What is the future of exchanges?

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Why have digital asset exchanges found it difficult to disrupt traditional exchanges?

Many domestic exchanges are monopolies, so they are intrinsically hard to disrupt. A blockchain-based order book does not offer a sufficient improvement over a traditional order book. Exchanges are also often owned by their users, which want lower prices at least as much as fatter dividends. In such cases, digital asset exchanges are better advised to focus on post-trade services, with a view to cutting the operational costs and risks incurred by users rather than seeking to disrupt issuance and trading. 

What strategies should traditional exchanges pursue? 

Experience has shown that it makes no sense to replicate a traditional stock exchange on blockchain, and offer issuers and traders a choice of issuing, trading, settling and custodying digital assets in much the same way as they issue, trade, settle and custody traditional assets. Investment in new technology must either make an incremental improvement to the existing system or redesign the functions performed by an existing system completely. This does not mean traditional exchanges face a binary choice. Their investments should aim to bridge the gap between digital assets and conventional securities. For example, enabling traditional clients to issue digital assets or trade cryptocurrency on a secure blockchain, and cryptocurrency investors to custody digital assets in a traditional central securities depository (CSD), allows both existing and prospective clients to experiment with established techniques as well as new ones. Once momentum builds and volumes appear to favour a transition to digital assets, traditional exchanges can reinforce their investments and build an infrastructure to support a wholesale shift of business. An obvious axis of growth in the back office is to offer settlement of digital as well as traditional assets in central bank money.

Must traditional exchanges overcome internal opposition to investing in digital assets?

An established institution, in which people have worked for a long time, will struggle to develop a culture of innovation. Yet the management knows they cannot expect technological developments and market conditions to favour their existing systems, products and services indefinitely. This is why major financial institutions invest in start-ups and partner with digital asset companies. The investments bring external skills and knowledge into the organisation, which do influence corporate cultures. They also expose the company to innovations that might be profitable. But public companies must be mindful of the share price, and ensure the shareholders support the management strategy.

Is it easier to launch a digital asset exchange now than it was five years ago?

The exchanges – both traditional and digital asset – that pioneered the construction of security token exchanges faced two principal constraints. First, they worked with earlier versions of the blockchain protocols, which affected design decisions, and favoured private rather than public blockchains. Now digital asset exchanges can use public blockchains, combine matching, trading, settlement and custody within a single entity, and offer settlement not just atomically but on any timetable the parties choose. Secondly, the pioneers had to invest despite a high degree of regulatory uncertainty. Now, legal and regulatory uncertainty has abated in enough major jurisdictions, including at least two in the European Union (EU), to enable businesses to plan with confidence. That said, regulatory differences between jurisdictions do remain a disincentive to investment by digital asset exchanges. The United Kingdom regulators do not approve the use of Stablecoins to settle the cash leg of transactions, for example. The Swiss blockchain legislation, to take another example, is now less progressive than the EU equivalent. Yet the need, under the Central Securities Depositories Regulation (CSDR), for securities tokens in the European Union (EU) to be issued into a central securities depository (CSD) remains problematic - at least outside the DLT Pilot Regime sandbox, where waivers and exemptions allow issued securities to be registered on a public blockchain. Lack of harmonised regulatory frameworks for digital assets across Europe, Asia, the Middle East and North America are likely to remain a serious obstacle to the growth of digital asset markets, but the problem is much reduced by comparison with five years ago.

How will digital asset exchanges interact with central securities depositories (CSDs) in the future?

It is difficult for incumbent CSDs, which not only fulfil crucial depository and settlement (and sometimes clearing) roles in traditional markets but operate under regulatory mandates, to embrace change wholeheartedly without putting vital market functions at risk. In addition, their users, which often double as owners, have digital asset strategies of their own which CSDs must be careful not to disrupt. A CSD cannot, for example, build a digital asset exchange, but a digital asset exchange can build a CSD. What CSDs can do is build the operational market infrastructure which enables their users to support the digital asset activities of their underlying clients in a fully compliant way. That work includes making it easier for users of one digital asset exchange to inter-operate with counterparts on different digital asset exchanges. This course is obviously easier to pursue in the United States (which has a single CSD) than in the EU (which has more than 30 CSDs).

What is the attitude of European regulators towards the role of CSDs in tokenised markets?

