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Capital markets infrastructure: it’s time to update the system!
Spiko 101
Nov 6, 2023

Capital markets infrastructure: it’s time to update the system!

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Far from the media headline on the setbacks of the - still too many - crypto fraudsters, blockchain technology has quietly but surely made impressive progress over the past few years. If you are a crypto builder, you certainly didn’t miss Ethereum upgrades, the deployment of scaling solutions, the emergence of cross-chain communication protocols and the launch of competing base layer architectures.

At Spiko, we believe that blockchain technology can replace the scattered and often outdated databases supporting today’s payment and securities settlement systems. We further believe that the technology, the market and regulations (at least 🇪🇺) are mature enough for this transformation journey to start now. We think that it won’t be spearheaded by industry incumbents, and that’s why we’ve created Spiko.

As a reader who may have stumbled upon this blogpost, you may wonder: why should I care? Because the implications of having the backbone of financial services running on modern and shared databases will be huge. Today, we’ll try to dig into why. Welcome to the world of on-chain finance!

But does finance need innovation? 🤔

Shouldn’t finance be boring as the saying goes, and human capital allocated to more important sectors of the economy?

Since the 2008 global financial crisis, this view has been quite prevalent among influential intellectual and policy circles. For the better, as pre-crisis excesses were real and new prudential rules have made commercial banks somewhat more resilient (though U.S. regional banks customers may question that). For the worse, as a financial sector frozen by overly rigid regulations, stuck in outdated processes and technologies, controlled by oligopolies, can be no good to society.

And there are reasons to be concerned. Financial innovation (”fintech”) has been a real thing but it has mostly focused on the edges of the financial system, improving UI / UX, and connecting the Internet economy to the traditional finance rails. Meanwhile, basic transactions such as transferring money cross-border or investing in certain assets like bonds, remain expensive, long or complex. In a word: inefficient. The financial sector at large has continued to concentrate within a handful of ultra-dominant players. The share of financial services in GDP has continued to rise. These typically aren’t attributes of a highly dynamic and innovation-driven sector. In the words of Marc Andreessen: “The measure of abundance is falling prices”.

Maybe banking should be boring (narrow banks anyone?), but finance shouldn’t. We ought to make finance exciting again.

The status quo is not ok 😟

Spiko’s focus won’t be payments but capital markets, namely money, bonds, equity, derivatives markets. These serve vital economic functions: allocate capital, i.e. facilitate the flow of funds between capital allocators and businesses or governments, and price risk. With the digitisation of securities and the electronification of trading, they have undergone significant changes over the past decades.

But while the dematerialization of securities from paper-form to book-entry was a zero-to-one breakthrough in the second half of the 20th century, innovation in the so-called “post-trade industry”[1] has since been far too slow. Consider the following: buy and sell orders are now posted and matched at the speed of light on trading venues, and yet it typically takes several days to settle a trade, namely to process and finalise the transfer of securities (usually against cash).

Finance is like an ultra-modern facade still powered by manual generators. Behind the shiny scene, cumbersome and lengthy settlement processes remain the norm.

Key steps and intermediaries of the securities trade lifecycle. Source: Spiko

As we can see in this (simplified!) flowchart, the current order-to-settlement process is long and complex, sequenced into many operations, involving a large number of databases and intermediaries, and sometimes even different organisational levels (front / middle / back office) within the same intermediary.

How is that possible? Well, the system is rigged with technical debt (we see you, Cobol fans 👀). And the implications are real:

  • Unnecessary high costs that are eventually borne by retail investors, either directly or via institutions tasked with allocating their capital[2];
  • Billions of capital locked up in the system as collateral to absorb risks induced by the presence of all these intermediary layers and the length of the resulting processes;
  • Markets that cannot operate, i.e. price risk and margin requirements, continuously;
  • And still tons of settlement fails and reconciliation errors[3].

On top of that, the picture is grimmer in Europe than in the United States, due to the legacy of capital market development along national borders. With 30+ national stock exchanges and 30+ central securities depositories, the degree of complexity is multiplied by geographic fragmentation. Political debt adds up to technical debt. As a result, it is unsurprisingly more complex and expensive to trade and invest in Europe than in the United States.

Interestingly, initiatives aimed at reducing settlement times in capital markets have been rather pushed by regulators through top-down arbitrary requirements than by the industry through bottom-up innovation, which, in and of itself, is a testament to the industry’s inertia. And with the current pushback in Europe against a plan to move from T+2 to T+1 business day(s) settlement, we are approaching the limits of what can be achieved with the current market structure and technological stack[4]. The system is broken and needs a fix.

