Blockchain is one of the hottest topics in financial industry nowadays. 2015 was the year of high expectations about how blockchain could proliferate beyond bitcoins, 2016 has been emerging as a year of expectations that at least some of the ideas expressed before would transform from PowerPoint files into proofs-of-concept, prototypes and (who knows?) even killer apps

Blockchain is one of the hottest topics in financial industry nowadays. 2015 was the year of high expectations about how blockchain could proliferate beyond bitcoins, 2016 has been emerging as a year of expectations that at least some of the ideas expressed before would transform from PowerPoint files into proofs-of-concept, prototypes and (who knows?) even killer apps.

Interest in blockchain seems to be inspired primarily by anticipated benefits (from those who may say that understand them) and by concerns that blockchain could, as hoped by others, revolutionize (disrupt) existing market structures or, as recently attributed by Dan DeFrancesco, by FOMO (Fear of Missing Out).

This brief note is organized as a collection of several straightforward statements open to criticism, and is one more attempt to guess how blockchain might be disruptive for ‘traditional markets’.

1. Breaking down ‘traditional markets’

‘Traditional markets’ here are existing markets for public instruments and with ‘central authorities’ – primarily, exchanges’² for trading, CCPs for clearing, CSDs for settlement. By contrast, ‘non-traditional markets’ are existing or potential markets for ‘private’ instruments – public equity, other securities not traded on public markets, loans, etc.

Non-traditional markets are likely the most probable area where bitcoin-style ecosystems could be developed and the only financial space where blockchain prototypes have been already announced – Nasdaq Linq for public equity, Symbiont ‘smart securities’ (initially intended for corporate debt, syndicated loans, securitized instruments and private equity), Overstock for private bonds and Digital Assets for ‘capital investment’ of Pivit®³.

The border line between ‘traditional’ and ‘non-traditional’ markets is not impenetrable, e.g. when central authorities provide non-core (or ‘other’ as in Table 1) services like the above-mentioned Nasdaq Linq.

2. Breaking down ‘blockchains’

2.1. Public blockchains

Everything (or almost everything) that is known about blockchain has come from it’s implementation for bitcoins, is successful to some degree.

Historically, blockchain is a distributed ledger realized as an encrypted chain of transaction blocks (hence blockchain) verified in the course of ‘permissionless proof-of-work’ or mining.

More generally, such public blockchains pave the way to P2P ecosystems, i.e.:

• systems without intermediaries like brokers, custodians and central authorities;
• self-sufficient systems with rules and procedures embedded into and with no (or little) references to external provisions.

At the same time, public blockchains are not as P2P as may appear at first glance. Users (‘peers’) interact with each other not directly but via some system designed and developed by somebody comparable, by it’s overall influence, to central authorities (but with no, or at least with less, responsibility).

2.2. Private blockchains

For reasons mentioned briefly below, the advantages of making central authorities completely redundant are not absolutely obvious. So, the idea has come to somehow merge central authorities with blockchains, thus creating ‘private blockchains’ where ‘blockchain’ is truncated to ‘just another kind of distributed database’ allowing ‘data infrastructure without physical presence’ (quote from Preston Byrne).Private blockchains differ from public blockchains mainly in that:

• private blockchains are explicitly organized by some central authority (with explicit rules and responsibilities);
• users of a private blockchain are not ‘peer’ to the central authority, the latter may have exclusive rights of rulemaking, or access to full (e.g. non-anonymized) data, or doing some procedures (e.g. default management), etc.;
• consensus about block validity in private blockchains is achieved usually (though, maybe not necessarily) via ‘permissioned proof-of-stake’ when ‘stakes’ are determined by (or under the rules of) the central authority. Such ‘forging’ instead of burdensome mining may decrease costs and significantly improve speed and other performance metrics.

In extreme cases, central authorities may withhold stakes, leaving itself as a sole verifying body (‘fully private networks’). Actually, why not – if central authority is trusted enough to be ‘super-peer’, then why is it not valid for running and verifying a ledger?

