What traditional stock exchanges need to do now

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Over the near 20 years that have elapsed since Reg NMS and MiFID 1 overturned the traditional model of securities listing and trading, stock exchanges have had to cope not only with the fragmentation of liquidity but with the increasing power of digital technology and the digitised data it can consume, process and distribute. With the emergence of tokenised assets issued on to blockchain networks, the forces of technology and data have combined to present exchanges with the greatest threat-cum-opportunity they have ever faced. Looking at the European landscape, Massimo Butti, former Head of Equities at SDX, points to where the real opportunity lies.

The stock exchange business model, which was traditionally geared to transactional activity, has undergone significant transformation since the days of the first demutualisations in the 1990s and early 2000s. Major exchange groups in Europe have diversified vertically.  Their revenue streams are now less dependent on Initial Public Offerings (IPOs), listings, and transactional activities on “lit” markets that advertise their best bid and offer prices. 

The importance of data to the changing business model of traditional stock exchanges

Revenues are now more dependent on data, data analytics, benchmark indices, and pre- and post-trade services. This has significantly broadened the scope of exchange operations. Exchanges, which once focused solely on raising capital and facilitating trades, now offer a plethora of products that include rapid price discovery and execution, risk management, regulatory reporting, investment services, custody and clearing. The benefits for customers include substantially enhanced capital efficiency and regulatory compliance.

But data has become the most significant revenue driver for exchanges. The London Stock Exchange Group (LSEG), for example, is capitalising on the demand for data analytics and benchmark indices. It has boosted its data revenues through the acquisition of FTSE International Limited in 2011, Yield Book in 2017 and Refinitiv in 2021.  Likewise, Deutsche Börse bought out the SIX Group share in STOXX in August 2015, adding it to its existing DAX products and amalgamating both with the analytical capabilities of Axioma in 2019. In 2022 the German exchange added the Kneip fund data business in Luxembourg and in 2023 the Danish asset management software company SimCorp, with the aim of using its client base to distribute data and data analytics products. 

Data sales are expected to continue to grow for exchanges for the foreseeable future, despite recurrent buy-side complaints about the high cost of purchasing data their transactional activities have helped to create. While exchanges face competition from independent data vendors such as Bloomberg, FactSet, MSCI and S&P Global, revenues will remain healthy, driven by the demand from algo traders and artificial intelligence (AI) and machine learning (ML) trading models that consume vast amounts of data and by the index providers supporting passive investment products. Environmental, Social and Governance (ESG) investment strategies are also creating a new demand for high-quality, curated data.  The appetite for fixed income data, which was previously patchy and hard to obtain, is also increasing.

The attractions of post-trade clearing and settlement services

Post-trade services are the other principal new source of growth for exchanges. Exchanges are responding to buy- and sell-side demand for tools to manage counterparty risk and optimise capital usage following the introduction of regulatory requirements aimed at moving Over the Counter (OTC) derivatives transactions to centralised clearing through Central Counterparty Clearing Houses (CCPs). 

LSEG has gradually increased its majority stake in LCH, the London-based CCP for equities, fixed income, commodities, foreign exchange, repo and swaps, to 82.6 per cent. Deutsche Börse has controlled the Eurex derivatives exchange and its Eurex Clearing CCP since 2012. The 2020 purchase by pan-European share trading platform Cboe Global Markets of EuroCCP (now Cboe Clear Europe) from its four shareholders - Euronext, Nasdaq, ABN Amro and The Depository Trust & Clearing Corporation (DTCC) - was a further sign of the importance of clearing revenues to exchange groups. 

The shortening of settlement cycles is also increasing awareness among market participants of the risks and costs (in terms of fines and buy-ins) of failing to settle transactions on time. Europe moved to settlement on trade date plus two days (T+2) in 2014 and, following the switch in the United States to settlement on trade date plus one day (T+1) in May 2024, is now on course for a T+1 or even T+0 timetable. This is creating opportunities for exchanges that own central securities depositories (CSDs) to reassure buy- and sell-side firms that the risks can be managed.   

Though LSEG had to sell Monte Titoli, the Italian CSD, as part of the terms for acquiring Refinitiv, the exchange continues to settle FX trades. Deutsche Börse, which has owned Clearstream, which controls the German CSD as well as the Luxembourg-based Clearstream international CSD (ICSD), since 2002, now earns nearly a third of net revenues from securities services. These encompass not just settlement and custody of securities, but sophisticated services designed to increase the efficiency of cash and capital usage through collateral mobilisation and management. 

