The Path to Blockchain-Based Financial Markets

The Three Waves of Fintech

Energy around fintech’s third wave is focused on blockchain as a core technology for financial markets as opposed to crypto as a blockchain-based asset class. Third-wave companies and technologies have continued to attract investors and advance in scope and maturity. In the face of a 35% year-over-year decline in total venture capital fintech investments, Wave Three companies received 17% of that funding, in line with 2021 and up from 7% in 2020.¹ Fintechs and incumbents both expanded the scope of their Wave Three initiatives which now encompass all asset classes (see Figure 1). And some projects have matured beyond proof of concept. With Project Ion, the Depository Trust and Clearing Company (DTCC) is processing more than 160K transactions a day on a blockchain-based infrastructure it launched in Q3 2022.² Asset managers have issued closed, open-ended, and ’40 Act funds using blockchain infrastructures for processes including KYC, investor accreditation, and secondary trading.

Wave Three Initiatives Encompass All Asset Classes

Two trends underlie this early momentum. Blockchains continue to mature and become more business-ready with upgrades and advances that address security, privacy, and scalability challenges. And at the same time, there is more alignment around the core benefits that blockchains can potentially offer in financial services: efficiency gains beyond what incremental digitization delivers, easy tradability across asset types, and the programmability of critical functions via smart contracts.

While the technology’s maturation and benefits will continue to advance us towards a blockchain-based financial services infrastructure, some significant challenges will slow the transition and extend the journey. Our current infrastructure performs well, remains reliable and scalable, and has more established security. Entire value chains, businesses, and bottom lines are built on top of it, providing deep support for the status quo. There’s still a lack of benchmarks and roadmaps to justify and execute a blockchain transition, and the benefits of being a first mover are uncertain.

The regulatory framework for blockchains remains murky, while the posture of many new entrants who seek to reinvent the industry while ignoring established market practices and regulations is more naïve and unhelpful than it is bold. And for regulators and investors, the recent collapse of FTX, BlockFi, Celsius, and Terra/Luna threatens to further blur the distinction between blockchains as a foundational technology and crypto as a blockchain-based asset class.³

A Framework for Charting the Transition to Blockchain-Based Financial Markets

The transition to a financial services industry built on a blockchain-based infrastructure is expected to take years and happen in phases. To understand how this transition will occur, we interviewed more than 50 people including fintech investors, founders, and executives at incumbent firms. Based on our own research and these interviews, we mapped out a path for the industry’s transition to the blockchain, with the phasing for individual products and market functions determined by three factors (see Figure 2):

Factors Determining Readiness to Transition to Blockchain-Based Financial Markets

Regulatory Environment

The regulatory environment differs dramatically across financial products, and determining how it will impact a product’s transition to the blockchain depends on two variables:

Complexity of record keeping and clearing requirements. The more parties involved in the record keeping, trading, clearing, and settlement of a product, the harder it may be to reach the consensus necessary for its transition to the blockchain. For example, it could be easier in equity swaps where records can usually be maintained by the parties on either side of a trade, than in public equities where records are stored like matryoshka dolls with a central depository, a qualified custodian, a transfer agent, and a broker dealer each holding their own copy, all of which must be continuously reconciled. Charting a transition path also is dependent on the complexity of clearing requirements, which differ by product as well. Even though they are all derivatives, for example, equity swaps and forward rate agreements clear directly between the two sides of a trade, while interest rate swaps and credit default swaps are negotiated bilaterally but must clear via a central intermediary.

Availability of blockchain-related regulation. At best, the current regulatory framework for the use of blockchains in U.S. financial markets can be described as a work-in-progress, inhibiting a transition to the blockchain. Well-crafted regulations will include rules that apply to crypto assets separate from rules that govern the use of blockchains for traditional financial products and practices, distinguishing what is being traded from how it is being traded. Swiss regulators, for example, allow blockchain-based securities record keeping without requiring a parallel system, easing the path for a faster transition. This has allowed their national exchange to combine depository and trading functions onto a single blockchain-based ledger. Some companies in Switzerland custody traditional securities and create “tokenized twins” of them, which are then listed on blockchain-based exchanges. The SEC, on the other hand, does not currently allow companies to maintain record keeping exclusively on a blockchain, forcing blockchain-based capital market operators to maintain a traditional database continuously synchronized with the blockchain.

