Blockchain needs change, not compromise

Baozou Comment : Blockchain and distributed ledgers are extremely disruptive technologies, which are different from the existing system to a large extent; therefore, it is impossible to integrate them into the existing market system. Doing so will only reduce the level of existing market operations and fail to reflect its huge potential. Therefore, if you want to significantly improve the existing system, you must make comprehensive changes to achieve real improvement and avoid unnecessary troubles.

Translation: Annie_Xu

Taking advantage of new technologies requires a radical approach; otherwise you’ll just end up with refurbished versions of existing systems.

New technologies are weakened or even overwhelmed by the need to maintain old systems; because their inefficiency is the reason for their existence. Sometimes new technology may be less efficient than the old one, of course, just because it cannot be integrated into the old process.

Blockchain and distributed ledgers are radical.

Together they could revolutionize finance, but people in the financial world are bound by habit and old procedures refuse to budge.

Therefore, if new technologies are to transform the financial industry, they must gain the support of major financial institutions.

So I was excited to see the Japan Exchange Group (JPX) release a working paper to seriously explore the application of blockchain and distributed ledgers in capital markets. Researchers and six financial institutions conducted two proof-of-concept studies covering securities issuance, trading, clearing, settlement, cash payments, as well as ownership, dividends, data ownership, privacy, and stock splits.

They concluded:

"Distributed ledgers have the potential to transform the structure of capital markets, encourage new business development, improve operational efficiency and reduce costs."

Sounds inspiring, doesn't it?

The problem is that anyone can say this. This article says it. But I don’t provide proof. And frustratingly, there is no JPX human support for this proof of concept exploration.

JPX researchers said companies will have to change how they operate and try to fit distributed ledgers into existing business processes.

In the Dark

Transparency has always been considered desirable in financial markets, but it has a great impact on market institutions. Transparent markets are less susceptible to fraud risks, but are full of market tycoons and fierce competition. Therefore, initiatives to increase transparency may promote the development of "black markets".

This is where the problem with distributed ledgers comes in. It eliminates the trusted third party, which is considered the core of distributed ledgers; therefore transactions on the blockchain must be public.

Unfortunately, rather than considering ways to increase transaction transparency while discouraging black markets, JPX decided that public blockchains were out of the question. They believed that financial market participants would never agree to make all transaction data public.

So they back off and move to permissioned blockchains with trusted third parties, thinking of it as the same trusted third parties that we have today, like CCPs, exchanges, and custodians.

I started thinking, if a distributed ledger is just an embedding of the functionality of an existing system onto multiple computers, what is the advantage? It is true that a distributed architecture can greatly improve system resilience, unlike the current system where the failure of a major participant can bring down the entire network, as happened with the bankruptcy of Lehman Brothers.

This is an important benefit of distributed ledgers, whether public or private; but I don’t see how it can be achieved in terms of lower costs and higher efficiency.

Sanctity

JPX then found that the distributed ledger did not perform well in transactions, so it decided to focus its research on settlement and clearing business, and also discussed ownership registration.

I used to be a project manager in the capital markets, and I asserted that if trading behavior does not change, clearing and settlement cannot change significantly. Change must be done end-to-end, otherwise there will only be a nightmare of compromise. The integration and connection of the front-end and back-end is the main factor causing inefficiency and high costs in the capital markets.

I don’t see any benefit in embedding the above process into a distributed ledger. It will only make things worse.

JPX limits its distributed ledger research to clearing and settlement because order matching and pricing in a decentralized environment are inefficient, and traders often cancel or modify transactions, which puts a burden on the immutable blockchain.

But why don’t they think about their practices? Is there a way to price and match orders without collecting a bunch of transaction data? Would the introduction of an immutable blockchain encourage better trading behavior?

Dealers are volatile creatures, but if the workings of capital markets are to be transformed radically, their practices cannot be sacrosanct.

Strange assumptions

JPX researchers only discuss but do not solve practical problems, so the third fundamental issue is the trade-off between capacity and applicability.

In existing financial transactions, centralized systems can handle transaction speed and capacity issues better than decentralized systems, but at the expense of system resilience. Public chains solve some of the problems, because the current proof-of-work mechanism is slow to develop and cannot meet the needs of high-volume transaction environments. Using Byzantine fault tolerance to verify private and consortium chains is faster. However, a complete solution requires more technological advances.

JPX saw potential new bottlenecks in the distributed ledger environment, including the slowdown of running smart contracts, a key issue that they did not address.

But the exchange doesn’t care if the bottlenecks of the existing system will affect the distributed ledger environment. For example, financial intermediaries currently follow know your customer needs and anti-money laundering rules. Strangely, JPX believes that this will not change the distributed ledger environment, and even the main benefit of distributed ledgers comes from the elimination of financial intermediaries if it is used for cash settlement business.

There are other strange ideas, such as the central bank may issue digital currency on a private chain or consortium chain; but it will not be applied to the RTGS system (real-time gross settlement system), which means there is a competitive relationship between the two.

To be fair, the purpose of this study is just to prove its potential in the capital market. Although the more work JPX does, the more it can achieve this goal; some compromises are necessary.

It is now time to reassess how the way capital markets operate needs to change in order to realize the efficiency and cost promise of distributed ledgers.

The real benefit of distributed ledgers is not to restructure capital markets, but to rethink capital markets for a completely different future world.