The shifts away from listing and trading to data and post-trade services are reflected in the revenue mix of exchanges. At LSEG, the Data and Analytics segment revenues in 2023 accounted for 66 per cent of total revenues and the Post Trade segment for 15 per cent.  Capital Markets, including the FXAll and TradeWeb platforms that came with the Refinitiv acquisition, accounted for only 19 per cent of total revenues. Likewise, Deutsche Börse reported a 32 per cent year-on-year increase in their data and analytics business in 2023 and a 35 per cent surge in securities services, while cash equity trading declined by 15 per cent. Even at Euronext, which still derives nearly half its revenues (48 per cent) from trading and listing, the combined revenues from data and post-trade are growing and reached 40 per cent of the total in 2023.

The dangers for exchanges that cling to the models of the past

The strategic direction of LSEG, Deutsche Börse and Euronext looks smart by comparison with those exchanges that have not managed to pivot into more lucrative services and continue to depend on transactional revenues for their survival. For them, the landscape promises to fragment further. Operators of “lit” markets face competition from “dark pools,” Multilateral Trading Facilities (MTFs), Organised Trading Facilities (OTFs) and – following the passage of the second iteration of the Markets in Financial Instruments Directive (MiFID II) - the emergence of Systematic Internalisers (SIs) as well. Infinitely scalable algorithms, smart order routers, and the wide availability of hyper low-latency markets has made High-Frequency Trading (HFT) volume less sticky, increasing competition between exchanges for volume and compressing their margins across asset classes and products. 

The spike in primary markets activity - the bread-and-butter business of traditional exchanges and the main pillar of their capital-raising franchises - witnessed in 2020-21 has not sustained itself. Instead, IPOs have settled back into a volatile pattern, with many companies opting to stay private for longer or, in certain cases, even de-listing to escape rising regulatory compliance and governance costs and to take advantage of a private equity industry flush with funds. Moreover, local and regional exchanges in Europe and other parts of the world have seen reduced revenue not just from IPOs and listings but in secondary market activity, due to aggressive marketing by American and Asian venues, which are luring companies outside their home markets and capturing a disproportionate share of listing activity.

Tokenisation: Is it an opportunity or a threat?

So, what is the way forward for exchanges that have not managed to adapt their business model to the changed environment, lack either a viable data business or post-trade capabilities, and continue to rely primarily on transaction revenues that not only fluctuate in line with trading volumes and competition from other regions but are experiencing increasingly compressed margins?

Tokenisation is one opportunity they can exploit. The future is still open to the establishment of a competitive edge in this new area of financial market infrastructure. The winner will be the organisation that can better adapt to evolving market demands, including the largely untapped potential for tokenisation of securities, funds and other assets, and the probable convergence of Decentralised Finance (DeFi) as a whole with Traditional Finance (TradFi). 

The issuance of tokenised assets on to blockchain networks has already created several challengers to traditional stock exchanges, ranging from cryptocurrency exchanges to specialist security and fund token venues. Although they are still small and largely unregulated, these venues have the potential to compete with incumbents by offering easier access to both mainstream and alternative asset classes in innovative ways. They are already spawning entire ecosystems around specific types of tokens and developing new models of liquidity. 

While it is true that a perceived lack of regulatory clarity is not conducive to the launch of large scale blockchain initiatives by financial market infrastructures (FMIs) of any kind in Europe – it is no longer true to say that regulatory uncertainty is a barrier to entry. In the European Union (EU), the Markets in Crypto-Assets Regulation (MiCAR) is coming into force in the second half of 2024. 

Although work is still necessary to decide if a particular token is governed by MiCAR or not, the Regulation provides a considerable degree of regulatory certainty over cryptocurrencies and Stablecoins. From December 2024 Crypto-Assets Service Providers (CASPs) can be authorised to provide services as regulated enterprises. The EU securities regulator, the European Securities and Markets Authority (ESMA), has also launched a Distributed Ledger Technology (DLT) Pilot Regime to provide a “sandbox” for FMIs to experiment in the provision of token trading, clearing, settlement and custody services.   While it is true that no authorisation has been granted yet, ESMA has received applications from four FMIs that are likely to compete with incumbent FMIs for a share of the tokenised asset markets.