Market Dynamics

Just like mountains form through the layered accumulation of sediments, financial market processes are the result of conventions and technology stacks that have accumulated over decades. How and when a transition to the blockchain will occur depends on the:

Complexity and Rigidity of Markets. Financial markets aren’t complex just because of regulations. Instead, myriad conventions have taken root on their own, or to abide by or bypass regulations. For some products, the involvement of intermediaries like transfer agents—a central security depository (CSD) or a central counterparty clearing house (CCP)—is often an established market practice, not an explicit regulatory requirement. And whether they’re required or not, current market practices could create profits for intermediaries. Market makers make money by centrally netting trades and by lending or borrowing shares in the time lag between trade and settlement. Holding an account with a CCP enables clearing brokers to charge trading fees to smaller introducing brokers. Exchanges charge brokers for pricing data, which they are required to buy to guarantee best price execution. Any new infrastructure that changes how markets work will face pushback from incumbents trying to protect their positions. For some products, market rigidity is magnified by entrenched dominant players that have helped the SEC and FINRA design regulations.

Opportunity Size. Startups and incumbents need to see a path to sustainable benefits and returns before they invest in building and transitioning to a blockchain-based infrastructure. Obviously, the size of an asset class is a good place to start assessing that opportunity. But it’s not sufficient. While the municipal bond market is worth less than 10% of the public equities market, there are more than 36,000 municipal bond issuers—with each often issuing multiple bonds—versus about 6,000 listed public equities. Based on Municipal Security Rulemaking Board data, Alphaledger reported that more than 12,000 munis are issued each year, versus an average of 260 IPOs. And most munis pay regular coupons, compared to about 40% of public stocks that pay dividends. Put this together, and there’s a bigger near-term opportunity for blockchains to improve the efficiency of issuance and payment processing for munis than for public stocks. Real estate is also a huge market, and blockchains promise enhanced fractionalization and tradability, but buildings are so heterogeneous that the due diligence required to set prices is slow and manual. Net/net: we believe real estate is a smaller near-term opportunity for blockchains. Finally, the maturity of a product’s current infrastructure also influences the opportunity size: their lack of digitization could make private equity funds a more compelling short-term opportunity than public stocks, which already operate on a robust and effective infrastructure.

Blockchain Technology Parity

Blockchain technology needs to be at least on par with the current infrastructure before a product or process will transition. Parity encompasses performance factors like reliability, security, and scalability, as well as the availability of comprehensive development and deployment software. Determining parity for a product requires assessing the full chain of processes involved in buying or selling that product and the current technology supporting those processes. With private equity, for example, functions like KYC, AML, and accreditation verification are usually performed manually, so the bar for parity with a new technology is quite low. On the other hand, public stocks not only involve many more, often complex, processes like netting, collateral management, and foreign exchange, but the underlying infrastructure supporting those processes is highly automated and effective, raising the bar for parity.

A Three-Phased Transition to the Blockchain

Applying the above framework, we have created a map of a three-phase transition of financial products and practices to the blockchain, highlighting more likely early versus later adapters of the technology (see Table 1). Work is underway across all asset classes to support this transition, so all three phases have already kicked off, but each will reach maturity at different times. In our framework, maturity is reached when a blockchain-based infrastructure becomes the norm for a product or practice, akin to how running business operations on another core technology, the cloud, has gradually become the norm over the past decade. Just running a blockchain-based process in parallel, such as the DTCC is doing with Project Ion, or only handling newly issued securities as with tZero’s exchange, is insufficient for maturity. In general, we expect products in the first phase to transition to the blockchain within the next five years, while the second and third phases are likely to take up to ten and fifteen years respectively.

Readiness to Transition to a Blockchain-Based Infrastructure by Financial Product

Phase One: Primed Conditions for Transition

Products with the least complex regulations and market dynamics, such as private funds, private company shares, bilateral repos, FX forwards, and equity swaps, will likely transition to a blockchain infrastructure first.

