Part of a thought-leadership series by Aaro Capital
Digital securities are traded within a distributed ledger but represent assets that exist in the real world. In this post, we examine whether they can disrupt financial markets by offering a more efficient way of processing trades.
A digital security, also known as a security token, is issued, safeguarded and traded within a distributed ledger, or more specifically a blockchain. However, it is designed to represent an asset that exists outside the blockchain, and therefore complies with existing legal frameworks. Examples of such connected assets are equity stakes in companies, debt, and units in an investment fund.
On the surface, digital securities combine the advantages of two worlds. On the one hand, there is frictionless and decentralised trading within a blockchain. On the other hand, digital securities can in principle represent any type of asset and are connected with the real world, unlike cryptocurrencies which are not. Can this new blockchain technology influence the way we trade, issue and safeguard real world assets? Will the incumbents that operate the various financial markets respond by adopting Distributed Ledger Technology (DLT), or will they just digitise the assets, using their existing, centralised database architecture?
To answer these questions, we need to first disambiguate the differences between three different settings. The first setting comprises traditional securities, traded within standard financial markets. The second setting consists of cryptocurrencies or tokens that are traded within a blockchain but have no direct connection to the outside world. Finally, the third setting comprises digital securities that are traded within a blockchain and are directly linked to assets which exist outside of the blockchain.
Trading Traditional Securities
Figure 1: Traditional Securities Trading Infrastructure
Traditional securities are traded in local markets and for limited hours. They are also heavily regulated by local jurisdictions. When a trade takes place, multiple counterparties and intermediaries are involved, such as investors, brokers, custodians and the exchange. They are not only involved in the execution of the trade, but also in clearing, settlement, compliance and depositing. Although some parts of this process have become digitised, others have not. This often means it can take several days until a trade is settled. More importantly, each counterparty in a trade has a different ledger that records their own version of reality, i.e. the trades which have taken place and the money transfers. These ledgers need to be reconciled frequently, which is resource intensive, especially when a trade falls through.
Figure 2: Reconciliation Process between Entities in a Trade
Trading Tokens and Cryptocurrencies
Figure 3: Decentralised Exchange with No Intermediaries
The second setting is on the other extreme in terms of speed and absence of frictions. The market for decentralised cryptocurrency trading is global and operates 24/7. There are no intermediaries and settlement is instant, all done via smart contracts. Moreover, regulation is very limited and there is one ledger, so there is no issue of reconciliation between different databases. All participants trade in a trustless and decentralised environment, knowing that their transaction history is immutable.
Can this be the future of financial markets? The answer is no, at least in the short term. There are several reasons. First, cryptocurrency trading is very limited as compared to the volume of trading for all assets, so it is not clear how fast the technology can scale, at least without sacrificing part of its decentralised nature. In the report “An Introduction to Distributed Ledger Technology”, we analyse the scalability trilemma, which specifies that it is very difficult (if not impossible) for a distributed ledger to simultaneously achieve scalability, decentralisation and safety.1 Second, decentralised exchanges must be pre-funded, so that the seller owns it and the buyer is not borrowing money to fund their purchase. This allows for real-time settlement of trades, minimising the scope for errors and intermediaries who deal with clearing, settlement, compliance and depositing.
A Hybrid System for Digital Securities
All these characteristics minimise the need for regulation. However, this is not the case if digital securities are traded, because they need to comply with the existing rules that apply to the assets that they represent. Moreover, if trades are not pre-funded, as it is usually the case, then settlement cannot be instant and there is a need for intermediaries who deal with the post-trade clearing and compliance. Under these conditions, is there scope for blockchain technology, and DLT more generally, to disrupt financial markets, by enabling a more efficient marketplace with digital securities, as compared to standard markets with traditional securities? This is possible, as long as we can use blockchain to clear some of the bottlenecks that occur in traditional trading.
Archax, a digital securities exchange regulated by the FCA, provides an interesting thesis.2 One of the main bottlenecks in standard markets with traditional securities are created not because there are several intermediaries, but because these intermediaries have their own databases, or data silos, that need to be constantly reconciled with each other, creating delays and errors, hence the need for multiple checks and regulation. More fundamentally, intermediaries do not trust each other enough, in order to entrust their data and the maintenance of a unique database to a single central authority.
Figure 4: Securities Trading Infrastructure with Blockchain
This is the bottleneck that blockchain technology can help resolve. By providing a permissioned ledger, each counterparty can have full control of its own data. They can then give or revoke read/write permissions to other participants. Because the ledger is unique, there is only one version of the history of transactions, hence there is no need for reconciliation or the incompatibility problem of different database architectures. By having a permissioned ledger, only some counterparties can participate in the trade, by verifying their identity. This decreases decentralisation, which means that scalability and safety can increase without any bounds.
Digital securities are traded within a blockchain but represent assets that exist in the real world. Can they disrupt financial markets and the way we process trades? It seems that that they can, by creating a hybrid system that combines the benefits of blockchain technology with the inevitable presence of intermediaries and the regulatory requirements of traditional markets. The intermediaries that provide post-trade functions are still present, however they are able to communicate better and quicker, within a permissioned ledger, doing away with the need to maintain and update multiple databases, which are often incompatible with each other.