More progressive traditional exchanges in Europe such as SIX Group have long since recognised the disruptive potential of blockchain and have outpaced competitors by launching Swiss Digital Exchange (SDX), which offers fully regulated issuance, trading and settlement services to issuers and investors active in tokenised securities. SDX is collaborating closely with both regulators and members to modernise the Swiss marketplace, expanding into Asia with a local partner (AsiaNext) and helping clients invest in cryptocurrency derivatives as well as security tokens. 

In addition, SDX provides a hedge for sell-side incumbents against the possibility of disintermediation because its digital asset offerings can be integrated easily into the current market infrastructure while offering the additional benefit  of atomic settlement (in which one leg of a transaction settles only if the other leg settles simultaneously)  in wholesale central bank digital currency (wCBDC). Project Helvetia, in which SIX works with the Swiss National Bank (SNB) and the Bank for International Settlements (BIS) Innovation Hub to explore how tokenised assets can be settled on a blockchain in central bank money, has already passed through three phases and was in June 2024 extended for a further two years. This could pave the way for a major upgrade of the Swiss bond issuance and repo market infrastructure and eventually precipitate a shift into a full blockchain architecture that supports atomic settlement of bonds and repo in wCBDC.

The SDX cryptocurrency staking service, on the other hand, offers institutional clients that hold cryptocurrencies easy access to a new source of revenue. While cryptocurrencies remain a small market (the total market capitalisation was just US$2.13 trillion in August 2024(1)) by comparison with the traditional global equity (US$115.02 trillion at end-2023(2)), debt capital (US$140.7 trillion) and mutual fund (US$74.56 trillion in Q1 2024(3)) markets, they do provide useful experience of DeFi and will help forward-looking exchanges manage the convergence with traditional capital markets. 

This convergence play is clearly evident in another Swiss initiative: Rulematch, a spot cryptocurrency trading venue for financial institutions. It uses the same technology and matching engine as traditional exchanges, replicating the same market structure with a central order book and identical rules. Similarly, Deutsche Börse has launched a regulated spot platform for cryptocurrencies, Deutsche Börse Digital Exchange (DBDX), on which they will develop a complete cryptocurrency ecosystem and value chain for institutional trading, settlement, and custody. 

The settlement and custody services are provided to DBDX by another Deutsche Börse acquisition, Crypto Finance, which is a provider of trading, custody and investment services for cryptocurrencies. Based originally in Switzerland, where it is regulated by the Financial Market Supervisory Authority (FINMA), Deutsche Börse acquired the company in December 2021. The DBDX-Crypto Finance combination can be expected over time to develop into the provision of services to the security and fund token markets. 

Ultimately, the potential of digital assets is as large as the existing securities and funds markets. However, the long-term impact of tokenisation, especially on traditional central limit order book (CLOB) revenues, remains uncertain. 

In the United Kingdom, LSEG announced in September 2024 the intention to use blockchain to build an end-to-end digital market ecosystem to raise and transfer capital across asset classes. However, the service might be available to professional counterparts only. The truth is that, thanks to the increased efficiency of equity trading since the passage of 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 Europe in 2007, tokenisation is highly unlikely to disrupt blue-chip equity activity on CLOBs. 

However, tokenisation could have a more significant impact on the less liquid – even illiquid - corporate bond markets and the seemingly ever-expanding universe of Exchange Traded Funds (ETFs) and other Exchange Traded Products (ETPs). The news in May 2024 that Tradeweb Markets, the fixed income trading platform owned by LSEG, was working with a blockchain technology vendor founded by former PIMCO employees that has experience of using blockchain in the fixed income markets (Alphahedger) and had invested in the tokenisation engine provider Securitize, is a further indication that tokenisation may have effects in the bond markets earlier than in the equity markets. 

In continental Europe, exchanges have identified post-trade services as the most promising area for the application of blockchain, notably in the funds industry. In 2023, the Luxembourg-based FundsDLT blockchain-based transfer agency service developed by the Luxembourg Stock Exchange was acquired by Deutsche Börse and folded into the Clearstream Funds Services order routing service while also offering full digitisation of security issuance through their D7 service. Clearstream rival Euroclear, which owns the FundSettle mutual fund order-routing platform, in July 2023 acquired Goji, which specialises in private market funds.  Though these CSD services increase transparency and transferability of assets it is not yet clear how they can attract sufficient order flow and develop liquidity to support CLOB markets.  

Are private assets the real tokenisation opportunity?

