Current State of Securities Practice with Pain Points

In the financial instruments issuing procedure lies an old problem. All institutions use their own heterogeneous information technology (IT) systems, which are incompatible with each other. If the bond and share securities are not traded in exchanges, which we call over-the-counter (OTC) trading, there is no dominant system to link the trading parties together. The participants of this procedure include the securities issuer, the subscriber, the funds, fund of funds (FOF), or other types of financial intermediary and the final investor. Some say that the most used “tech” here is Microsoft Excel. In most countries, we have exchanges or other types of information centres performing the task of bookkeeping and clearance. In practice, those central servers do not cover all securities businesses. Only part of standard commodities are allowed to trade.

Stock exchanges do not cover: some non-standardized securities or other types of financial instruments or fundraising activities (e.g. trust, unlisted bonds). The initial fundraising takes part in the primary issuing, but there can even be a multilayer structure of investment participants. We have multiple exchanges or other trading centres even within one country, which is a fractioned marketplace. Before blockchain technology, there was no good way to synchronize trading information among multiple nodes or centres.

Present efforts turn out to be just another system for a limited group of players. Time and money are wasted due to these barriers. We have witnessed some banks developing innovative services to bring the different stakeholders together to solve the problems above. What is unsolved: the participants need no bank regulation, they want to keep private.

Without a universal bookkeeping and clearance centre that is universally accepted, security participants are fragmented and human accountants need to do the bookkeeping, reconciliation and payment. Even if some incumbents claim they are fully connected with automation, it is only in their field and unrepresentative. The consequences are: in the closing period of fundraising, the issuer or secondary funds could wait for days because the trade is not confirmed in real time. The fundraising information is not automatically passed through the vertical structure of incompatible participant systems.

In the conventional issuing procedure (see Figure 1), the issuer passes on all debt, for example to the subscriber or an investment bank. The subscriber then sells the debt to several buyers. The buyers can be funds, trusts or other types of financial intermediaries. The buyer here may buy and pay for it or just promise to buy. The buyer may need to find a secondary buyer to buy. The secondary buyer may repeat this process until it reaches the final buyer. There is always the risk that the secondary buyer cannot fulfil their purchase promise. Therefore a confirmation period is needed, and marketing for a little surplus so that the full amount of fundraising at its required level can be met. The purchase and subscribing or payment information cannot pass through the nodes of financial intermediaries. The information between the nodes is heterogeneous data. This is the fundamental reason for the need for a long fundraising period, confirmation period and redundant accountancy.

Future State of Securities Practice with Blockchain

The aim of this chapter is not to explain how blockchains or smart contracts work, but how they can be applied. With blockchain technology, no central instance for information consistency is required. Instead, the primary subscription and secondary transactions can be largely optimized. It is a universal and democratic way to synchronize all parties. To include all participants, the blockchain platform should not include a subjective rating. It only performs as a public technical solution. On a blockchain-based platform, the issuer, subscriber and all other types of financial intermediaries are connected.

In the fundraising/issuing process shown above, any participant in the vertical structure can be called a seller if they are above another actor and can be called a buyer if they are below another actor. Every seller creates a security entry in the blockchain, specifying the amount to be raised. The information of a subscription promise or purchase order of any buyer and secondary buyer is immediately published and synchronized with the whole network. As a result, the issuer and subscriber know the status of the fundraising process throughout the participant network. Therefore, the time span of the fundraising and confirmation period can be reduced significantly.

In the repayment process, the work of a fund accountant causes the settlement time to be T + n. It must wait for repayment from the chain of subsequent sellers. The cash flow must go from the issuer through multiple financial intermediaries. In both the fundraising/issuing and repayment process of a blockchain structure, information can flow in real time.

In portfolio/distributed investments, especially with some non-standard or unlisted financial assets, the investment/fundraising and repayment process becomes so sophisticated that the bookkeeping and accounting becomes very complex. For example (see Figure 2), an unlisted fund invests in hundreds of unlisted non-standard financial assets. A compliance issue could result in certain jurisdictions. In the case of a fund or trust, the investor’s money is pooled into the fund’s account, the fund then invests the money into the portfolio or distributed assets. If all participants are equipped with blockchain and smart contracts, under the direction of terms defined in the smart contract, then the money can flow directly from the investor to the asset, bypassing the intermediate fund, and the money is not pooled in the fund’s account. With this feature, further innovation is possible. [What do we mean by this? For example, a personal portfolio with no security from authority’s regulation. A fund is regulated in any country to various degrees, which should acquire legal-body status at least. Now it may be totally free.] The benefits are:

• Wider diversification. We were discussing the convenience of a portfolio with blockchain above. Blockchain also enables participants to get connected to a wider range of counterparties if everyone is in the same chain. Investment diversified by geography is more convenient.
• Asset seeking and sales. An investment intermediary is always seeking financial assets. Due to information silos, a financial institute reaches a limited group of clients around it, so it knows only a small fraction of the whole market, especially in unlisted non-standard assets. In the blockchain platform, all assets are listed under the permission of the issuer and broadcasted to the network. A search engine filters and thus helps investors to find any asset in every corner of the world. And vice versa, a fund to promote its products will easily broadcast the asset to the whole network. The agent intermediaries for promotion may no longer be needed.
• Some financial instruments are issued worldwide. Even if it was not issued globally, foreign investors can invest directly from abroad or through a financial intermediary arrangement. In this case, participants are from different sovereign countries, so stock exchanges or centralized marketplaces are beyond their reach. A blockchain platform overcomes these barriers. The trading information is not restricted by any country or bound by centralized marketplaces. In a minimal case, the blockchain record is just bookkeeping that encounters no regulatory restriction.

In the real world, all marketplaces – including stock exchanges – keep their ratings on trading participants. One reason is regulation. Another reason is that these marketplaces make the rating due to risk control and their own reputation. Value is added to a listed financial asset after the scrutiny of these marketplaces, but it also rejects some assets and therefore some participants choose the OTC route. Blockchain financial trading platforms offer the participants simplicity, privacy under their control and provide the convenience of listing. If a blockchain platform includes a rating, it will reject clients having any conflict with its standard. This creates a fraction with different value groups and is against the initial intention of blockchain or a decentralized autonomous organization. Therefore, the blockchain should not contain any rating. It should only perform as a neutral financial infrastructure, like the internet stands for neutrality and is built on protocols which do not care if you are transmitting text or video steaming. Since ratings create market fragments, trading participants will take jurisdiction shopping to seek for the most convenient marketplaces.

Conclusion

Blockchain technology provides a wealth of opportunities for the investment and asset offering sector: all types of participants are connected globally in a democratic way without a rating. OTC trading will be optimized, where the assets listed are broadcast to the whole network, so that asset seeking and sales promotion become global rather than local. Purchase and payment information can penetrate layers of institutions and all participating stakeholders within minutes rather than days of human operation. The fundraising, confirmation and settlement periods can largely be optimized based on real-time information.