Lessons learned: Taurus and the ASX blockchain integration

image by Tamarcus Brown via StockSnap
image by Tamarcus Brown via StockSnap

London, 1993. A big decision was about to be made, that would send ripple effects across Europe and forward through time, acting as a warning against ambition and consensus.

For the past 10 years, the London Stock Exchange had been working on a significant upgrade of its securities settlement system. With paper-based systems groaning under the 1980s boom in share ownership, pressure was building not only from nimbler competitors but also from the regulators across the Channel. If London wanted to maintain its role as the continent’s money centre, it needed to upgrade.

The new system was called Taurus, and its goal was to remove as much physical documentation from the system as possible. It also planned a move to rolling settlement, reducing the payment period for equities from three weeks to three days.

Yet things were not going well. The first sign was the rhythm of missed deadlines.

From the outset, the project was complicated. It aimed to include as many sector stakeholders as possible, in spite of conflicting interests. Institutional investors wanted a fast, reliable service, while private investors wanted lower costs. Also, the existing registrars (dominated by large banks) were given a say in the development of a centralized registry, even though it would undermine their business model. Well into the development cycle, they torpedoed the idea.

What went wrong?

In the haste to get development off the ground, the project allegedly started without a clear roadmap. And delays gave more time for the various stakeholders to add requirements.

Even with clear and stable stewardship, that scale of development would have been tough. Yet the project management structure was not clearly defined, and the lack of centralized control meant that interlocking pieces were being developed out of sync, with sections of the process at different testing stages, while other functions had not yet been designed.

Also, given the long lead time (which ended up being more than double the initial estimate), the system – if launched – would already have been behind the competition from day one.

The final straw came when an investigation in 1993 revealed that completion would take another two to three years, at double the cost-to-date.

The decision was taken to scrap the whole project. The exchange’s investment of over £70 million (over £140 million in today’s money) was lost. The London Stock Exchange handed over responsibility for the development of a new stock trading system to the Bank of England, and its CEO resigned.

It wasn’t just the colossal waste of money and the damage to its reputation that made many fear for the exchange’s future. Hundreds of brokers had based their systems development on the assumption that Taurus would be the main platform, and thousands of employees had been trained. The total cost to London’s financial centre was estimated to be in the hundreds of millions of pounds.

Of course, it’s easy to see in hindsight where things went wrong. And it’s easy to believe that today, big systemic projects would be managed with different principles.

While that may be the case, the fate of Taurus serves to highlight the colossal complexity of introducing a new systemic platform. Throw in a technology that has yet to be tested “in the field”, and you have a potential powder keg of risk.

All change

I’m talking about the decision of Australia’s primary securities exchange, ASX, to upgrade its clearing and settlement platform to one based on distributed ledger technology.

Announced late last year, the news sent waves of excitement through the blockchain sector – it would be one of the first major public-facing applications of the technology, which many have touted as having the potential to decentralize finance.

Introduced with bitcoin, the blockchain offers a way of sharing data that removes the need for validation from a central authority. The elimination of redundancies and the speed with which information can be transmitted and acted on present significant cost reductions, especially intriguing in an era of diminishing margins and increasing competition in the financial sector.

It’s not yet clear whether the technology that ASX will use (developed with blockchain startup Digital Asset) will technically be a blockchain, in which information is stored in blocks that are irrevocably linked to previous blocks, ensuring data integrity. The official press release referred to “digital ledgers”, and while the two terms are often used interchangeably, some distributed ledgers don’t rely on linked blocks to share and verify inputs and outputs. However, since the boundaries of the new technology are being blurred as the concept evolves, the announcement was treated as a triumph by blockchain sector participants – official, public validation of the potential benefits.

Be careful

And yet, it is by no means the windfall that the headlines proclaimed.

First, it isn’t happening anytime soon. At the end of March, the ASX will reveal a potential live date for the new platform – it will most likely be years away. We won’t get a clear indication of the expected timing until the end of June.

And, as we saw with Taurus, in complex undertakings, deadlines are often extended. Hopefully the new system will be revealed within a much shorter timeframe than the failed British attempt’s estimated 13 years…

If it gets revealed at all. The ASX platform does need to be replaced – known as CHESS, it is 25 years old and is struggling to keep up with newer and nimbler competitors. But the decision to build on top of a relatively untested technology with uncertain scaling and bottlenecks is a brave one. And few development projects progress without setbacks.

