The idea of building stock exchanges, registries and CSDs on the blockchain is far from new. Indeed the Australian exchange operators invested US$170m in its attempt to migrate the CHESS trading and settlement system to a blockchain based approach, only to throw the towel in after many years of valiant – but ultimately fruitless – effort. It’s a question that we at Avenir Registrars have debated with clients and pondered internally on many occasions, but after due consideration we believe that some core aspects of traditional securities markets cannot benefit from distributed ledgers owing to three key factors – namely Technology, Trust, and Price. At least for now.
Breaking this down further, the primary technology challenge faced by those who see a blockchain based future is that such approaches cannot live in a vacuum. If every financial system was based on an indelible distributed ledger then we would be facing a different dilemma, but a register built on the blockchain would still have to coexist with other conventional systems such as a broker or settlement interface. That co-dependence on other systems creates issues for blockchain “transaction finality” where legacy systems may be reversible yet the blockchain isn’t. Transactions being reversed due to a patent error is a challenge that a distributed ledger, by definition, can’t accommodate. What’s more, efficient sub-processes such as aggregated clearing and settlement at the broker level would also need to be migrated onto the block chain – these processes are largely hidden but a fundamental part of running an efficient market in today’s world.
Next up is the concept of trust. 100 years ago, the London Stock Exchange truly enshrined it with the enigmatic motto “my word is my bond” and this social construct still sits at the heart of markets today. A blockchain doesn’t remove the need for trust or to trust human institutions. Distributed ledgers are after all still built on verification and trust, but it is faceless and without the reputational risk of an individual being ostracised for bad behaviour. This is the fallibility of blockchain, as it’s far harder to discredit lines of code. They don’t tend to take offence, whereas trust and respect are hard-wired into the human psyche. The idea that blockchains can somehow eliminate the need for trust persists, but it’s a weak argument.
And finally we have the real challenge presented by the cost or price of running the blockchain. The sheer volume of securities in circulation globally multiplied by the number of transactions conducted on a daily basis – with a disproportionate skew coming from ultra high frequency traders – creates a challenge of unimaginable scale. The consensus algorithm required to support a distributed ledger is extremely expensive, both in data storage and in the energy required to maintain it. This environmental cost of running blockchains is making its way up the agenda, accelerated by the next generation of market participants who are ever more aware of the fragility of our planet. And the accompanying costs here – not just in terms of the power required to run these systems but also the implications of mitigating any harmful outputs – means it’s important to remember that the blockchain isn’t free. Indeed the costs are far more opaque, bucking the trend of moving towards transparent pricing, something that has underpinned so much market evolution in recent years.
Can we say that the securities market will never adopt distributed ledger technology? Absolutely not. But the idea that now is the time seems somewhat removed from reality. Processing costs – and the accompanying environmental impacts – need to plummet and genuine system accountability needs to become an ingrained concept. But perhaps the biggest single challenge of them all is a collective willing to hand off irrevocable trust to a machine, when the current market infrastructure works and is being increasing digitised in any case. At least for the current generation dominating market participation, seemingly going against the adage, ‘if it ain’t broke, don’t fix it’ and taking a leap of faith into an entirely new system, will be the biggest hurdle of them all.
An amended version of this article originally appeared in the October 2023 version of AIM Journal. You can download a printable version here.