Traditional exchanges are in danger of missing the point about tokenisation

Download the book

A quarter of a century ago exchanges were threatened by a technological revolution. The combination of increased computer storage and processing power, plus the Internet, threatened brokers with disintermediation and traditional exchanges with extinction. 

The highly intermediated open outcry futures markets, unable to compete on cost with electronic trading, were early victims.

Exchanges are facing their second revolution in a quarter of a century

Electronic trading came to the telephone-based bond markets from 1998, with the launch of Tradeweb.  Equity markets were slower, and dependent on regulatory initiatives. The introduction of Reg NMS in the United States in 2005 and the Markets in Financial Instruments Directive (MiFID) in Europe in 2007 spawned dozens of alternative trading venues. 

The rapid success of Chi-X Europe, created in anticipation of MiFID, still symbolises the immensity of the changes. Within just three years of launch, it had garnered a fifth of all European equities’ trades by the simple device of competing on price.

With electronic trading, and especially with the growing availability of information (including price information) in digital form, the idea of an “exchange” came to seem infinitely extensible. 

In the first decade of the 21st century, platforms emerged to enable investors to trade in energy, carbon emissions and the weather, to bet on sports results and to engage in spread-betting (in other words, to gamble on whether the price of an asset will rise or fall). Whether these were “exchanges” or not mattered only to pedants.

But technology did more than question definitions. It did more even than extend activity and divert it from trading floors and telephone networks to computer screens. It exposed exchanges, most of which were originally mutually owned non-profits, for what they then were: high volume, low margin utility businesses. 

By lowering the cost of entry, technology made it easier for new entrants to compete with exchanges in some or all of the services that exchanges once monopolised. Chi-X Europe proved that was the case, and the traditional stock exchanges absorbed the lesson.

Traditional exchanges are still living with the consequences of that first revolution

As the content of this inaugural edition of the Future of Finance Digital Asset Exchange Guide (DAEG) confirms, traditional exchanges are still engaged in a long retreat from their beginnings in volume-dependent, low margin trading activities.

As part of that process, exchanges have taken a growing interest in post-trade activities. This was predictable, given that a clear winner from the turmoil at the turn of the century was central counterparty clearing houses (CCPs). 

These offered market participants measurable benefits in the netting of trades and the more efficient mobilisation and management of collateral to support them. CCPs have since extended their reach into equities, bonds, foreign exchange and (with a push from the regulators) OTC derivatives such as interest rate and currency swaps.

Naturally, questions of integration arose. Should every exchange have its own CCP or should trades on some or all exchanges pass through a common clearing house? This prompted other integration conundrums. Should cash markets merge with derivatives markets? Should exchanges also own the central securities depositories (CSDs) that settle trades?  Should integration be vertical (trading, clearing and settlement in a single entity) or horizontal (trading, clearing and settlement provided by separate entities)?

Market developments have delivered more than one answer to these questions over the last 25 years. Exchanges, CCPs and CSDs have merged, sometimes vertically and sometimes horizontally.  

Technology-induced change tends to be like that: untidy, though never chaotic. Which is why the events of the turn of the century remain relevant today. Exchanges are once again facing the threats and the opportunities created by another technological change – namely, the third iteration of the Internet, or Web 3.0.

What Web 3.0 means for traditional exchanges

 Web 3.0 is a catch-all term for moving the Internet from its Babylonian captivity by large, closed and centralised technology companies to open, decentralised, peer-to-peer networks. 

What Web 3.0 means for exchanges is adapting to capital markets characterised by the issuance, trading and servicing of tokens on blockchain networks between digital wallets controlled by individual investors identified by digital identities. 

Importantly, the tokens must be “native.” If tokenisation is restricted to “asset-backed” tokens or “digital twins” – in other words, the underlying equity or bond or other assets continues to exist in its original form – its potential to disrupt incumbent exchanges will be limited. 

But if issuance and trading of financial assets take place on blockchain networks in “native” form only, traditional exchanges will find their occupation is going and then gone. 

Despite the existential nature of this threat, a consensus has developed at exchanges in favour of an incremental approach, of which the chief component is a blockchain-based infrastructure for privately managed assets. 

As the cover story in this Guide explains, it is an understandable reaction to the tokenisation challenge, since it staunches a source of lost business and fits with what exchanges are doing already in other ways. But it ignores an important aspect of the promise of Web 3.0 – the restoration of the retail investor. 

Some neo-exchanges are alive to this issue. They have focused on hosting tokenised private equity funds and reducing the minimum subscription amount to levels - the lowest Future of Finance has identified is US$1,000 – that retail investors can afford. 

It makes use of a feature of token technology (fractionalisation) and appeals to asset managers (who widen their distribution) but it still leaves a great deal of intermediation in place between the assets and the investors, which is a contradiction of the promise of Web 3.0.

The future of stock exchanges might be retail, not institutional

But the greatest risk for exchanges of a limited approach is not a lack of technical purity. It is ignoring a generational change. 

There is a reason Millennials and Gen Z are big buyers of cryptocurrencies rather than equities, bonds and mutual funds. The current infrastructure for traditional financial assets does not appeal to or work for younger investors. 

Those younger investors have also noticed the half-hearted efforts of traditional exchanges to embrace blockchain, tokenisation and Web 3.0. They use other organisations, which are more committed. 

The most respectable cryptocurrency exchange, Coinbase, did not exist 12 years ago. But in 2023 it had 105 million registered users, of which eight million transact at least once a month. 

The company is worth US$50 billion, which is the same as the 223-year-old London Stock Exchange Group and greater than Deutsche Börse AG. Coinbase has infrastructure, value and above all scale, and among retail consumers too. 

So the question posed by Ruben Lee in a seminal study of what was happening to exchanges at the turn of the 20th century - namely, “What is an exchange?”(1) – is being posed once again, and in an acute and urgent form, by the blockchain-based networks that host cryptocurrencies and security and fund tokens. 

Of the five coin and token platforms interviewed in this Guide, only two are certain that they can even be properly described as “exchanges.”

Yet all of them are engaged in one or more of the activities that any informed observer would regard as intrinsic to an exchange: raising capital in a primary market or setting a price for capital in a secondary market. 

This is true of every neo-exchange in the cryptocurrency or security token or fund token market. Yet these exchanges have also extended the idea of what an exchange can be and do. 

Coinbase has enabled retail investors to buy and sell cryptocurrencies and utility tokens (it lists 392) but it also offers its users custody, yield-enhancing staking and lending services, and even banking services such as cash management and the provision of credit. 

Decentralised exchanges (DEXes) such as Uniswap may be more ascetic, but they too offer peer-to-peer marketplaces for retail holders of cryptocurrencies. 

It is always hard to make sense of what is going on when events are still unfolding. In this case, it is made doubly hard by the need to believe that the future of finance is being scripted in the troubled cryptocurrency and Decentralised Finance (DeFi) markets, rather than by the adaptation to technological change of the traditional financial services industry. 

The subject of our book review in this issue makes a spirited case for “crypto” as still the true source of innovation. If she is right, that will reinforce the fear of some traditional exchanges, but also the complacency of others. Either way, I hope our efforts in this Guide illuminate at least a part of the world that is struggling to be born. 

---

(1) Ruben Lee, What is an Exchange? The Automation, Management, and Regulation of Financial Markets, Oxford University Press, 1998.