Building the future of finance on public blockchains

In previous blogposts, we discussed why the infrastructure underpinning capital markets - and especially securities’ ownership registers - should be hosted on a better tech stack and notably on better database technology. But we have thus far avoided discussing what type of database would be most appropriate. This will be the topic of today’s blogpost.

From private databases to public blockchains 👐

Securities’ ownership registers currently live in centralized databases operated by depositaries and custodians. Because these databases are not interoperable by design, reconciliation issues are pervasive. As a result, transaction settlement processes (i.e. basic property transfers between investors) are cumbersome, slow and costly.

To remedy this situation, three main options may be explored:

• Option 1: improve the connections between existing databases, typically by designing and opening APIs
• Option 2: deploy new, more suitable databases among depositaries and custodians, for example a distributed ledger with shared access rights among regulated actors
• Option 3: start issuing securities on public blockchains, namely on tamper-proof decentralized ledgers, accessible and auditable by anyone

Each has its own merits and drawbacks. Option 1 has been the main focus of incumbent infrastructure providers who are working on improving their stack while maintaining their moat. But it falls short of solving one of the main issues currently plaguing capital markets infrastructure, namely the fact that cash and securities live in separate databases. As long as this separation persists, there’s no way around the reconciliation issues that make settlement complex and inefficient.

Option 2 was in vogue around 2014-2017 with a waive of “enterprise blockchain” initiatives aimed at deploying permissioned networks whose nodes would be operated by market participants. Those projects were mostly led by incumbents, with the hope of reducing their back-office expenses. To date, these initiatives haven’t achieved product-market fit.

Our goal isn’t to get into partisan quarrels but to explain why we believe Option 3 deserves to be pursued and supported as a legitimate path, alongside others that will hopefully compete with it.

What makes public blockchains different 💎

So let's focus on what sets Option 3 apart, especially from Option 2.

In the field of distributed databases[1], public blockchains stand out by granting equal rights to all participants in a permissionless manner. Their ledgers can be read - and thus audited - by anyone, in real time. Anyone can freely participate in their operations, initiate transactions and contribute to their validation within pre-established protocol rules.

Compared to private alternatives, public permissionless networks have compelling and differentiating properties, particularly for financial applications.

1. Native composability and interoperability. Open source development of infrastructure and applications implies that the value created by different engineering teams compounds. As an example, financial primitives don’t need to be rebuilt over and over. A tokenization protocol for securities can be inherently interoperable with existing lending protocols, allowing seamless integration for using securities as collateral to access liquidity. Building and operating on public ledgers thus opens up a true platform effect, which is a game changer vs. the status quo of financial instruments living in siloed tech stacks.
2. Security inherited from open-source software development. The open-source development and built-in decentralization of public networks tend to enhance security and auditability. It ends up making them more robust from a security standpoint than private alternatives which tend to falsely equate control with security.
3. Economic incentives to foster adoption. At their core, public blockchains leverage economic incentives, usually in the form of a native token (e.g. ether), to drive participation and align interests. This makes them easier to bootstrap and helps solve a key issue faced by Options 1 and 2, namely a lack of incentives to collaborate.
4. Community and cultural appeal. Anyone looking at the distribution of community and engineering talent can see that public blockchains outperform their private rivals on that front too. Bear in mind that there are more active developers in the public blockchain ecosystem today than employees at Euroclear, DTCC, Euronext, Deutsche Börse and Nasdaq combined.
5. Compliance at the application (rather than at the infrastructure) level. It’s a fallacy to believe that open networks cannot accommodate the encoding of regulatory requirements. Compliance can indeed be implemented within smart contracts, without disputing the permissionless nature of the base layer. In essence, public networks enable similar capabilities as private networks, and obviously much more.

These properties make public blockchains prone to catalyzing network effects. In finance, network effects mean more capital, more liquidity, hence more efficiency. At some point, it could become extremely difficult - if not impossible - for private corporate networks to contend with such forces.

An emerging technology 🚼

Now, applied to capital markets, the use of public blockchains as underlying infrastructures will be transformative and result in:

• securities’ ownership registers that become public (pseudonymized of course)[2],
• ownership transfers that can be freely and directly initiated by securities’ holders, without necessarily requiring the intervention of an intermediary,
• ownership registers that can be updated by anyone, under everyone’s control, according to predefined and shared hardcoded rules.

Blockchain technology certainly has things to improve (e.g. on the computing performance front) and most importantly cultural barriers to overcome, before gaining widespread acceptance. But engineering problems tend to be solved by engineers. And as evidenced by the growth of the Bitcoin network and the Ethereum ecosystem, open networks may instinctively scare incumbent financial institutions but are increasingly adopted - and trusted - by the general public.

We are therefore confident that public blockchains as computing and storage infrastructures are not only promising enough, but already mature enough, to start building tomorrow's capital markets upon.

[1] A database is “distributed” when several parties hold and maintain a real-time copy of the ledger. A blockchain can act as the way to order and validate the transactions updating the ledger.

[2] Pseudonymization is the method of hiding personally identifiable information to prevent the identification of the person to whom the data relates without additional information which is held separately. On a public blockchain network, only the public addresses are visible to everyone.