For the past few years, financial institutions have been investing in blockchain technology with the idea that it could reduce the cost and complexity of many of its processes, ranging from payments and settlements to tracking shareholder assets.
As the recent PRI paper on blockchain pointed out, much discussion has focused on cryptocurrencies, rather than the underlying blockchain technology which has the potential to reshape the investment industry, offering significant opportunities as well as generating potential risks to system stability. Blockchain could facilitate secure decentralised transactions, reduce incidents of fraud, and increase transparency and efficiency in multi-party transactions.
Indeed, blockchain’s ability to store information on a shared network of computers, spread across the Internet and synced without the need of a trusted third-party, has also drawn the interest of stock exchanges. Many exchanges are looking at blockchain as a way to overhaul the complex procedures that govern their operations including pretrade, trade, custody, settlement and shareholder services. These multi-layer processes can be costly, time consuming, duplicative and error prone.
While there are numerous cases of stock exchanges using blockchain technology, the case studies below were chosen to illustrate two different applications for blockchain in an attempt to spur greater discussion on how stock exchanges could diversify their business models with the use of this technology.
London Stock Exchange Group
In 2017, the London Stock Exchange Group (LSEG) plc teamed up with IBM to build a blockchain-based platform to digitally issue shares of small and medium size enterprises in Italy. The project was built and tested by Borsa Italiana, which is part of the LSEG. Traditionally, information for shareholders of SMEs was held manually on spreadsheets, or even on paper-based records, with each shareholder holding their own version of the information. Conversely, information recorded on a shared digital ledger can be viewed by everyone on the network and can only be changed if each party agrees. By establishing a golden source of data, this can reduce the need for reconciliation of information held by different companies.
Storage of shareholder information on a shared digital ledger should make it easier for SMEs to interact with their shareholders and provide more transparency to investors on their ownership. Another benefit could be that blockchain helps the SMEs gain greater access to credit.
This could also be an important step towards being able to digitize the actual shares, as well as future debt. The impact on company financing could be immense, particularly small, private companies. Improved liquidity could make these investments more attractive to investors and the exchange itself could have lower administration costs and more transparent oversight.
The role of stock exchanges in supporting SME growth was explored in a recent WFE-UNCTAD report. In the report it was noted that SMEs face significant constraints, including lack of access to finance. The World Bank suggests that 70% of SMEs in emerging markets lack access to credit. The WFE-UNCTAD report goes on to note that the initial and ongoing compliance requirements and costs of traditional equity markets may represent a barrier to SME listing. This has prompted policymakers, regulators and exchanges to develop regulatory regimes and platforms that are appropriate to SMEs. Some earlier literature is critical of the success of these ‘junior exchanges’ due to low take-up and the low amounts of capital raised. However, the number and scale of SME platforms has grown significantly over the last 12 years, and at end 2016, there were over 7,000 companies listed on various SME platforms across WFE member exchanges in over 40 countries. SME markets promote and support SME listings, not just by facilitating access to capital, but also by providing an environment that enables SMEs to thrive, including eliminating or reducing listings fees, offering business development assistance and ensuring less frequent reporting requirements.
By testing new applications for blockchain technology, the LSEG could help contribute to the further growth of SMEs’ listings on stock exchanges and improve their access to the necessary capital for growth.
In 2015, Nasdaq chose blockchain startup Chain for a pilot to test the trading of shares in private companies, which do not trade on an exchange and entail a lot of paperwork. In October of 2015, Nasdaq unveiled Linq, a solution allowing private companies to digitally represent share ownership using blockchain-based technology.
Chain’s open-source blockchain platform enables financial institutions to transfer money and other digital assets, securely and almost instantaneously. The goal was to test blockchain in the Nasdaq Private Market, a marketplace for pre-IPO trading of private company shares. Nasdaq conducted the pilot with five clients. At the time, Nasdaq officials said that the manual process of tracking shares could be overwhelming and expensive.