It’s fair to assume that the planning will be meticulous and thorough. But will it manage to avoid the pitfalls of overwhelming systemic change?

Learning from the mistakes of Taurus will help. But the leap forward in technology with this development adds a new layer of complexity.

A large part of the problem will be managing expectations. While “blockchain” has been hailed as “the next industrial revolution”, we are not going to see a new decentralized stock exchange emerge before our eyes. As far as the public is concerned, things will continue pretty much the way they are.

For the financial and technology sectors, though, it is a big deal. If all goes well, back office costs will be reduced, new efficiencies will be explored and distributed ledger technologists will learn much from the real-world rollout.

The true change, however, will come years down the road, as other exchanges around the world take a look at their own clearing and settlement processes, as regulators encourage compatibility and connectivity, and as frictionless cross-border trading finally begins to look like a possibility.

But first, the ASX system needs to be successfully launched. And, as we’ve seen, it’s nowhere near as easy as it sounds. While the decision to migrate a country’s main securities settlement and clearing platform to a distributed ledger is good news for the blockchain sector, it is too soon to celebrate.

Snap and its impact on decentralization

Snapchat ipo

Snap’s recent IPO created a stir not only because of the impressive valuation and the post-launch price pop. It also generated controversy due to the voting rights of the listed shares. As in, they don’t exist.

As a result, FTSE Russell (market leader in the creation of global market indices) has decided to exclude Snap from its global indices when they are revised in June, pending revision. This is a blow to the company, since inclusion in an index implies a significant boost in liquidity, especially given the recent surge in demand for index-based funds.

Bloomberg’s Matt Levine points out that the increasing role of index funds in the market confers an increasing amount of power to the index creators. That FTSE Russell can make such a key decision about the market prospects of a company is disconcerting, especially since the criteria are not clear.

Here we start to scratch the surface of a fundamental shift in market models.

Although FTSE Russell has said that it will collect opinions from investors before making a firm decision, the fact that this is even up for review implies a judgement call.

The concerns are apparently centered on the governance model. Fund managers and even the SEC have also expressed concerns, citing uneven representation and its potential impact on disclosure requirements.

But the deeper issue at play is this: centralized vs decentralized control.

Giving all shareholders a say in how the company is run – who’s on the board, capital increases, corporate policy, etc. – is a more “democratic” approach to governance. Spreading responsibility for major decisions across the ownership structure is a gesture of faith that the owners will have the company’s best interests at heart, and that a collective decision carries more weight than one taken in isolation.

However, giving up control is understandably difficult for most founders (even with a fortune on the table in exchange). Hence the creation of a separate class of shares for outside investors (ie. not the founders and not the initial backers) with no voting rights. In fact, the founders have created a separate share class for themselves, with 10x the voting rights of the “normal” shares owned by the original backers (1 share, 1 vote). So, Snap’s founders effectively can do whatever they want with the company.

While that may sound fair on the surface, when you admit external investors, you relinquish control. At least, that’s how economics has worked up until now.

It’s not obvious why public companies bundle ownership and voting rights, other than the belief that it makes the shares more attractive. Snap has gone the other way, alleging that the market wants the founders to retain control.

In theory, their argument should be easy to prove: if investors don’t want that, they won’t buy the stock. Since the share price has remained well above its launch at $17, we can deduce that investors are not too unhappy.

What’s more, the market’s widely accepted definition of “ownership” implies responsibility, but there apparently is no legal basis for that interpretation.

The market has also always assumed that owning a “share” means owning part of the company. That definition seems to be changing, with the advent of new types of representation such as token-based dividend rights and blockchain-based funding models.

Snap’s decision highlights not only a shift in sentiment, but also a widening gap between the two schools of thought: those that think ownership should be decentralized, and those that don’t.

The debate looks set to intensify over the coming months, and not just because of the tie-in with political trends of anti-globalization and concentration of power. Underlying disquiet over the decentralizing influence of blockchain technology is likely to encourage attempts to regulate or channel applications. A heated discussion of the meaning of ownership is likely to surface, and the emergence of alternative investment vehicles could call into question established power structures.

If you’re thinking that this sounds like a full-blown attack on the capitalist model, you could be right.

Only this time, the resulting schism is unlikely to be as ephemeral as Snapchat’s messages.

