trading of securities of private companies (a good testing
field, since trading is limited and usually occurs between a tight circle
42 For example Euronext.
43 See also World Federation of Exchanges and Iosco (2016).
2017] M. Geranio: Fintech in the Exchange Industry ... 261
of investors). The company Chain.com was the first able to use the platform
to issue shares to a private investor, documenting a major advance
in the application of blockchain technology. Nasdaq enabled the issuer
to digitally represent a record of ownership using Nasdaq Linq (a cloud
based management tool), while significantly reducing settlement time
and eliminating the need for paper stock certificates. A few more companies
joined the platform in the following months, and Nasdaq confirmed its
strong interest in the distributed ledger technology to be applied also
to public markets in the next future. Indeed, at the same time, Nasdaq is
developing distributed ledger technology to improve proxy voting,
company registration and public-pension registration at the Tallinn Stock
Exchange, Estonia’s only regulated secondary securities market, as well
as the Estonia Central Securities Depository (ECSD).
An alternative example for the issuing field comes from a new entrant
in the financial industry: Overstock, an e-commerce corporation that
became the first to issue its own corporate bonds on a self-developed
blockchain, eliminating the possibility of naked short selling and reducing
settlement time to near zero. Six months after the bonds’ issue, Overstock
earned regulatory approval to issue also equities through its blockchain.
In September 2016, the company announced it was partnering
with Keystone Capital to work with regulators on further developments
for its platform.
In January 2016 the Australian Stock Exchange (ASX) acquired
a 10 million stake in Digital Asset Holding, a New York based start up
to promote R&D on blockchain applications. A few months later ASX
announced to have completed the first version of a potential distributed
ledger-based replacement for its existing settlement system. The process
involved working with regulatory bodies in Australia as well as relevant
exchange stakeholders. ASX is now weighing how to go about replacing its
existing settlement system, known as CHESS, with the new blockchain
prototype. ASX expects to conclude investigations and implement the new
system by 2018.
A further example released in 2016 comes from SIX Securities Services
(Switzerland’s post-trade market infrastructure) that has developed
a blockchain powered service covering the full bond trading life cycle
from issuance to settlement. The prototype enables the issuing of bonds
as smart contracts that specify at what dates coupon payments are made,
262 Masaryk University Journal of Law and Technology [Vol. 11:2
for what amounts and when repayments occur.44 The smart contract is
connected to the chain where buyers can allocate money to the bond
by paying in digitalised currency. SIX Securities Services said the benefits
of using blockchain technology include having one source of data stored
on the ledger and significant cost reductions from the removal of operations
and reconciliation processes.
The central securities depositories of Russia (NSD, National Settlement
Depository) also revealed in 2016 to be at work with a tech startup to test
the exchange and transfer of blockchain assets. In addition, they signed
an agreement with South Africa depository (Strate) to work together
on a shared ledger technology project focused on proxy voting.
Blockchain innovations involve also commodities market. In 2016
the Royal Mint, a 1,000-year-old institution owned by HM Treasury, has
partnered with with Chicago Mercantile Exchange (CME Group) to build
and launch a digitised gold offering called Royal Mint Gold (RMG).
The innovative product, launching in 2017, will see The Royal Mint issue
RMG as a digital record of ownership for gold stored at its highly-secure
on-site bullion vault storage facility. CME Group will develop, implement
and operate the product’s digital trading platform. Taken together, this new
service will provide an easier, cost-effective and cryptographically secure
alternative to buying, holding and trading spot gold.
In addition to industry players, concrete signals of interest
in the blockchain technology has surged also from regulators
and supranational institutions.
Throughout 2016, Central banks became significantly more interested
in utilizing blockchain’s potential, particularly in the area of settlement.
The Bank of England, European Central Bank, Bank of Japan and the US
Federal Reserve all announced they were conducting exploratory research
into the potential adoption of blockchain, indicating a strong preference
to try and foster a culture of digital innovation going forward.45
One of the most active regulators in the field has been the Bank
of England. First, it has founded FinTech Accelerator in partnership
with firms working with new technology to explore how innovations could
be used in central banking. In particular, the central bank is testing
44 See also SIX(2017).
45 Bank of America Merrill Lynch. (2016) How Will Blockchain Change European Market
Structure? Exchanging Views.
2017] M. Geranio: Fintech in the Exchange Industry ... 263
an artificial intelligence system with the Canadian startup MindBridge AI
to spot abnormalities in financial transactions and explore the benefit
of machine learning technology for analyzing the quality of regulatory data
input. It has also partnered with San Francisco-based startup Ripple, to trial
a blockchain-based technology that would make cross-border payments
and the movement of currencies more immediate. A further long term
research programme of the Bank of England concerns the implications
of a central bank issuing a digital currency.
G20 countries documents released in 2017 also recognize the potential
of Blockchain technologies to build an inclusive global digital economy that
is auditable, secure and transparently accountable to the world’s citizens.46
Hence, G20 countries are expected to take the lead in initiating several
concrete steps to support public and private sector blockchain innovations
and establish internationally agreed regulatory frameworks to interface
with them.
6. CONCLUSION
Stock exchanges are currently investing in blockchain technology
to maintain their competitive position in the security industry. Main
impacts are expected to be on post trading business. Settlement and custody
will be the most impacted areas, since the distributed ledger will streamline
and shorten the process for holding and exchanging assets. Clearing will
also benefit by providing faster margining and risk management, especially
for derivatives.
Differently, trading will remain on exchanges and ATS as the actual
technology is much faster than blockchain and it is not in the interest
of stock exchanges (and of a relevant portion of their clients, such as high
frequency traders) to implement the new technology.
Some incumbent players and new entrants in the field are also launching
applications in the issuing sector, and some possibility to trade as well,
focusing on least served market segments, such as small and medium
enterprises, for which extreme speed in transactions is not a relevant issue.
Undoubtedly fintech has a huge potential to rewrite many processes
in the financial markets, once technological and regulatory issues will be
46 Maupin J. (2017) The G20 Countries Should Engage with Blockchain Technologies to Build
an Inclusive, Transparent, and Accountable Digital Economy for All. G20 Insight. Available from:
http://www.g20-insights.org/policy_briefs/g20-countries-engage-blockchain-technologies-
build-inclusive-transparent-accountable-digital-economy/
264 Masaryk University Journal of Law and Technology [Vol. 11:2
solved. If it will succeed also in disrupting entry barriers and vested
interests of incumbent players is less easy to say, as it will depend upon
the efforts put in place by new entrants but also from the sustain that
the new technology will receive from regulators and public authorities. First
steps taken on this direction authorize an optimistic view.
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