Private funds and private company shares, for example, are generally exempt from SEC registration, and their record keeping is straightforward. They settle bilaterally and are traded during specific liquidity events, such as a capital raise or a redemption window. Their market structure is relatively simple, involving few intermediaries, if any. The opportunity size is significant. Globally, there are about 95,000 private companies with revenues over $100 million, about ten times the number of comparably sized public companies.⁴ While only accredited investors and qualified clients can typically access private funds, that’s still more than 10% of American households, with about $75 trillion in wealth.⁵ The final factor making private funds the most likely early adopters is that they are at the early stages of digital transformation, thus making a transition to the blockchain easier and more immediately beneficial.

For these phase one products, steps toward a blockchain transition are already underway. Asset managers are planning to –– or launching–– portions of their funds using blockchains. In some cases, blockchains store fund rules and investors' KYC and accreditation data, which smart contracts use to automatically verify compliance with fund rules in multiple jurisdictions. The resulting efficiencies have allowed some managers to cut the minimum ticket size for investing in funds versus traditional distribution channels. Some ticketing products allow investors to easily reuse their KYC/AML credentials across different investments, reducing the time, cost, and friction of buying new funds on their platform. To enhance market liquidity, fintechs are also building blockchain-based alternate trading systems (ATSs), less-regulated types of exchanges. Established public exchanges are laying the groundwork too. Nasdaq Private Markets is exploring how to incorporate public blockchains into its infrastructure, and the Johannesburg Stock Exchange partnered with fintech Globacap to extend into private markets on a blockchain-based platform.

The first phase also includes other financial products which trade bilaterally and have lighter regulatory constraints. Mainstream financial firms have traded more than $300B of bilateral repos over private blockchains since October 2020.⁶ Other firms have used blockchain networks to trade equity swaps—which are negotiated and cleared bilaterally—obviating the long-held reliance on phone calls and Excel files sent via email.

Phase Two: Transition Requires Multi-Lateral Coordination

Products in phase two have record keeping and trading processes that involve several participants because of regulatory requirements or market conventions. Transitioning these products to a blockchain will require multiple intermediaries to coordinate efforts. Parties with a vested interest in the status quo will slow transition efforts unless they can see an upside based on technology gains or market position. Phase two products include tri-party repos, bonds, real estate, interest rate swaps, and credit default swaps.

The market for trading bonds is dependent on many intermediaries, most of which have a vested interest in practices and roles. Bond data is frequently recorded redundantly across up to seven firms. Accepted market practices such as over-the-counter trading relies on dealers servicing investors by phone, which makes price negotiation opaque and trading more expensive. Settlement takes up to three days, which increases the capital needed to manage counterparty risk. Practices like these might not be ideal for issuers and investors, but intermediaries want to protect them. So, in figuring out how to introduce blockchains to the bond market, a Singapore company decided to work directly with custodians like Citi and The Northern Trust Company to establish new market practices. Each custodian runs a node of its blockchain-based bond exchange. The custodian immobilizes the original bond and relists it in tokenized form on the bond exchange, where prices are determined by an automated order matching engine and bonds can trade in any fraction and settle instantaneously. The bond exchange foretells what the transition path might look like for bonds, but hurdles will extend the journey. The U.S. would have to adopt regulations like those in Singapore that allow existing securities to trade over a blockchain, and intermediaries will have to progress beyond early trials.

Real estate is another market where complex practices will draw out its transition. Companies are laying the foundation by enabling investors to buy a fraction of individual residential or commercial properties and earn yield from tenants’ rent. By owning the building through an LLC and then distributing the LLC ownership through tokenized private shares, these fintechs have figured out a way to list, trade, and service physical assets on a blockchain. But a big challenge remains: pricing real estate involves coordinating with appraisers, inspectors, and realtors who each collect and evaluate their own data, mostly through manual processes, and often separately for the buyer and the seller. A digitized and simplified price discovery process that investors trust is a necessary precondition before blockchains become a foundational technology in real estate trading.

Some important advances needed to transition derivatives to a blockchain infrastructure are occurring. For example, some firms are tackling the sheer number and complexity of swaps by using International Swaps and Derivatives Association standards to record a swap’s terms more uniformly on a blockchain. Smart contracts are then used to signal to trading parties when settlements are due. Efforts like these are sufficient to support the transition of equity swaps in the next few years. But it will likely take longer for interest rate and credit default swaps, since more work is needed to bring along entrenched clearing houses.

