It is conceptually possible for a market to consist of investors only. The investors would buy and sell from and to each other when the need arises to adjust their investment portfolios. However, today, the markets would not be as liquid and efficient if the trading processes were not facilitated by professional firms that make it their business to organise the formal listing of securities and derivatives contracts, and to provide venues that permit the trading, clearing, and settlement of the listed securities and derivative contracts in an orderly fashion.
Traditionally a preserve of monopolies of national exchanges, since the early 2000s, developing Web 2 technology has permitted new types of trading venues to emerge that offer system-based multilateral trading facilities. The term “multilateral” refers to the fact that the operators of the trading venue facilitate simultaneous access by many market participants, allowing them to compete for transactions. The offering of such alternative trading systems is an activity that typically brings the operator within the regulatory perimeter as a “multilateral trading facility” or as an “organised trading facility”.
Once a trade is executed via a trading venue, on the designated settlement date, the obligations arising under the transaction will need to be settled through payment and securities settlement systems, which involves operations carried out via central bank clearing systems, a national central securities depository (CSD), or an international CSD of choice, such as eg, Euroclear or Clearstream. Accordingly, transactions made via a trading venue, be that a traditional exchange or an alternative trading system, cannot be settled without the assistance of a firm that has access to the relevant payment and securities settlement systems. Appointing a specialist custodian, therefore, is a practical necessity.
There are several risks involved with settlement. The main legal risk is known as “finality risk”, that is, the risk that the settlement is not final because it could be the subject of an adverse claim made eg, by a liquidator or a beneficiary of a constructive trust. Finality risk is reduced through specialist legislation, such as the legislation that was introduced as part of the implementation of the EU’s Settlement Finality Directive. The main commercial risk relating to the settlement of a purchase transaction is typically referred to as “principal risk”. It is the risk that one party settles its obligation, but the other party does not. Principal risk is managed operationally through a process generally described as “delivery versus payment” (DVP), which means that parties to the settlement seek to synchronize the settlement instructions. The post-trade infrastructure will permit custodians, brokers, and dealers to access web-based “settlement engines” offered by operators of payment and settlement systems so that it is possible to verify whether matching settlement instructions have been given. However, that does not necessarily mean that the funds transfer and the bookentry securities transfer are synchronized de facto. The funds transfers may occur on a net basis in batches, while the book-entry securities transfer may occur on a settlement-by-settlement basis.
Exchange 4.0 refers to the role of exchanges in the so-called fourth industrial revolution, a phrase coined by Professor Klaus Schwab, Founder and Executive Chairman of the World Economic Forum, to describe “new technologies that are fusing the physical, digital and biological worlds, impacting all disciplines, economies and industries”.
According to Professor Schwab, the fourth industrial revolution has “the potential to connect billions more people to digital networks, dramatically improve the efficiency of organizations and even manage assets in ways that can help regenerate the natural environment”. These themes of connectivity, efficiency and new methodologies for asset management share many characteristics and aims of markets in digital assets.
Therefore, Exchange 4.0 addresses current questions about how distributed ledger technology (DLT) can change the market infrastructure, clearing, settlement and custody systems, that underpin trading venues, and therefore, can change the marketplace for financial assets.
Its implementation is based on the blockchain technology, and the open-source philosophy developed in the crypto and decentralised finance worlds.
A key feature is interoperability. Although the traditional exchanges have sought to build links between their trading venues, the book-entry securities settlement systems in particular for equity securities, due to the intransigent nature of the issuers’ domestic property and company laws, are still very much a national affair. Accordingly, trading, clearing and settlement on the traditional trading venues continues to be conducted in a mostly closed environment. If exchanges, custodians, and other service providers could work together free of domestic legal barriers across asset classes, venues, and jurisdictions, investors would benefit from network effects. This model works on decentralized exchanges built on Web 3 technology, which are not hindered by the traditional silo barriers. Automated market makers (AMMs) eliminate conventional order books as well as the need for central clearing, central counterparty, and CSD structures. Instead of discovering prices for an asset to trade at via matching engines or market maker quotes, AMMs are smart contracts – computer scripts that are deployed on the blockchain using DLT – that create liquidity pools, and these pools execute and settle trades in digitised cryptographic assets held in and controlled by the smart contract based on predetermined algorithms, automatically, instantaneously, and verifiably. Trading and settlement occur simultaneously and settlement, transfer of the cryptographic asset, does not rely on a trusted intermediary, nor necessarily on the application of domestic property laws.
These are expected to be a combination of those benefits already identified as a result of digital transformation and decentralisation, together with specific benefits from a distributed exchange model. The list includes:
A. The general benefits of moving the issuing of securities from an analogue to a digital form, permitting digitised trading and settlement:
B. Benefits in compliance and risk management:
C. Benefits in the ability of exchanges and customers to be “future ready” (ie use natural language processing to access information, and therefore artificial intelligence applications to handle the information and therefore smart contracts to run operations in relation to the information) because:
D. Benefits from use of blockchain and DLT:
E. Benefits of working with digital assets:
In addition, the opportunity for exchanges is considered to be broader than simply trading operations because “digital transformation” can put them in a position to gain benefits of network effects. A recent Deloitte report said:
“The exchange of the future will be characterised by new revenue streams, streamlined operations, and symbiotic network of ecosystem partners made possible by emerging digital shifts.”
For those that know about them, metaverse developments are a good analogy here in the sense that they support portability of digital assets combined with the functional and the legal ownership of digital assets. It seems unlikely that a generation of customers that become used to the benefits of the metaverse would accept these not being available in their financial life when this ceases to be readily distinguishable from the rest of their online lives.
Just as exchanges are siloed, so the regulatory rules relating to exchanges are siloed. Ultimately, the logic of Exchange 4.0 requires harmonisation of these regulatory rules. Meanwhile, interoperability relies on knowledge of and compliance with a cascade or regulation for each venue. For example:
Web 3 technology can clear the barriers to cross-border settlement identified in the 2001 Giovannini Report on cross-border clearing and settlement arrangements in the European Union and Exchange 4.0 technology can create a single market. However, national property and company laws serve as a barrier to the efficiency and risk reduction improvements that are to be had from tokenising assets. For instance, where national law requires that a publicly traded company deposits the issued equity instruments in a national CSD, many of the benefits of tokenisation are negated. National legislators will need to support the adoption of the new technology by adjusting legal requirements that once served investor protection and settlement efficiencies but are now an obstacle to advancement.