A paradigm shift 💡

Let’s start by acknowledging the source of the problem: cash and securities live in separate, scattered and poorly integrated databases. Split up by instrument, by intermediary, by geography, and so on. The need to bring together different systems that were not designed to communicate natively and seamlessly with each other creates undue complexity.

So how do we solve this? Enters blockchain technology. But why? Couldn’t we simply standardise and modernise the current tech stack? Create API integrations to empower existing databases to communicate effectively with each other? We could, theoretically. But it would require an extremely high level of coordination that is likely unattainable. Also, it wouldn’t end the deadly need for reconciliation processes between distinct, closed-source databases.

Meanwhile, blockchain technology brings immediate solutions to the issues crippling the system. Cash and securities on the same global and public ledger is a zero-to-one breakthrough unleashing the magic of atomic settlement, namely the instant exchange of assets between mutually untrusted  parties. A transaction now becomes effectively inseparable from its settlement. The trade is the settlement and vice versa. The settlement date is no longer measured in days but in seconds. The entire sequence of post-trade operations disappears and with it the associated risks and costs.

Settlement dates on traditional finance rails. Source: Spiko

Of course, such a system isn’t without drawbacks. By design, on-chain trades need to be pre-funded[5], which, compared to how the current financial system operates, is both unusual and potentially challenging. Besides, blockchains as computing infrastructures are suboptimal in terms of throughput and latency compared to local and centralised servers optimised for specific needs like trading.

Yet one must realise that using a blockchain as the base layer to issue and settle securities is by no means exclusive of using off-chain computing and deferred settlement for specific needs. In fact, one of the strengths of the on-chain financial system lies in the realm of possibilities it opens up, or put differently in the increased optionality it brings to market participants.

Change starts now 🌱

The direction of travel is clear: putting off-chain assets on-chain, a.k.a. tokenisation. And then using the financial primitives that are being built in DeFi to empower these new assets.

Even though we are still at the very beginning of this journey, things are underway. With stablecoins, the “cash leg” of on-chain markets has taken off. The “securities leg” must now follow suit. This will be our relentless focus. Before the on-chain issuance of securities becomes the norm, bridges must be built between traditional databases where the overwhelming majority of securities are registered (and will remain registered for the foreseeable future) and the blockchains, where securities will live on parallel, more efficient rails.

There are essentially three reasons why we think the timing is right:

  • Blockchain technology is mature enough to start hosting financial services at scale. The technology is far from being set in stone (and thankfully so!), but what we have is already a solid foundation to build on. Throughput, latency, account abstraction and privacy will be figured out in the coming years.
  • Demand exists. The value of tokenized dollars outstanding has grown from less than $3bn five years ago to over $120bn. Over 25 million blockchain addresses hold more than $1 in tokenised form according to Brevan Howard. And with the opportunity cost of holding non-yield bearing assets in the current rate environment, tokenised U.S. T-Bills are starting to carve out a piece of the cake, up from $100m at the beginning of 2023 to $750m today according to
  • Regulatory clarity is (somewhat) there, at least in jurisdictions such as the European Union, where the native issuance of securities on-chain is lawful and the distinction between on-chain cash (a.k.a. stablecoins or e-money tokens) and on-chain securities is clear.

What’s next 🚀

In the upcoming weeks, we’re excited to bring you a series of blogposts delving into the future of (on-chain) capital markets:

  • Private vs. public blockchains? Why the future is public
  • Registered vs. bearer on-chain securities? Things aren’t black and white
  • Navigating the current on-chain securities landscape
  • A special announcement 👀👀

To stay updated, follow us on X / Twitter or join our Telegram channel.

[1] “Post-trade” refers to all the processes that start once a trade has been completed and culminate in the actual exchange of assets between the trade’s counterparties.

[2] According to a McKinsey study, the post-trade industry’s global turnover was $56bn in 2015.

[3] According to an ESMA study of settlement fails in European central securities depositories, an average of ∼3% of all bond trades and ∼8% of all equity trades were unable to settle between December 2020 and December 2022.

[4] If settlement fails were to become too frequent, lowering the settlement date would indeed cause more harm than good. See e.g. Is T+1 settlement viable for ETFs in Europe?

[5] In the traditional financial system where settlement is deferred, market participants do not need to have the assets in their possession at the time of transactions. Conversely, in the on-chain financial system, where settlement is atomic, possession at the time of transactions is a prerequisite.

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