If recent events have revealed anything, trust in the traditional financial infrastructure that powers our global capital markets has waned – especially among retail investors.
The GameStop (GME) short squeeze¹, run by people who have come together online, is evidence of what can happen when power is marginalized. Huge volumes, unexpected buying pressures, and the impact of a handful of market participants demonstrated how brokerage and post-trade processing functions can be quickly marginalized.
While the financial world is still affected by these events, the key message for any capital market participant is that critical parts of our infrastructure must be future-proof.
It just so happens that there is already a revolution in financial market infrastructure that lends itself perfectly to the principles of transparency and trust – blockchain. Here we examine why blockchain can provide the core infrastructure needed to redefine the broker side and post-trade landscape in capital markets.
Building trust through blockchain
When Robinhood adjusted users’ margin requirements for GME², some saw this as an insult to retail investors. But was that response due to an incomplete picture of what was really going on behind the scenes?
We now know that the real problem that forced Robinhood to place higher margin requirements on certain positions was the intensity of trading activity. This overloaded the capacity of several actors during the buying, selling and settlement process. This in turn led to a backlog of settlement requests and subsequent liquidity problems at clearing houses. Of course, the public backlash due to these liquidity problems was felt most strongly from the first cog in the machine – the brokers.
If the post-trade processing had instead been carried out via a blockchain ledger without permission, individual market participants would have been able to identify these bottlenecks in the settlement process in the chain. This could potentially have offset some of the focus on brokers and given market participants a broader view of the settlement process – and a real perspective on where market inefficiencies lay.
On the flip side, brokers wouldn’t simply have to rely on good faith to prove their intentions or to confirm their decisions to their clients. Instead, the entire process in the blockchain would be transparent, verifiable and verifiable.
PwC, a Big Four professional services company, agrees that blockchain could be used in this way to provide a shared and trusted ledger of asset information³. This would reduce operational complexity and provide a single verified source of truth.
Since transactions in a blockchain have to achieve consensus from several decentralized nodes in order to be verified, the process becomes “trustworthy”. In other words, participants no longer have to rely on the accuracy of information from another market player.
As a result, implementing a decentralized general ledger of the history of asset trading could help maintain information parity between retailers and institutions and build trust where it is needed most.
Blockchain could not only bring more transparency to brokers, clearing houses and market participants. But it could also contribute to the speed, efficiency and visibility of the clearing and settlement process itself.
Clearinghouses, which are often not seen in the background of daily trading, are currently de facto the actors in the post-trading processing of the capital markets. Like any institution, clearinghouses serve an important purpose, but they have their limitations.
However, blockchain could transform post-trade processing in a number of ways. Decentralized ledgers could disrupt clearing houses with a single confirmation of asset flows and transfers in the chain. Alternatively, blockchain could help existing clearing houses automate their back-end processes and streamline communications with brokers and those who keep share registers.
This, in turn, would allow real-time flow of assets and information and reduce the likelihood that a clearinghouse would encounter liquidity issues during times of volatility. As a result, confidence in the capital markets could be maintained and strengthened.
Complexity leads to inefficiency
When you place an order with a broker, the journey of most average users begins and ends with the capital markets. However, the whole process from purchase to settlement is very complicated. Many processes behind the scenes take place without the knowledge of private investors. Blockchain could give this process a level of transparency for the average user while providing better back-end infrastructure for institutions.
For example, several intermediaries take part in the post-trading and settlement process. Each entity must maintain its own data silos to keep track of asset flow and duplicate data between each participant. Each actor must also trust that the correct information has been conveyed to him by the intermediary before him.
This leads to coordination errors and dependency on a central recording system. This can also lead to delays in processing and to a higher expenditure of time, personnel and capital for all participants. It is also the main obstacle to instant cross-border settlement of assets and capital, despite the technology in place to facilitate instant settlement of assets.
The complexity of the post-trade processing funnel can create a bottleneck in the normal operations of our capital markets. This, in turn, has slowly undermined participants’ confidence in the capital markets and their infrastructure.
The means to restore confidence? Deploy the blockchain
Having previously been embedded in traditional capital markets infrastructure through my role in banking, my move to blockchain technology was timely given the current discussions about maintaining investor trust. This need for trust and transparency in our capital market infrastructure inspired me to research alternative technologies.
Ultimately, this led me to blockchain and especially Cardano. The Cardano blockchain already had a blueprint for transparency and trust. This arose from the highly decentralized blockchain protocol and focus on pushing power to the limits of their community.
Just a few months after joining the Cardano Foundation, we are at a critical point for the entire financial world. Triggered by the events of 2020 – and driven by a new vision for 2021 and beyond – the capital market infrastructure, the blockchain and the need for open and fair financial instruments collide. Where we lead them and how we shape the future is now in our hands.
For Cardano, that future is now. Our next major milestone, the Mary Hardfork, will welcome the arrival of the indigenous token forge and pave the way for decentralized financial infrastructure (DeFi) in the chain.
In our view, the first recipients of a trustworthy capital market infrastructure will be in emerging countries. Blockchain is about to roll out faster if traditional infrastructure is not yet in place or local communities have failed.
In the capital markets, this may include tokenized real assets that are traded on peer-to-peer marketplaces. It could also be used to gain access to decentralized identity solutions that enable those without a bank account to participate in the global financial ecosystem.
What does this mean for Cardano and the entire blockchain industry? First, the maturity of blockchain technology has converged almost perfectly with the growing need for more confidence in capital markets. The rise of DeFi has also proven that we can use blockchain to move real values and assets safely and efficiently.
Now that the technology is in place, we can focus on integrating blockchain solutions with our existing capital markets infrastructure and providing decentralized solutions for emerging markets where the demand for trustworthy trading infrastructure is high.
Frederik Gregaard, CEO of the Cardano Foundation, founded in Switzerland in 2016, represented at more than 20 locations worldwide. www.CardanoFoundation.org
The above is the author’s opinion and does not constitute financial advice.