Going a step further, in May 2015, Nasdaq teamed up with Citi to announce an integrated payment solution using a distributed ledger to record and transit payment instructions based on Chain’s blockchain technology. This meant that investors in private securities on Nasdaq could use Citi’s cross-border payments facility and blockchain to buy, sell and settle transactions. The integration can allow exchanges like Nasdaq to address the liquidity challenges of private securities by streamlining payment instructions between multiple parties.
Meanwhile, Nasdaq has been at the forefront of a number of additional blockchain initiatives. In 2015, Nasdaq also voiced interest in developing an e-voting system on its Tallinn Exchange in Estonia using blockchain technology. Nasdaq worked with the government of Estonia to pilot blockchain-based e-voting for shareholders to express themselves at corporate annual general meetings (AGM). Known as proxy voting, this describes a process whereby shareholders cast votes at an AGM without actually attending the meeting. Selecting as its partner Chain’s open-source blockchain platform, Nasdaq also leveraged digital identification solutions used by the Estonian government to issue ID cards to foreigners through their e-Residency Program. Later, in 2017, Nasdaq successfully completed a test that allowed investors who own shares on the Tallinn exchange to vote online during AGMs or transfer their voting rights to a proxy.
As a result of the project, Nasdaq now has a working PoC (proof-of-concept) that can identify citizens based on their Estonian digital ID – either their Estonian ID card or e-Residency card. What motivated the project? According to Nasdaq’s report, AGMs are typically high-cost events with, on average, low shareholder participation. As cross border investments grow, there is more demand for a secure, cost-effective and flexible solution that can facilitate shareholder voting from a distance. While some investors might delegate their proxy voting to a custodian bank, they are not 100% certain that their vote was placed as they wished. Thus, Nasdaq saw blockchain as an opportunity to improve corporate-investor interactions. In addition, the creation of a low-cost, easierto- access solution would allow cross-border shareholders to exercise their voting rights, potentially leading to further growth in cross-border listing, trading and settlement activity. By leveraging blockchain’s secure technology, exchanges could give voters more control over their voting rights and easier access to their voting history.
Decentralised exchanges and the ixo Foundation
For the purpose of discussing the future of traditional, centralized stock exchanges, it is worth examining the approach the South African ixo Foundation is taking to leverage blockchain technology to optimize sustainable development impact. The Foundation is developing a protocol that allows data about projects — such as when a child has been vaccinated— to be recorded on a blockchain. With a blockchain-based system, a decentralized impact exchange is used to create verified impact claims, essentially ‘proof of impact’. This proof can be used to access social impact bonds and government subsidies, and drive down the cost of evaluation. The data from these impact claims becomes a part of a global impact ledger, an open data common that organizations, governments and researchers can access to make informed decisions and optimize impact initiatives.
Using the innovative protocol, the Foundation partnered with a local UNICEF backed non-profit to provide evidence that a project related to pre-school attendance in South Africa could have legally agreed upon targets that could be tracked and digitally recorded using blockchain. In this example, as the claim of impact is authenticated, a cryptographic token is issued, which becomes a new asset class that could become the basis of a new regulated, investing asset.
This approach could be of interest to the investment community as the lack of measurement and certification standards may be holding back capital flows into the social and green bond sector in particular. Current methods of measuring impact have been found to be inefficient, expensive and prone to error and even fraud. This case demonstrates one example of how the application of blockchain could be built upon and taken to scale to leverage greater measurable impact.
Estimates demonstrate that evaluating the impact of development projects costs as much as 5%-7% of the overall budget. Specifically examining social impact bonds – where public agencies connect with investors and service providers to deliver a certain outcome, such as reducing prison recidivism or improving childhood literary – they are reported to be more expensive to validate, with evaluation rates sometimes as high as 30% of the bond cost.
The question therefore arises: could blockchain become the panacea? There is increasing recognition that blockchain, a distributed ledger technology that tracks bitcoin, could be utilized to record and measure proof-of-impact. While the full potential of this technology is not yet market read, the tokenization of information related to impact has immense potential to provide a tangible method for investors to ensure capital flows in ways that have a measurable impact on the UN’s SDGs.
Evolving business models and new applications of technology by stock exchanges
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Applications for blockchain