Friday 5 February 2021 9:43 am

Blockchain will bring trust back into capital markets

If recent events have revealed anything, it’s that trust in the traditional financial infrastructure powering our global capital markets has been eroding – especially among retail investors.

The GameStop (GME) short-squeeze¹, driven by individuals who came together online, is a testament to what can happen when power is pushed to the edges. Huge volumes, unexpected buying pressure, and the impact of a handful of market participants showed how brokerage and post-trade processing capabilities can quickly be pushed to the brink.

While the financial world is still reeling from these events, the key message for every capital market participant is that critical parts of our infrastructure need future-proofing.

As it happens, there is already a financial market infrastructure revolution long in the making that lends itself perfectly to the principles of transparency and trust – blockchain. Here we explore why blockchain can provide the core infrastructure required to reimagine the broker-side and post-trade landscape in capital markets.

Delivering trust through blockchain

When Robinhood adjusted user’s margin requirements on GME², some saw it as an affront to retail investors. But was this reaction driven by an incomplete picture of what was truly going on behind the scenes?

We now know that the real issue which forced Robinhood to set higher margin requirements on certain positions was the intensity of trading activity. This overloaded the capacity of multiple actors across the buying, selling, and settlement process. In turn, this led to a backlog of settlement requests and subsequent liquidity issues for clearing houses. Naturally, the public backlash from these liquidity issues was felt most heavily by the first cog in the machine—the brokerages.

Instead, had post-trade processing been carried out via a permissionless blockchain ledger, it could have been possible for individual market participants to identify these bottlenecks in the settlement process on-chain. This could potentially have offset some of the focus on brokers, giving market participants a more complete view of the settlement process—and a true perspective of where market inefficiencies were.

On the other side of the equation, brokerages would not simply have to rely on good faith to prove their intentions or validate their decision-making to their customers. Instead, the entire process would be transparent, provable, and auditable on the blockchain.

Big Four professional services firm PwC agrees that blockchain could be used in this way to provide a shared and trusted ledger of asset information³. This would cut operational complexity and provide a single verified source of truth.

As transactions on a blockchain must achieve consensus from multiple decentralized nodes in order to be verified, the process becomes ‘trustless’. In other words, participants no longer need to trust in the veracity of information from another market actor.

As a result, implementing a decentralized ledger of asset trading history could be instrumental in maintaining information parity between retail traders and institutions, providing trust where it’s needed most.

Not only could blockchain introduce greater transparency to both brokerages, clearing houses, and market participants; but it could also assist in the speed, efficiency, and visibility of the clearing and settlement process itself.

Clearing houses, often existing unseen in the background of day-to-day trading, are currently the de facto actors in post-trade capital markets processing. Like any institution, clearing houses serve a vital purpose, but they have their limitations.

But blockchain could transform post-trade processing in a number of ways. Decentralized ledgers could disintermediate clearing houses by providing a single on-chain confirmation of asset flows and transfers. Alternatively, blockchain could assist existing clearing houses in automating their back-end processes, streamlining their communication with brokerages and those maintaining share registries.

In turn, this would allow real-time flows of both assets and information, reducing the likelihood that a clearing house runs into liquidity issues in times of volatility. As a result, trust could be maintained and enhanced across capital markets.

Intricacy leads to inefficiency

Placing an order with a broker is where most average users’ journey with capital markets starts and ends. But the entire process from purchase to settlement is highly intricate, with many behind the scenes processes taking place unbeknownst to retail investors. Blockchain could add a layer of transparency to this process for the average user, while simultaneously providing better back-end infrastructure for institutions.

For example, multiple intermediaries participate in the post-trade and settlement process. Each entity must maintain its own data silos to track asset flows, duplicating data between every participant. Each actor must also trust that they have been sent the correct information from the intermediary before them.

This leads to reconciliation errors and a reliance on a central system of record. It can also cause delays to settlement, and a greater expenditure of both time, human hours and capital across all participants. It’s also the key barrier to instant settlement of assets and capital across borders, despite the technology existing to facilitate instantaneous asset settlement.

The complex nature of the post-trade processing funnel can introduce a bottleneck to business-as-normal for our capital markets. In turn, this has slowly eroded trust in capital markets, and their infrastructure, from its participants.

The remedy to restore trust? Deploy blockchain

Having been formerly embedded within the traditional capital markets infrastructure through my role in banking, my move into blockchain technology was timely given the current conversations around maintaining investor’s trust. It was this need for trust and transparency in our capital market infrastructure which inspired me to explore alternative technologies.

Ultimately, this led me to blockchain, and more specifically to Cardano. The Cardano blockchain already had a blueprint for transparency and trust. This emerged through its highly-decentralized blockchain protocol, and its focus on pushing power to the edges of its community.

Just a few months after joining the Cardano Foundation, we now stand at a critical juncture for the entire financial world. Triggered by the events of 2020 – and powered by a new vision for 2021 and beyond – capital markets infrastructure, blockchain, and the need for open and equitable financial instruments are colliding. Where we take them, and how we shape the future, is now in our hands.

For Cardano, that future is now. Our next major milestone, the Mary hardfork, will welcome the arrival of native token forging, paving the way for on-chain decentralized financial (DeFi) infrastructure.

As we see it, the first recipients of trustworthy capital market infrastructure will be in emerging economies. Blockchain is poised for more rapid adoption where traditional infrastructure is yet to become incumbent or has failed local communities. 

In capital markets, this may include tokenized real-world assets traded on peer-to-peer marketplaces. It could also be used to provide access to decentralized identity solutions that empower previously unbanked individuals to take part in the global financial ecosystem.

So, what does this mean for Cardano and the wider blockchain industry? Firstly, the maturity of blockchain technology has converged almost perfectly with a growing need for greater trust in capital markets. The rise of DeFi has also proven that we can move real-world value and assets securely and efficiently using blockchain.

Now that the technology is in place, we can focus on integrating blockchain solutions into our existing capital market infrastructure, and delivering decentralized solutions to emerging markets where demand for trusted trading infrastructure is high.

References: 

  1. https://www.bloomberg.com/opinion/articles/2021-01-30/gamestop-gme-short-squeeze-who-will-surrender-first
  1. https://www.barrons.com/articles/robinhood-blocks-buying-in-gamestop-amc-and-other-stocks-51611844496
  1. https://www.pwc.co.uk/financial-services/fintech/assets/blockchain-in-capital-markets.pdf

Frederik Gregaard, CEO of the Cardano Foundation, founded in 2016 in Switzerland, represented in more than 20 locations worldwide. www.CardanoFoundation.org

The above is the author’s opinion and does not constitute financial advice.

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