With a few notable exceptions, the opportunities in conventional equity, debt and fund markets all involve leveraging blockchain technology to enhance or re-platform existing exchange processes. Many of these are already in need of upgrades. But, while these improvements will doubtless yield benefits through more streamlined interfaces and shorter settlement windows, they are likely to fall short of fully harnessing the transformational potential that blockchain offers to FMIs.

The challenges of managing the transition to blockchain-based markets will be complex but not insurmountable. In exploiting the opportunities, exchanges must ensure that the economic incentives of the various participants in the eco-system are aligned. Users of exchange services, especially on behalf of clients, will naturally be sensitive to any suggestion that exchanges threaten them with disintermediation. To maintain their support, exchanges will have to convince clients that their role remains infrastructural rather than client-facing. 

Secondly, exchanges must ensure that the various systems deployed are interoperable and that integration is as seamless as possible, not just between legacy systems and blockchain systems, or between tokenised asset markets and traditional equity, fixed income and fund markets, but across the pre-trade, trade and post-trade functions as well. 

Operating across tokenised as well as traditional markets will present exchanges with unfamiliar challenges. The centralised liquidity pools of a traditional stock exchange operate in a different way from the decentralised liquidity pools of the tokenised future. Mastering the differences is complicated by the fact that traditional markets are highly regulated, while the regulation of tokenised markets is still developing. 

Which is why many believe that the best long-term opportunity - for exchanges lies in using blockchain to capture privately managed assets. Private markets could be viewed as a “green field” opportunity for exchanges to bring their expertise in managing highly standardised markets to the fragmented reality of private assets. 

Though made up of multiple asset classes – real estate, private credit, private equity, infrastructure and alternative assets – private markets are large (McKinsey put private markets assets under management at end-June 2023 at US$13.1 trillion)(4).  But they are also fragmented and, thanks to a lack of infrastructure, suffer from scalability and liquidity shortcomings.

According to BCG, the market for tokenised private assets could grow to US$16 trillion by 2030, (5) representing 10 per cent of global Gross Domestic Product (GDP). Yet they may not be a particularly attractive opportunity for exchanges. Privately managed assets are inherently illiquid and do not trade frequently. The lack of transparent valuations and efficient price discovery mechanisms, extended ownership chains and complex regulatory compliance obligations all contribute to this illiquidity. Superficially, exchanges ought to be sceptical about an asset class that generates few transactions, and which will struggle to develop economies of scale through trading frequency and volume.

However, the opportunity can be viewed from another perspective. The best chance in privately managed assets might lie not in generating revenue from a high volume of secondary market transactions and distribution to new classes of investor but in using blockchain to create a new ecosystem that solves some of the problems holding back their democratisation. Effective integration with existing financial infrastructure, creating complete interoperability and fungibility with traditional assets, would be the most profitable long-term objective. But, using tokenisation to provide clear ownership chains and help managers of the assets to meet increasingly onerous regulatory and governance demands, could be a useful bridgehead that can be expanded over time. 

A prime example of what an exchange could do to seize this opportunity is the development of a service that orchestrates, standardises and simplifies the private equity fund value chain. Although tried and tested, the traditional Limited Partner (LP) structure for investors is highly intermediated and (as a result) expensive, creating a bias to selling large lots to small groups of large institutional investors. 

Blockchain could transform the operational efficiency of interactions between fund managers and LPs (notably capital calls) and so reduce costs. This in turn would allow fund managers to lower fund ticket sizes and widen their distribution to include less wealthy and less institutional classes of investor. Programmable capital drawdowns using blockchain technology would make it economic for funds to sell lots for as little as US$1,000 without any increase in the costs of registration and records – indeed, it would facilitate a decrease in such costs. Token exchanges have in fact already succeeded in reducing fund ticket sizes to these levels.

Provisions that require the consent of partners for unit transfers could be coded into smart contracts and automated.  In effect, shares in privately managed funds would enjoy the same benefits as investors in securities already enjoy when securities are issued into a CSD, which not only maintains the integrity of the issue but also records subsequent changes of ownership. 

The General Partners (GPs) would have access to a continually updated cap[italisation] table, as well as access to a range of investors which might subscribe capital to the fund at a lower price. LP structures would benefit for the first time from operational standardisation, shorter settlement cycles, immutability of records and increased transparency. These benefits would widen distribution to qualified investors as well improving the possibility of creating secondary market liquidity on a regular basis. 

