How a Stock Exchange Could Work (with Blockchain)
A Re-evaluation of the Post-Trade Process
(Disclaimer: This is Part 2 of a two part piece on blockchain replacing traditional exchanges. For Part 1, a technical explanation of how current stock exchanges work, click here)
Given its single, shared public ledger and ability to instantly verify proof of credit for any participant, blockchain makes a compelling case for replacing the exchanges of the past. With a technical understanding of what’s currently happening behind the scenes of stock exchanges, we can now explore how the vast majority of those systems and parties can be eliminated (or highly optimized) with blockchain.
Why is there such an intensive process for a securities trade in the first place, though? As a quick reminder from Part 1, all of the different systems, parties, and organizations involved in the current trading scheme exist primarily for two reasons:
1. There is no guarantee of fulfillment (credit) between two trading entities. One party exchanges cash, and one party exchanges equity — but how does either know the other will follow through?
2. There is no single, shared record of financial transactions (ledger). Each system and bank uses their own record and must continually check with all the others’ to make sure they match. Consequently, there is no proof of credit between institutions since they use their own private ledger.
With blockchain’s single, public ledger, both of these issues disappear. The balance of any individual investor, trader, or organization is publicly available to any participating system. As such, smart contracts (outlined below) are automatically able to verify proof of credit (via reference to the public ledger).
The Trade Lifecycle (with Blockchain)
The Pre-Trade Phase
As things were before, there must be a buyer looking to acquire a security and a seller looking to liquidate their security for a trade to occur. To increase the probability of a successful transaction, any blockchain exchange must therefore have significant volume. While the technology here is extremely promising, the number of traders on the exchange will undoubtedly be its limiting factor.
With regards to price discovery, a blockchain exchange will almost certianly be an order driven market (a.k.a. a continuous auction market) where prices are determined transparently (and algorithmically) by all the orders sent to the market. Buyers and sellers will be able to sell directly to eachother through a smart contract, which could function as the broker, the order matching service, and the clearinghouse.
A smart contract is essentially an algorithm on the blockchain that automatically executes when its conditions are met. In the case of the trade, these conditions could be:
1) if Seller A actually owns Security A
2) if Buyer A has sufficient credit to purchase Security A
3) if the price of Security A is within specified buy/sell limits for Seller A and Buyer A.
The Trade Phase — No More Brokers
With smart contracts and blockchain, there’s no need for a broker to place the order on an exchange. A decentralized app (DAPP) would essentially house the smart contract and function as the internet-equivalent of a website on the blockchain. (Smart contract = post a photo, DAPP = Instagram, blockchain = server). Thus, the exchange would technically be a DAPP with various smart contracts and algorithms to match and settle trades.
A trader looking to execute an order would log into the DAPP (which would look like any normal trading website), place their order, and have it matched with the complementary buy/sell order via an algorithm. No more broker fees.
The Post-Trade Phase — A Thing of the Past
After the trade is executed and matched, instead of passing that information onto a clearinghouse, the smart contract would automatically settle the trade and transfer the funds/securities between the two parties. It’s that simple—no need for the NSCC, DTC, or settlement banks. It doesn’t matter if the two trading parties trust eachother or have good credit history—the blockchain’s public ledger and the DAPP’s smart contracts circumnavigate these roadblocks.
Without countless auxiliary organizations functioning behind the scenes to minimize credit risk, trades are not only settled faster, but also cheaper. There’s no need for a broker to execute the trades, there’s no need for a separate entity to match the orders, and there’s no need for a clearinghouse to act as the central counterparty in the exchange. Trades made on a blockchain exchange would be settled on a T+0 basis and would only be subject to the gas price (mining fee) of the network.
Additionally, with one public ledger the chance of two organizations or banks having different accounts of the same event disappears. A blockchain exchange really is that much simpler. So, what’s the downside?
Shortcomings
With all it’s promise, there’s still a few key problems that need to be resolved before blockchain becomes the backbone of future exchanges.
- A User-friendly Blockchain Experience
The current blockchain ecosystem, with its unfamiliar lingo, scammy reputation, and technological barrier to entry (explain a public key and why you need a wallet to an average internet user) stymies the potential user-base it could enjoy. Blockchain needs its consumer internet moment.
2. A Critical Mass of Users
As discussed in the pre-trade phase, without a large volume of users the probability of a successful trade is significantly reduced. This decreases the overall liquidity of the exchange, diminishing investor’s confidence in their ability to exit the market exactly when they want to. Blockchain needs a sustainable, high-growth DAPP to keep users engaged and committed to the ecosystem.
3. Transaction Speed
The Ethereum blockchain can currently handle around 15 transactions per second. Bitcoin, around 4 transactions per second. Visa, around 50,000 transactions per second. Blockchain has a long way to go before it can be practically used at scale, but it’s on its way. The popular DAPP Cryptokitties reached a critical mass of users only to have the Ethereum network freeze up (because of the overwhelming traffic from cryptokitty trades), ultimately causing the demise of the Cryptokitties platform. Furthermore, the relatively slow transaction speed of blockchain would increase the implicit costs of potential trades due to timing and loss of price advantage. While trades would still be settled on a T+0 basis (compared to current exchanges T+2 basis), there would be a greater chance of price fluctuations by the time the transaction settled. Blockchain needs more transactions per second to qualm developers’ doubts over both its ability to scale and its ability to handle their platform’s anticipated usage.
Conclusion
Blockchain can undoubtedly replace and improve the backend of today’s exchanges. Even with its unproven history, the elimination of broker fees, NSCC fees, DTC fees, and bank fees is all too promising. With a user-friendly DAPP, sustainable distribution, and blockchain’s inevitably increasing transaction speed, DIFEI could have an exciting home on the blockchain.
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