In the short term, CSDs in the EU will operate within a dual regime. Inside the DLT Pilot Regime, issuers of tokens on to digital asset exchanges will not need to issue into a CSD. Outside the Pilot Regime, they will continue to be obliged to issue into a CSD. This dual system will not persist indefinitely, because the crucial role of a CSD is not the maintenance of the integrity of an issue, which can be done more efficiently by blockchain. The crucial role is to achieve settlement finality or legal certainty, enforceable in the courts, that the ownership of an asset has been transferred. This is as important to digital assets as it is to traditional assets, but blockchain currently delivers only probabilistic finality, not the legally irreversible finality defined in the Settlement Finality Directive of the EU.  Until security tokens are genuinely native and do not exist outside the blockchain, and European law is fully adapted to blockchain technology, settlement finality will remain the preserve of CSDs. So incumbent European CSDs are, by definition, unable to deliver settlement finality for digital assets, even if a digital asset exchange is a regulated entity.  The DLT Pilot Regime does not envisage successful experiments with alternative models supplanting the CSDs either but, rather, integrating with them. This is why digital asset exchanges have had to develop their own solutions, including building their own digital CSDs. 

Should European CSDs consolidate in the face of the blockchain challenge?

Europe has more than 30 CSDs. Efforts to consolidate them at the turn of the century, accompanied by an animated debate on the respective merits of “vertical” integration with domestic stock exchanges or “horizontal” integration across borders, were only partially successful. Vertically integrated stock exchanges that incorporate CSDs have inhibited further consolidation. However, even those exchanges that have evolved away from primary and secondary market revenues must recognise that the history of financial markets proves that technology can move market participants and the liquidity they bring from one location to another quickly if the financial incentives are powerful enough. The exchange-traded derivatives markets, which were completely overturned by the switch from open outcry to screen-based trading at the turn of the century, provide a particularly vivid instance of this phenomenon. Since blockchain represents a similar technological paradigm shift, prudent exchanges will be working out how best to coax traditional instruments into the era of digital assets, by working with issuers, intermediaries, investors, regulators and legislators to design an efficient transition and a supportive legal and regulatory environment. But blockchain presents even independent CSDs with a long-term structural challenge in the sense that the decentralised nature of the technology undermines the role of CSDs as centralised depositories of issued securities, settlers and recorders of transactions and registrars of who owns what. By building a blockchain market infrastructure a CSD inevitably diminishes its value as the operator of a regulated market infrastructure in a particular location. However, the role of CSDs as controllers of data on blockchains might even increase. National CSDs might survive in Europe not in their current guise of post-trade operational monopolies but as guardians of the integrity of data held on blockchains.

What does the history of traditional stock exchanges teach about the impact of technology?

Internet technology has already transformed traditional stock exchanges. At the turn of the century, traditional stock exchanges generated most of their revenue from listing and trading securities. It was profitable business. At the time, the major stock exchanges of Europe all enjoyed operating margins of more than 50 per cent. Such high levels of profitability encouraged regulators to increase competition. Regulation National Market System (Reg NMS) in the United States in 2005 and the first iteration of the Markets in Financial Instruments Directive (MiFID 1) in the EU in 2007 gave rise to all sorts of alternative trading venues, fragmenting liquidity, and squeezing margins. Some traditional exchanges adapted by increasing their exposure to post-trade services and data vending, where they have restored healthy margins, while exchanges that persisted with traditional business have continued to see their margins squeezed. Indeed, some traditional exchanges were eventually acquired by newcomers that understood better the impact of Internet technology and digitised data. Today, the London Stock Exchange makes more money out of data than it does out of listing or trading. None of these adaptations surprised the audience, which believes that the privatisation of equity, the disruption of established markets by new trading platforms and increased asset class specialisation by challenger exchanges empowered by new technology explain the shift by traditional exchanges into data and post-trade services. They record a history that proves digital technology has the power to disrupt incumbent exchanges. Indeed, blockchain technology is already fostering a new breed of specialist token exchanges, focused not just on cryptocurrencies but on corporate bonds, real estate, Real-World Assets (RWAs) and carbon credits. These new exchanges pose a familiar question (to what extent is liquidity fragmenting and, if so, how can it be consolidated again?)  and force traditional exchanges to ask once again what, if anything, they should do in response. But the lessons of the history are clear. First, they suggest that the exchanges that survive, let alone thrive, will have lower costs, the ability to offer their users access to every asset class, excellent collection and publication of price and other information and the ability to distribute a wide variety of both digital assets and traditional financial instruments. Secondly, history shows that law and regulation ultimately determine where issuers and investors gather to do international business. Many exchanges will always dominate their domestic market, but only a handful will enjoy the legal and regulatory strength and stability to win cross-border business.