Private blockchains are deemed to inherit the benefits of public ones (though the final answer to the question ‘how are these benefits possible in the absence of permissionless mining’ seems yet to be given), first of all:

• data integrity:
  • uniformity: each user or subscriber will get the same golden source of data;
  • resilience and prevention of data loss or damage;
  • immutability;
• origination from transactions, traceability and potentials for individualization (coloring) of basically fungible instruments (‘tokens’);
• data enrichment, e.g. for creation of auto-executable ‘smart contracts’.

2.3. Hybrid blockchains

There also may be a ‘hybrid’ intended e.g. for smoother interoperability between central authorities by providing common distributed ledgers and/or integrating their ledgers (e.g. as ‘sidechains’).

Similar to public blockchains, hybrid ones are basically P2P for central authorities (but with radically less top-tier peers), similar to private blockchains they (1) may rely on mutual trust between top-tier peers and may not require permissionless mining (in this sense they may be called ‘consortium blockchains’), and (2) may also include second-tier users (members of central authorities).

3. Breaking down ‘disruption’

Traditional markets (in the general sense) may be disrupted across two layers:

• ‘P2P disruption’, i.e. full or substantial disintermediation when central authorities are substituted with P2P interactions;
• ‘non-P2P disruption’ when centralized models remain as principle, but business processes within central authorities change radically. This may be harmful or even crucial for incumbent institutions who will not able to address new challenges.

4. Mapping blockchain models to disruption layers

4.1.Public blockchains and P2P disruption

By definition, the only blockchain model which might cause P2P disruption is the public blockchain if it appears to be achievable in traditional markets. But, as seems to be recognized more and more, this is not very likely to happen.

To support this skepticism, some general observations and (anti-) cases are provided below (see Table 1).

4.1.1.Some general observations in favor of centralized services

First of all, not all centralized services, which are to be made due to P2P disruption, are really bad and/or outdated. As has been stated in the recent DTCC white paper, the benefits of such services for most modern financial markets ‘present a high bar that distributed ledger technology must improve upon’. There is still substantial value-adding in centralized services, e.g.:

• specialization of dedicated institutions improves quality of services and reduces operational costs and risks;
• liquidity concentration, netting, etc. contribute to larger cost and risk reductions through economies of scale and scope;
• central authorities are important (self-) regulatory bodies responsible for market ruling and surveillance.

It is sometimes said that one of the advantages of public blockchains over centralized models is that there is no ‘single point of failure’ (e.g. see in Euroclear/Oliver Wyman ‘Utopia’). But even if this is true, it also may mean no single (or none at all) point of claim if something goes wrong since blockchain, like any other technology, is hardly 100% bulletproof. So, one more example of value-adding by central authorities is that they arrange dispute procedures and take responsibility – up to wasting their capital.

Secondly, modern financial markets are not very consistent with a P2P framework (e.g. legal monopoly for CSDs).

Thirdly, it is sure that public blockchains have been neither intended, nor designed for purposes of external use, especially in traditional markets – problems of latency, anonymity, settlement finality, etc. are often named as something to be addressed to make native blockchains viable here.

4.1.2.(Anti-) Case 1: Trading

Distributed ledger here may mean an order book, a list of transactions (executed orders), or even a list of settled transactions if trading is to be merged with settlement (see Table 1) verified for compliance with some rules of order submission and matching. Since such a concept is deemed to be not quite consistent with permissionless mining (e.g. for latency reasons), solutions to walk away are proposed (like permissioned proof-of-stake) which may actually mean change to non-public blockchains.

But even if distributed ledger is implemented into trading, it would not automatically push out exchanges from traditional markets because order and trade processing are not the only value-adding centralized services. Exchanges are also involved in listing and contract design, liquidity promotion (e.g. via market-makers), (self-)regulation and so on. Further unnecessity of these activities seems to be far from being proved, so who will be responsible for them in P2P trading (if and when it happens) is also far from being clear.

4.1.3. (Anti-) Case 2: Settlement

Distributed ledger here may mean a list of settled transactions verified for availability of necessary assets to prevent their ‘double spending’ (in bitcoin terminology). To make this concept workable, finality supported by blockchain should be upgraded to the legally required level of certainty.