Stock exchange technology problems

New-York-Stock-Exchange-Facade1 800

The Wall Street Journal reported this morning that the NYSE’s Arca exchange, which hosts the trading of more than half of the exchange-traded funds (ETFs) listed in the US, suffered a “glitch” at the end of trading yesterday. All live orders were cancelled, and a “backup method” was used to determine settlement prices.

Why is this interesting? In part because of the lack of information. The NYSE is not disclosing details about why the system failed. Either this is because they don’t know (disconcerting in this day of electronic information) or because they’re trying to figure out how to spin it (which could mean that it’s more complicated than just a simple “glitch”).

It’s also interesting given recent progress made in blockchain applications for trading and settlement of securities.

The NYSE is not as deeply invested in blockchain exploration as other exchanges (notably the Australian Stock Exchange, Nasdaq and Deutsche Börse). It is an investor in cryptocurrency exchange Coinbase, although the exchange’s interest in bitcoin seems to be limited to the index it launched in 2015. Nor is it one of the more technologically advanced exchanges. Bats, for example, has a better reputation on that front.

Maybe what happened yesterday will underline the need for a more robust, transparent solution. Maybe this will affect the scope of the resources thrown at the problem. Maybe the end result will be a blockchain platform, or maybe not – either way, we will likely end up with answers to questions we haven’t even asked yet.

 

Banks and the blockchain just got closer

Last week a consortium of 11 banks trialled a blockchain experiment: they sent tokens to each other on a distributed ledger. You’re probably thinking that this sounds simple. You’d be wrong. It’s taken months of work to build the underlying structure and to test the security. And it seems like it’s finally paying off.

by Phillipp Henzler for Unsplash
by Phillipp Henzler for Unsplash

The work has been done by the group led by blockchain developer R3CEV, which in mid-2015 started to “recruit” banks to help it develop blockchain standards for banking applications. The philosophy is that bankers know best what bankers want, so why not involve them in the development process from the beginning, in exchange for the right to use the result? It makes sense, right?

The level of interest even surprised the company itself. From a base of 9 banks signing on in mid-September, it rapidly grew to 42 banks by the end of 2015, when it closed the window of admission. Among the participating banks are big global names such as Barclays, UBS, Bank of America, Banco Santander, Goldman Sachs, Citibank, Deutsche Bank, HSBC, Société Générale and Morgan Stanley, to name just a few.

A few days ago 11 of the members simulated the exchange of value on a ledger without a centralized authority, by sending tokens back and forth. The tokens represented theoretical assets, and the experiment aimed to show that the transfer of securities could be done instantly, securely and at low cost. All of the transferred tokens arrived at their test destinations intact and instantly verified by all nodes. The experiment worked.

Additional simulations with additional members will take place over the next few months, and the process will be adjusted to include different types of assets and settlement methods. This trial used Ethereum as a blockchain base, but R3CEV has specified that it is also experimenting with other ledger technology. The company is not revealing details about further experimentation, but has indicated that their attention in 2016 will widen to include non-banking institutions. Does that mean government organisations? ONGs? Transnational support?

We’ll no doubt hear more about this over the coming months, and it serves as further indication that 2016 will see the roll-out of important and far-reaching use cases for ledgers, the blockchain and for bitcoin.

from xkcd
from xkcd

Getting so many big names in banking to collaborate on a transfer structure that harnesses the technological advantages of the blockchain without depending on bitcoin (which would technically make it not the blockchain but a blockchain-inspired ledger) is exciting and encouraging. It’s a big step towards making the legacy banking and trading systems more efficient and transparent. However, banks being fairly cautious animals by nature, many are also experimenting with the blockchain on their own account, either with in-house teams, or in collaboration with other blockchain developers such as Digital Assets Holdings, Chain, Symbiont and Ripple. Confusing? Sure. But the interest is there, work is being done, and it’s not a winner-take-all situation.

The blockchain and the stockchain

At the very end of last year, a major milestone was reached in the bitcoin world. Or it wasn’t, depending on who you listen to. And what your definition of “stock” is. Either way, what happened was a big step forward, and a harbinger of important changes coming to securities trading and business finance.