Is there an opportunity for an emerging market to leapfrog the established financial markets by building a public blockchain market infrastructure? 

The idea of a common or unified blockchain ledger, which provides interoperability by design because all asset classes (including cash) conform to the same technical standards, has been advanced or endorsed in different ways by the Regulated Liability Network (RLN), the International Monetary Fund (IMF) and the Bank for International Settlements (BIS). The governments of several countries, including Abu Dhabi, Ghana, Kazakhstan and Saudi Arabia, have embraced the idea of blockchain-powered cities or government machines. The opportunity to gain a technological head-start is sometimes likened to countries without legacy telecommunications infrastructures leapfrogging developed economies by switching straight to wireless communications. In the case of digital asset exchanges, a country could skip the order book phase of the transition to digital assets and adopt native assets issued on to and traded on a public blockchain immediately. However, translating theory into practice will take time and money. The opportunity is created by the absence of legacy, but the absence of legacy also means that liquidity must be conjured out of nothing.

Would a public blockchain infrastructure create an unacceptable risk in terms of operational resilience?

There are two views on this. One is that a government and financial and real economy entirely reliant on blockchain technology would be intrinsically resilient, in the sense that blockchain is a distributed database, in which every node has a complete copy of the current state of the machine (or ledger). The other view is that a government and financial and real economy reliant on blockchain to issue and trade and settle money and securities would be vulnerable to catastrophic failure if the government defaulted on its debts. After a default, it would be impossible to pay or get paid, or value assets, because the transition of the machine (or ledger) from one state to another would be fatally undermined and become chaotic.

What will the successful stock exchange of the future look like?

The audience had a clear view of what will determine success for the exchanges of the future. Two out of three members of the audience said the future is hybrid. In other words, the stock exchange of the future will host both traditional and digital assets. The second most popular choice – that stock exchanges will provide public or common blockchain platforms for apps designed and operated by third parties - attracted just one in six votes. Virtually nobody thought stock exchanges will disappear altogether and be replaced by peer-to-peer trading. The strategic choice made by some traditional stock exchanges over the last 20 years – namely, to become data vendors – is no longer seen as relevant. Nor, contrary to the advice proffered by some analysts of exchanges, did the audience believe exchanges have a secure future as manufacturers and distributors of investment products.

How long will it take to transition from the status quo to liquid digital asset markets?

Digital asset exchanges exist. They have secured operating licences from regulators. They have hosted issues of tokenised funds, securities, real estate and commodities.  They have attracted investors. They all believe that securities will be held on public blockchains in the future. But no digital asset exchange has yet achieved scale and day-to-day liquidity within and across asset classes. Which suggests the transition period will be extended. In parts of the capital markets, blockchain technology will not be embedded for a long time.  Yet the industry is possibly at an inflection point. The digital asset exchanges that exist are less intermediated than the exchanges of the past. Retail investors can connect to them directly. So can corporates, giving them the power to execute treasury functions such as payments, cash management, short-term credit, collateral management and foreign exchange in tokenised forms. Stablecoins and tokenised money market funds are already being used by corporates to make payments and earn yield. Exchanges are also less specialised in terms of functions they perform. They fulfil multiple roles – issuance, trading, matching, settlement, custody, asset servicing – that imbue them with the character of comprehensive financial market infrastructures rather than specialist exchanges. This broader remit is a function of the distributed ledger nature of blockchain technology and may over time precipitate a faster pace of change by eliminating costly intermediary functions. For now, however, digital asset exchanges are working with intermediaries such as brokers because they are a source of clients and liquidity. They are also working with cryptocurrency firms and exchanges, and DeFi applications, to build bridges between the three basic types of financial asset: traditional money market instruments and securities, security and fund tokens and cryptocurrencies. The bridges broaden access for assets and investors. A traditional custodian bank or CSD, for example, can now offer an existing traditional market client access to cryptocurrencies through their existing securities account. In the end, the transition is not between states but through convergence.