Exchanges could in effect mutualise the cost of the development of such ecosystems for privately managed assets, supporting product-specific smart contracts such as the ERC3643 token standard. ERC 3643 is an Open-Source set of smart contracts that facilitate the issuance, management and trading of tokens, including through built-in digital identity capabilities that militate against mis-selling. Smart contracts of this kind which decentralise and automate investor due diligence checks, can overcome a major bottleneck in the on-boarding of investors to private equity funds. 

One benefit of exchanges entering the private markets is that it would help to bridge the gap between private and public markets and between TradFi and DeFi. By making use of blockchain technology, it would also familiarise participants in traditional markets with its capabilities. Other opportunities to make use of blockchain will disclose themselves over time; indeed, some are evident already. 

Exchanges could, for example, validate transactions across different venues on behalf of investors for a small fee, helping to mutualise costs and maintain margins by acting as outsourced service providers. Exchanges could also offer Know Your Customer (KYC) and Know Your Asset (KYA) and Know Your Token (KYT) services, vetting investor participation in specific funds, markets or transactions, reducing mis-selling risk, and conducting due diligence on digital assets before their placement with investors.

Lastly, exchanges can treat blockchain as an extension of the technology-based services which many of them engage in already. They can provide token issuance services, asset immobilisation services between public and private blockchains, white-listing of exchanges and counterparts, and provision of programmable composite assets to enhance liquidity and achieve settlement finality. 

All these services could be turned by exchanges into chargeable service packages. However, this would require exchanges to a switch from a model based on transaction fees to a service or subscription-based model. This remains unusual but is not unknown (the Aquis Exchange, for example, has a subscription-based trading model in which the marginal cost of trades falls in line with increased volume). 

The role of regulation

This transition would be accelerated by confidence in the regulatory constraints. Regulation is of course a factor that exchanges cannot control, though it is one that they can influence in the direction of being clear, consistent and straightforward to comply with. Compliance will need to be built into the services that exchanges provide, in particular to ensure that, while novel products are developed for the mass market and access to high-yielding asset classes is democratised, investments always remain suitable for particular investors. 

If they cannot control regulation, exchanges can control the governance of their trading, clearing and settlement platforms. Governance structures need to be robust, and this robustness must be especially of true of exchanges that operate both public blockchain networks and private permissioned blockchain networks, or which interact with blockchain networks owned and operated by others. 

It can even be argued that exchanges will need to choose between the public and the private, and not attempt to straddle the divide as this might prove costly and land exchanges with sets of  hard-to-sell services that do not address client pain points. The oft-cited “public permissioned” model - in which a service is open to anybody but ultimately accessible only by a sub-set of approved entities is simple to describe, especially by analogy with the Internet, but might easily descend into  a regulatory compliance nightmare.

Conclusion

In developed capital markets, the traditional stock exchange model of hosting transactions between buyers and sellers has been challenged ever since Reg NMS was promulgated in the United States in 2005 and MiFID 1 was introduced in Europe in  2007.  These twin measures fragmented centralised liquidity. 

Major exchanges have responded by integrating vertically with post-trade services and increasing data revenues, which now significantly outweigh listing and transaction fees as a source of revenue. The remaining strategic question for them is tokenisation. The limited interest shown by traditional exchanges in tokenisation to date is likely prudent, since it is unlikely to disrupt the currently efficient model of equity issuance and trading. 

This suggests that the greater impact of tokenisation will be felt in the bond and fund markets. Developments in these markets will not leave exchanges undisturbed, but they are not an existential threat. Instead, the threat-cum-opportunity where exchanges must respond lies in privately managed and alternative assets. Here, by applying blockchain, they can provide centralised support services that would help to solve longstanding issues of liquidity and scalability in private markets, while helping stakeholders to shift from a culture based on transaction fees towards a subscription-for-services revenue model. 

This in turn represents a generational opportunity for exchanges that still rely heavily on the old transactionally intense paradigm (in which revenues depend on listing and trading fees) to use blockchain to innovate and close the gap with incumbents who have managed to diversify their services in post-trade services and data provision. 

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(1) https://coinmarketcap.com/

(2) SIFMA, 2024 Capital Markets Fact Book, July 2024.

(3) Investment Company Institute, Worldwide Regulated Open-End Fund Assets and Flows, First Quarter 2024.

(4) McKinsey Global Private Markets Review 2024: Private markets in a slower era, 28 2024.

(5) BCG, Relevance of on-chain asset tokenization in ‘crypto winter’, May 2022.