Meet Mr. Hong; he runs a stock exchange in Cambodia with a tiny market capitalisation of its listed companies. This exchange operates just like any other stock exchange in the world, in a sense, it is centralized, expensive and limited in transparency.
Let’s look at how his exchange works from the bottom up.
At the lowermost level are the brokers who help the retail investors get access to the stock markets. These brokers are members of an exchange or partners with a member who is licensed by an exchange in return for a hefty fee. Using the public platform maintained by the brokers, the investor places their trades and orders are relayed to an order management system which then matches buyers and sellers across the network. These members can avoid public internet congestion by maintaining direct private networks to the exchanges. Once the trade is completed, the exchange relays back the information to the member’s management system, and it displays this to the retail investor.
The capital market infrastructure for traditional exchanges involves buyer-seller matching, recording, regulatory compliance, liquidity support, transparency, and settlement. These processes involve multiple parties which lead to data fragmentation, and this makes it difficult and expensive to navigate through this environment. As a result, the full seamless operation relies heavily on the accuracy and honesty of all participants.
Let’s look at how transactions are recorded.
A broker maintains their records of which clients own what amount of stock and a national Govt entity records ownership by individual members and brokers. There is a settlement period cycle which is followed by most countries globally, which involves a two to three-day period in which everything is recorded. This idiosyncrasy requires capital being locked up for long periods while the trades settle. So the Govt entities record transactions for brokers who record the transaction for clients and this process is time-consuming and expensive.
How can blockchain give a kick to Mr. Hong’s business interests?
Thanks to the ability to streamline processes through automation and decentralisation, Blockchain has been called the future of financial services infrastructure. As a result, most of the prominent exchanges in the world are working to leverage the distributed ledger technology to overhaul traditional mechanisms fundamentally. The distributed ledger technology could enable savings for the entities involved by reducing the duplication of processes, settlement time, collateral requirements and operational overheads. This would minimize the need to set aside financial resources to cater to counter-party risks and achieve higher anti-money laundering standards and reduced risk exposure.
When comparing traditional exchanges to Blockchain based exchanges, we can see that the latter need not involve brokers and management systems. Here, retail investors can directly connect to the exchange via the public internet and all matches are performed on the platform itself. This removes the need for a broker as the middleman and connections for every trader depend on the reliability of public internet, not private networks.
Let’s take it a step further and see how exactly do the retail investors benefit?
Transparency: With the help of blockchains and distributed ledger technology, the connected stakeholders can track who owns what thus ensuring transparency. The high cost and requirements to become a stock exchange member mean entities will have better trading opportunities than everyone else. This means brokers, even public-serving ones, can trade for themselves more quickly than they can trade on behalf of customers. Thanks to co-located servers and private networks, private-internet members like proprietary trading companies and hedge funds could typically access information before it is publicly available. With the public ledger model, it would mean that no traders get an edge over retail traders by having the money to build private networks.
Low costs: Some low-cost brokers have embraced technology and automation for cost-cutting, but they are required to maintain memberships and networks. Exchanges themselves bear the cost for regulatory recording and other law-mandated activities, but Blockchain-based exchanges are moving asset records around on their servers. This means that in the long run, this would be more like incurring the costs of running a website, not an exchange.
Faster transactions: Blockchain records deposits and withdrawals, while the exchanges themselves record which clients own which assets, but without dependence on third-parties. This results in a speedy and near real-time reconciliation process, essentially removing the requirement of a clearinghouse, leading to almost immediate settlements.
Fraud Prevention:Fraudsters easily target multi-link processes particularly ones that require human interaction at different points in a chain. While blockchain allows for information to be shared in real time and the ledger can only be updated when all the nodes reach a consensus using a defined and automated mechanism. Hence for Mr. Hong, this drastically reduces the opportunities to commit fraud on his exchange and increases the cost exponentially for a fraudster to even attempt it.
What about companies?
One of the most significant benefits is the disjuncture of raising capital and listing. For traditional stock exchanges, the company must choose a particular exchange, pass listing requirements and then trade on that exchange. There is also a complicated ecosystem built around initial public offerings (IPOs), with consultants and underwriters taking their piece. For Blockchain-based exchanges, the company can also add an initial coin offering (ICO) either on or off the exchange platform, in which the company directly interacts with the public, who directly buy tokens.
This potential to enable stock exchanges to significantly reduce the cost and complexity, and increase the speed of trading and settlement processes securely, has the biggest names in the industry exploring blockchain technology. The path to its adoption will require working on long-term concerns such as scalability, common standards, regulation, and legislation. However, from a timing perspective, this will be an early mover advantage that will pay off dividends in leaps and bounds!