What will on-chain capital markets actually look like? 👀

Following the publication of our first blogpost Capital markets infrastructure: it’s time to update the system!, a question has often come up in your feedback (thanks 😍): what will “on-chain capital markets” actually look like?

With financial instruments migrating from central securities depositaries’ book-entry accounts to smart contracts on blockchains, what will happen to traditional finance (TradFi) players such as market infrastructure operators, custodians, asset managers or distributors like banks and brokers?

This blogpost attempts to provide some tentative answers. Just as any exploration of the future, it is inherently speculative. Don’t hesitate to reach out to share your views on X / Twitter!

A quick recap: the need for efficient settlement ⚡️

But first of all, let’s recall why we are here: similar to payments, capital markets are slow and we can do better. This may seem counterintuitive as they appear fast on the surface. You typically place a market order in the blink of an eye with your stock broker. Just like you feel like you pay a merchant in the blink of an eye with your debit card.

But they are slow in reality. And the reason is that settlement takes - a lot - of time. At least several hours, and usually several days. When you are a merchant waiting to receive payment for the service you just provided, or an investor waiting to receive securities you just bought, you know that all too well. We saw in our previous blogpost that the root cause for this inefficiency lies in the tech stack which is currently used to process transactions.

In our view, blockchain technology offers the most exciting alternative to the status quo. By enabling cryptographically secured transactions on a shared asset ledger, we eliminate the need to reconcile scattered and closed-source databases to settle cash and securities transfers. Settlement can become trust-minimised and efficient. Efficient because it runs 24/7 across the globe, in addition to being fast and cheap. Fast meaning seconds or even fractions of a second. Cheap meaning cents or fractions of a cent.

The new database administrators 🤖

So how do we enable this shift from legacy settlement rails to more efficient ones?

At a high level, the answer is trivial: securities (e.g. shares, bonds, notes…) need to be natively issued on-chain. The databases of securities holders, i.e. the ownership registers, must migrate from the book-entry accounts maintained by central securities depositaries to smart contracts deployed on blockchains by securities issuers or intermediaries acting on their behalf[1].

Therefore, from the financial services industry’s perspective, the most fundamental change will occur at the level of those who currently administer these registers, namely the central securities depositaries, the transfer agents, and to some extent the custodians.

When issued on-chain, securities will change hands via digital signatures. Private key holders will have a direct write access to the ownership registers. The notarial and settlement functions of central securities depositories will be profoundly transformed, as they will be delegated - some would say “decentralised” - to the nodes operating the new networks on which securities live[2].

Securities will thereby migrate from the “intranets” of depositaries and custodians to an Internet-like network of interconnected computers running the same protocol to communicate and stay in sync. The new database administrators will be block builders, validators, indexers - in short entities connected to blockchain networks to ensure their proper functioning[3].

The future of financial services on-chain 🏦

Yet beyond market infrastructures maintaining ownership registers and handling securities transfers, how will traditional finance be impacted by the adoption of blockchain technology?

• Issuers - whether businesses, governments or asset managers -  will have access to a  superior infrastructure providing them with the ability to know their investors, to monitor their registers in real-time and to smoothly perform capital and governance operations such as paying dividends or coupons, voting, etc. In terms of adoption curve, the first types of issuers that come to mind are asset managers who will be able to “wrap” existing (off-chain) securities into new (on-chain) securities through funds whose shares will be issued on-chain. Ultimately, businesses and governments will follow suit by directly issuing their securities (e.g. shares, bonds, notes…) on blockchain networks.
• Cryptographic wallets[4] will replace the traditional securities accounts to become the key product for accessing - and interacting with - securities. Accordingly, banks and brokers will become wallet providers and private key custodians, with wallets evolving from basic transaction signing software apps to full consumer or enterprise apps. These institutions will continue to differentiate through their brand and compete on UI/UX and features offered to customers. This will foster innovation, as competition will now be one on-chain transfer away. Imagine a world in which all banks or brokers have to use the same underlying infrastructure to design their consumer products, where all securities adhere to the same data standards, and where you can instantly transfer your securities from your account at BNP Paribas or Bank of America to your account at Trade Republic or Robinhood and vice versa. Not forgetting, of course, the possibility of being your own custodian.
• Exchanges or trading venues will connect to blockchain rails and offer on- or off-chain computing and matching services to liquidity providers. Here too, the end of closed source systems with corporate control over settlement rails will increase competition to attract capital and liquidity to the best venues.
• Eventually, the ability to encode market-making and collateralised lending functions directly on blockchains through the use of smart contracts will revolutionise access to securities services, as is already the case in the world of crypto-assets with on-chain protocols like Uniswap, Curve, Aave or Morpho.

Choosing the right data infrastructure ⛓️

You may have noticed that we have so far avoided discussing the type of distributed ledgers or blockchains that would be most suitable for hosting on-chain capital markets.

One central question you may have in mind is, for example: shall we favour networks with equal rights or, conversely, with special rights in terms of who can access and update the state? In other words: public or private networks? Permissionless or permissioned ones? We will address these questions in the next blogpost. 👇

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[1] For non-technical readers, a smart contract - or more specifically a token contract in this case - is a database deployed on a blockchain network with a mapping of addresses and associated balances, augmented with some functions that be called to update it according to pre-determined rules. Someone holds token A (let’s say bond A) when they control the private key of an address which has a strictly positive balance in the token contract.

[2] Operating meaning maintaining the latest version of the ledger and carrying out the operations required to update it.

[3] Block builders batch the transactions together and send it to relays which keep transactions in a block private until a validator commits to including the block in the chain. Validators run client software and receive proposed blocks from relays.

[4] Namely a pair of one (or several) public-private key(s). To draw an analogy between a wallet and a traditional securities account, the public address is the new identifier, and the private key is the new password.