Should stock exchanges be worried about blockchain?

As of mid 2017, the total market capitalisation of the world’s stock markets was around US$76.3 trillion. By country, the largest market was the United States (about 34%), followed by Japan (about 6%) and the United Kingdom (about 6%). There are currently around 60 stock exchanges globally.

Traditional stock markets are centralized, expensive and have limited transparency. Currently stock market traders, brokers, and regulators have to go through an inefficient process which can often take three days or more for a transaction to complete. This is mainly due to the role of intermediaries, operational trade clearance, and regulatory processes.

Whilst many exchanges were initially sceptical about the value of blockchain and wary of its potential to decimate existing centralized exchanges some stock exchanges are actively investigating the way they can use this technology including Nasdaq (U.S.A.), The London Stock Exchange (U.K.) and The Australian Securities Exchange (Australia), to name a few.

The major stock exchanges are investigating ways to use distributed ledger technology to overhaul the mechanisms behind their exchanges and produce more streamlined and efficient systems. Managing a stock exchange currently involves frantic and cumbersome processes which take significant time to execute, are costly and are inherently risky. The processes are multi-layered with pre-trade, post-trade and custody. Securities servicing is very complex. There is a strong case for experimenting with blockchain and distributed ledger technology as there is great scope to streamline the process.

Using blockchain technology, stock exchanges could run with no need for a centralized settlement. Smart contracts can be used to ensure the rules and regulations are built in to the technology eliminating the need for third parties. This is certain to make the process cheaper, faster and more secure. An exchange based on blockchain can have characteristics that monitor and report illegitimate network access built in. All users would have complete records of all transactions making this new type of exchange vastly more transparent than our current stock markets. The technology will permeate into all aspects of stock exchanges including clearing, settlement and other post trade processes.

From the businesses point of view, blockchain technology represents an innovative way to raise finance, using initial coin offerings as a cheap and efficient alternative to traditional IPOs. Blockchain has proven itself to be a superior alternative to listing on a stock exchange for lots of reasons. Reasons include the facility to offer more features to its token holders, shorter time spans to get established, increased trading speed, the ability to offer utility tokens rather than just security tokens and much more.  

Companies can utilize blockchain technology to create tokens in-house. These tokens have a smart contract embedded, which are designed to perform specific functions. These functions can grant permissions to users, drive promotions or allow holders to exchange features amongst other things. This makes the tokens much more applicable than traditional stocks on stock exchanges, It also helps increase engagement with investors and token holders.

The timescales of setting up a token on a blockchain can be measured in days (excluding the ICO and the marketing process). For a traditional stock exchange, the timescale is significantly longer. Not only is the setup time reduced, but the speed of trading on blockchain is getting closer to instantaneous eliminating speed limitations.

Despite all of the obvious advantages of using blockchain technology it does have its disadvantages. The case for using blockchain is not as straightforward as it is in other markets. A major concern of some classes of investors is the increased transparency. Under most proposed trading systems, the position of participants in the market will be exposed to the public as traders will be able to be identified. This would put many large and institutional investors at a disadvantage. Super, managed and hedge funds typically sell a large position gradually over a prolonged period of time. During this process it is essential that the process is not noticed by other traders who may wish to take advantage of large scale sales. Due to the transparency of the blockchain this type of selling could not be effectively applied. This potentially could see investors leaving these exchanges in search of less transparent markets to trade in dark pools.  

In the first quarter of 2018 ICOs raised $6.3 billion USD in funding exceeding the total amount of funding raised throughout 2016. The cumulative all-time funding received by ICOs has exceeded $20 billion USD. In 2017 traditional IPOs in the United States raised approximately $36 billion. ICOs seem set to usurp IPOs as the primary method of raising capital. Stock markets may find themselves increasingly irrelevant as investors move to these new platforms. However, migrating the existing $76 trillion of traditional stocks to new platforms will pose significant issues. Whilst traditional stock markets are working on their own blockchain propositions and will be seeking to migrate their existing listings to their new platforms, they will face the prospect of companies choosing to delist and relist on new platforms. The barriers to doing so will be significantly reduced.

Traditional stock exchanges are not the only parties interested in utilizing blockchain in capital markets and developing decentralised stock exchanges. tZero (a subsidiary of Overstock) are attempting to develop a security token trading system that complies with all applicable securities laws and regulations. If they succeed in doing so this will place them in direct competition with many of the world’s stock markets. The tZero team have made it clear that it is their intention to eliminate stock markets and oversee the eventual transfer of value of all the words stocks and shares transferred on to their new platform. How traditional stock markets compete against such a proposition is unclear. What we do know is that the existing exchanges will not go down without a fight and governments will naturally be reluctant to approve such a potentially disruptive and as yet unproven technology.


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