Phase Three: Complexity and Market Risk Slows Transition

Products in phase three—public stocks, ’40 Act funds, and mortgage-backed securities—are highly regulated, have complex market dynamics, and operate on a robust multi-layered technology infrastructure. On top of that, some of these products have tens of millions of investors whose retirements and financial security are tied up in them, so regulators and providers will be more cautious: record keeping redundancy is actually a feature intended to protect investors. The timeline for phase three will likely stretch out over the next 10 to 15 years.

While a blockchain-based infrastructure won’t be the norm for these products for at least a decade, some foundational steps are already underway in key market processes like pricing, order entry, and settlement. For example, the Pyth network is a blockchain-based platform where its 70+ members, including exchanges and broker dealers, publish the prices of their latest trades (including all Dow-30 U.S. public equities), and a smart contract determines a blended price and interval of confidence in real-time. Other companies offer smart-contract-based order entry. Instead of orders being sent to dark pools (trading venues where large financial institutions trade anonymously to minimize the market impact of their trades) or kept in the back office until pre-set market conditions are met, matching intelligence is coded within securities so that an entire portfolio is always interacting with the market, but each position only makes itself visible and trades under specific conditions. And the DTCC has already launched a blockchain-based securities settlement engine that is processing more than 160,000 transactions a day.

Advances in other jurisdictions and across other asset classes will also pave the way for phase three products. Thanks to an accommodating regulatory environment, Switzerland’s national exchange SIX no longer requires a CCP. On SIX’s blockchain-based infrastructure, execution on the book is dependent on settlement on the ledger. SIX believes that ledger-based settlement will greatly reduce counterparty risk, especially for riskier products, counterparties, markets, or trades. Players hope to cross-pollinate learnings from their various blockchain efforts that span asset classes from repos to money market funds. In such, private coins are now being tested by central banks to enable dollar-based real-time payments between local entities and their U.S. counterparties. While these are noteworthy advances, their impact on a full transition is limited as both funds being tokenized are newly issued securities instead of existing ones, and new systems are run in parallel with traditional ones to satisfy regulators.

As we were writing this, a string of crypto players have gone under. It’s important to stress the distinction between crypto as a blockchain-based asset class—one undermined by companies with insufficient risk management and compliance protocols, and leaders with questionable ethics—and blockchain as a foundational business technology. Nonetheless, it’s highly likely that the so-called crypto winter will impact the timing and environment for products transitioning to the blockchain across all phases. And while these meltdowns will make regulators and market participants more cautious and vigilant, they will also up the pressure on regulators to finally clarify the rules, giving savvy market players the opportunity to influence them.

Why It Matters

The path to a blockchain-based financial services infrastructure will take more than a decade. But it’s underway in just about every financial product and process. Here are some things to consider:

Crypto asset developments and blockchain as a foundational technology require parallel paths. Building businesses around crypto assets requires creating new data sets for pricing and fundamentals, portfolio strategies, trading tools, and technology stacks to accommodate this new asset class. But beyond crypto assets, because blockchains could fundamentally reinvent how our industry works, using and integrating them throughout our infrastructure requires us to think and plan in terms of wholly new processes and business models.

The transition of most financial products and market functions has already started. Regardless of which phase a product or process is in, fintechs and incumbents are already pressing ahead. The framework in this report is intended to help decide which products and processes deserve immediate focus, and which can be addressed later. To accelerate progress, the industry will need ways to cross-pollinate the learnings from each product’s individual path. While this is a technology-led transition, effective execution will require coordination across diverse functions including legal, regulatory, communications, research, and product development.

Blockchain-based financial services will enable new ways to do business and require new skills. Over the next 15 years, blockchains may become a foundational technology across the financial services industry. This transition won’t just be about doing the same things more efficiently. Instead, entire processes like money movement could happen with unprecedented speed and fewer intermediaries. And products like alternatives could be broadly available to many new investors. While some businesses like securities lending might face new threats, there could also be increased access to new opportunities and markets.