Is the financial market broken? Or why do we need blockchain? (Part 1 / 2)
Blockchain has shown in 2017–2018 that the ecosystem can be used for fundraising, which enabled the funding of several billion to innovative companies. But as fast as it started it has also shown that a completely unregulated market creates risk for investors. In this blog post, we will lay out the ideas for a future Crowdfunding market within Europe based on blockchain and will compare it to the financial market.
Fast forwarding the development of the financial market
From the beginning of the first publicly offered companies in 1602 by the Dutch East India Co to today, the financial market was always a reflection of the requirement to find liquidity for companies. Exchanges as we know them today have worked based on forms of auctions, which took place in coffee houses. The first institutional stock exchanges, which were growing out of coffee houses, were founded for example in London in 1773 and Austria in 1771 (founded by Maria Theresa).
The NYSE was not the first one in the USA but has become the biggest stock exchange. It was founded in 1792 with the so-called Buttonwood Agreement. The goal was that the price reflects the value of the stock and no other parameters. Therefore, the agreement stated that they only trade publicly on standard commissions. This agreement stated:
We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at a less rate than one quarter per cent Commission on the Specie value and that we will give a preference to each other in our Negotiations. In Testimony whereof we have set our hands this 17th day of May at New York. 1792. (Waxman 2017)
Fast-forwarding to the 20th century in which institutional investors evolved and several bubbles formed the financial market at that time. After World War I, there was an economic boom, which ended with Black Tuesday 1929 in the USA and several days later in Europe on Black Friday, where the stock market crashed, and all investors tried to sell their shares at the same time. With the crash, nearly 5000 banks in the USA closed. Identified reasons for the crash were irresponsible acting, misled investors and widespread insider trading. (History.com Editors 2019)
As a result, the Securities Act was passed in the USA in 1933, which requires the registration of securities sales. Additionally, the Glass-Steagall Act separated investment banking from commercial banking to restore public confidence. One year later the Securities Exchange Act was passed, which gave the Securities and Exchange Commission (SEC), which was created the same year, extensive power to regulate the securities industry. The SEC created the EDGAR database with all information such as file reposts, etc.
The most recent bubble which triggered major change was the financial crisis in 2007, where the subprime mortgage market crashed and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008 (Wikipedia). In the USA the Dodd-Frank Act is the response to the 2007 financial crisis. It gives the regulators the possibility to orderly liquidate financial firms, to mitigate systemic risk and the possibility to give emergency credits.
In Europe, MIFID II regulation is one of the impacts on the financial market, which states in its preamble:
The financial crisis has exposed weaknesses in the functioning and in the transparency of financial markets. The evolution of financial markets has exposed the need to strengthen the framework for the regulation of markets in financial instruments, including where trading in such markets takes place over-the-counter (OTC), in order to increase transparency, better protect investors, reinforce confidence, address unregulated areas, and ensure that supervisors are granted adequate powers to fulfil their tasks.
MIFID II lays out the different players of the financial market and builds, therefore, the baseline for the current activities on the financial market.
Architecture of the European financial market
The main task of the financial market is to exchange money for securities (shares or bonds) or securities for money. And the infrastructure has been built in order to reduce the risk in transferring the securities without receiving the money or paying without receiving the securities. Additionally, the information asymmetry should be reduced, that the price of the security represents the value behind the security.
In the financial market, a stock exchange transaction takes three steps: After the conclusion of the trade transaction (trade), the trade is entered into the clearing system (clearing) and then the transaction is settled (settlement). The clearing system is a medium for the legally binding transfer of means of payment or securities between economic entities with simultaneous settlement of claims and liabilities between contracting parties. The settlement can be compared to a sales contract in which there is a mutual exchange of goods and money.
Looking at the different roles, the exchange is the market, where based on predefined trading rules, supply and demand for securities can meet. The buyer and seller transactions are stored in an order book and, based on the order book, the exchange tries to find the best mechanism for the buyer and seller to match.
A central counterparty (CCP) is defined in Regulation (EU) No 648/2012 as a legal person that interposes itself between the parties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer. This means, that the CCP can combine different trades and only settles the final state.
Central securities depositories (CSDs) are systemically important institutions for financial markets that ensure the initial recording of securities, the maintenance of the accounts containing the securities issued and the settlement of virtually all trades of securities. The CSD is responsible for taking the paper security and creating the first electronic entry. This means that before a security can be traded on the financial market, it has to be registered at a CSD.
The custodian bank holds the securities for the owner of the security. In the financial market the buyer and the seller are not holding the securities by themselves. They are held at the custodian bank. This means that the custodian bank has an account at the CSD and takes the securities for the holder of the security in custody. Moreover, not all banks have an account directly at the CSD. It is also possible, that one bank holds custody for another bank.
To enable a person to trade at the exchange, a broker is needed. The broker takes care of the trade execution at the exchange. A private individual is not allowed to operate directly at the exchange.
The last role is the investment bank, which is the registrar or transfer agent, that supports the issuer in all the administration tasks.
This means, if person A wants to sell his or her shares to person B, person A has to contact the broker (which can be an online service). The broker connects the custodian bank to see how many shares person A has and then sends the trade to the exchange. Person B wants to buy the shares and contacts his/her broker in order to add a trade to the exchange for buying. The broker checks with the custodian if there is enough money on the account. When person A and person B have a matching trade, the trade is executed and sent to the central clearing counterparty (CCP). The CCP becomes the buyer to person A and the seller to person B. On the other hand, the CCP matches all other transactions with the same custodian banks and only settles the netted transaction. At the same time the money is taken from person B’s custodian bank and sent to person A and the securities are taken from person A and sent to the custodian of person B. Additionally, the custodian bank makes the tax calculation and sends the taxes directly to the state.
For settlement between different CSDs the TARGET2 securities ecosystem has been developed by the European Central Bank and, for the payment transaction, the TARGET2 payment system. Looking at the international level, SWIFT is responsible for taking care of message delivery.
Therefore, every transaction involves two brokers, two custodian banks, an exchange, a central clearing counterparty, a central securities depository and a transfer agent. In some cases, even more custodian banks are involved, if a custodian bank has no direct access to the CSD. In case several countries are involved in the transaction, there might be several central securities depositories included. Thus, the financial market has evolved from coffee house to a fully automated system, where the risk of transactions and costs are reduced, and the focus can be put on the securities price.
Part 2 will be published in a couple of weeks looking at the possible changes by using the blockchain.
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