What happened is this: Chain, which specializes in enterprise blockchain platforms, issued shares on Nasdaq. Only they weren’t traditional shares, they were digital. And not on the “regular” Nasdaq, but on a subsidiary newly created to handle this kind of transaction.

stock exchange

But how does that work?

Nasdaq Linq, part of Nasdaq Private Markets, was set up to facilitate the issuance, transfer and settlement of shares of privately-held companies on The NASDAQ Private Market using a digital ledger technology similar to that which powers bitcoin. (For more on the difference between bitcoin and the blockchain, see here.) Rather than a stock exchange mirror, Linq is more a shareholding management tool, especially useful for de-mystifying the chaotic structures thought up in the early days of a business. The ledger allows settlement time to be slashed (minutes rather than days), issued shares to be easily tracked, and related documents to be dealt with and executed online.

The mechanism was developed by Chain, so it is appropriate (or symbiotic, if you prefer) that its own securities be the first to try it out. Chain creates Nasdaq’s Linq platform, Nasdaq owns part of Chain, Chain is the first to issue shares using this technology… You get the picture.

Yet Chain won’t be the last to use this technology. Nasdaq has hinted that further digital share offerings are in the pipeline from ChangeTip, PeerNova and other blockchain startups. NXT, Ripple and Digital Assets Holdings, among others, are working on similar technologies, and we will definitely see several more transactions of this type over the next few months.

peernova

And depending on your definition of “security”, it wasn’t even the first. In August of last year, smart contracts platform Symbiont sold its own digitized private equity on the blockchain to an investor, and registered its founders’ stakes as well as stock options and shares granted to employees. Symbiont’s innovation is the creation of “Smart Securities”, which not only settles and records transfers, but can also pay dividends and convert stock options automatically.

Broadening the definition a bit, in June of last year US-based retailer Overstock sold a $5m “cryptobond” on its tØ blockchain-based security trading platform. In December it got regulatory approval for the issue of company shares on the bitcoin blockchain.

Whoever came first, all three innovations stand to make a big impact: Overstock because its tØ platform and upcoming digital share offering “proves that cryptotechnology can facilitate transparent and secure access to capital by emerging companies”, according to founder Patrick Byrne; Symbiont because it is leveraging the decentralized power of the bitcoin blockchain to make trades cheaper, faster and “smarter”, which will expand the use cases for bitcoin and open up trading to non-market players; Nasdaq because it is a globally recognized name with exchanges around the world. All of them increase efficiency by reducing settlement time, increasing transparency and removing middlemen.

This is exciting, but at the same time fraught with significant obstacles.

One is the inherent conservatism of investors. New technologies can be scary, especially ones that are not easy to understand. Institutions are used to the delayed settlement systems currently in place, and could well prefer to bear the steep economic cost of that inefficiency rather than risk not only losing their investment due to a tech malfunction, but also of looking foolish.

Another is the lack of understanding of the mechanism on the part of the private companies, and the fear of attracting the attention of the regulators. Especially in the US, where each state has different securities legislation, a non-physical security residing in “cyberspace” is too much of a conceptual leap for most funds and investors to feel comfortable with.

Another is the need to balance the open nature of the blockchain with investors’ need for privacy. What some might see as an advantage – the ability to track the ownership history of a share or bond – others might see as an encroachment on their desire for anonymity.

Yet these obstacles can be overcome with time, just as other technology adoption obstacles have been overcome in the past (remember the “no-one will use the Internet” prediction?). The advantages of blockchain-based securities settlement are clear: faster, cheaper and global. The need for simpler financing is also clear: initial cap tables and shareholding structures are usually a mess, scribbled on napkins and promised in meeting rooms. A secure and inexpensive method of issuing shares will make setting up a business easier, which could help to foster entrepreneurial activity. And as more and more high-growth startups avoid regulation-heavy IPOs, a reliable and liquid alternative will empower businesses of all sizes and make them less beholden to Wall Street and its international counterparts.

Who will be the winner here? Which business model will triumph? Will shares be on private ledgers or the public blockchain? I expect we will see a combination of forms and formats, with various platforms offering different advantages, with smaller businesses benefitting from enhanced control and transparency, and with an explosive growth in creative instruments backed by cryptography and maths.

It won’t be a smooth transition, and it won’t be quick. Nor should it. When it comes to investors’ money and companies’ financing, care needs to be taken. But the shift will happen, and as it does, it will lead to a more accessible and fair financial system.