An inspiring idea is to merge settlement with trading to achieve ‘instant settlement’. However, implications of this idea should be thoroughly assessed. To mitigate credit and systemic risk, exposures are to be properly collateralized at the moment when the trade is made (not after – because trade happens simultaneously with settlement) or even at the moment when the order is submitted. In other words, instant settlement requires real-time risk management including pre-order validation that is not the common model now, except in the Russian market (Moex) where it is a paradigmal approach.

Anyway, blockchain-driven settlement (if and when achieved) doesn’t immediately imply that there will be no space for CSDs anymore. Asset transfers (settlement in it’s practical sense) are not the only activity of CSDs who also get a legal monopoly for record keeping and notary services. To hand over P2P interactions to them may presume substantial rethinking of legal framework in general.

4.1.4. (Anti-) Case 3: CCP clearing

Clearing is, probably, the most disputable area for P2P disruption. Distributed ledger here may mean a list of obligations ready for settlement verified, as in the case of blockchain for settlement (see Table 1), for availability of necessary assets. If availability is confirmed, this list is to be forwarded to the CSD for execution, else embedded default management procedures have to be invoked to reshape the list of obligations for it’s final integrity. If such a concept is implemented, CCPs are foreseen to be replaced with ‘decentralized clearing networks’ (quote from Massimo Morini and Robert Sams).

This way of development, though theoretically thinkable, leaves open some important questions about clearing without a CCP, e.g.:

• How to achieve multilateral netting and make it legally binding?
• Is embedded risk and default management , with all potential risks and actions preliminary assessed and coded, a viable and realistic model?

Not a rare point of view is that blockchains, if and when implemented into centralized clearing, would not disintermediate it but, instead, lead to some ‘non-disruptive’ enhancements.

4.2. Private/hybrid blockchains and non-P2P disruption

Non-public blockchains could bring significant enhancements to traditional markets without undermining niche for central authorities in general. To make this happen it is necessary (1) to identify and prove use cases where the idea of distributed ledger would be more attractive than current business practices, and (2) to make sure that blockchain technologies (e.g. permissioned verification, sidechains) are valid and helpful for such cases.

Though all major central authorities have disclosed their intentions to explore applicability of blockchains to their core day-to-day activities, no particular use case seems to be revealed at the moment with a high degree of confidence.

Without prejudging possible future outcomes, some high-level guesses are presented in Table 1 where blockchains are broken into different models (as described above) and each of them is assessed for applicability to, separately, trading, clearing, settlement and other (non-core) activities of central authorities.

Basic assumptions for such guesses are as follows:

• use cases for private blockchains might take place where there exists (1) a sufficient level of trust to central authorities and (2)the interest of central authorities to provide users with golden sources of data thorough blockchain-based distributed ledgers;
• use cases for hybrid blockchains might take place where there is room for interoperability between central authorities.

So, hype, enhancement, or disruption?

The general answer seems to be that blockchains in traditional markets may be all of these:

• as a way to P2P ecosystems with no space for central authorities, public blockchains are, if not a hype, not very realistic in the world as we know it (another question is how long such a world will continue to exist);
• if certain conditions are met, non-public blockchains might bring significant enhancements to traditional markets;
• however, even if such enhancements are likely to leave intact the principal role of central authorities, this doesn’t give a lifetime guarantee for any particular incumbent institution and may be pretty disruptive to those who will fail to implement new technologies if they appear to be successful.

At least one good thing about blockchain is already known – it has already provoked revision of customary business processes to better adjust them to rapidly evolving competitive and technological environments. What will the results of this revision be and will blockchain be the technology to lay behind changes are other questions for further elaborations.

References:

1. Views expressed in the notes are the author’s opinion and should not be perceived as an official position of the Moscow Exchange.
2. ‘Exchanges’ are taken here in a broad sense covering any ‘organized’ marketplaces or trading venues.
3. Though no specific features of blockchain design in these prototypes have been publicly disclosed, some indirect indications vote for relating them more to ‘private’ blockchains rather than to ‘public’ ones.

This article was first published in edition 6 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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