Yao Qian: Analysis of the Concept and Progress of New Financial Infrastructure Based on Blockchain Technology

Original Title: "Contemporary Financier · Column | Yao Qian from the Science and Technology Bureau: The Transformation of Blockchain Technology and New Financial Infrastructure"
Author: Yao Qian, Director of the Science and Technology Supervision Bureau of the China Securities Regulatory Commission
Source: Contemporary Financier (bankershr)

Blockchain technology originated from the global wave of digital currencies that began in 2009, but its impact on finance has far exceeded the realm of digital currencies. Fundamentally, it creates a new type of value registration and exchange technology, representing a significant leap in ledger technology following its digitization. If the dematerialization of securities and electronic business processing was the first revolution in financial infrastructure brought about by information technology, then the digitization of securities and decentralized business processing may represent the second revolution in financial infrastructure.

Advances in Information Technology and the Development of Dematerialized and Electronic Securities

The oldest verifiable stock in the world was issued by the Dutch East India Company on September 9, 1606. It was printed on paper, containing information such as the investor's register, issuer, amount, and signatures of relevant personnel. This was a paper contract representing shareholder rights.

The drawback of paper securities is that their settlement requires physical movement, involving a series of operations such as printing, storage, transportation, delivery, stamping, and endorsement, which are numerous, lengthy, and inefficient. As the volume of securities trading surged, the settlement of paper securities became increasingly unmanageable, culminating in the paperwork crisis in the securities industry in the late 1960s. In 1968, the average daily trading volume on the New York Stock Exchange was 16 million shares, eight times the average of 2 million shares in 1950. Slow settlement processing led to a backlog of orders that could not be settled in time. The New York Stock Exchange had to shorten daily trading hours and close every Wednesday to handle the backlog of paper documents.

To resolve the paperwork crisis, the securities industries in Europe and America established the Central Securities Depository (CSD) system and the nominal holding system for securities, achieving non-physical settlement of paper securities through multi-tiered third-party bookkeeping, significantly improving settlement efficiency. However, securities were still primarily paper-based, and the costs, risks, and inefficiencies associated with paper securities remained.

By the late 1980s, the costs of computer storage and communication had significantly decreased, making dematerialization of securities truly possible. From the issuance stage, securities could be recorded using electronic ledgers instead of paper certificates, with the entire business process adopting efficient electronic processing. In 1989, Australia initiated a dematerialization reform for securities. In 1992, 1995, and 2001, the UK successively issued three "Dematerialized Securities Acts" to promote the dematerialization of securities. Other countries, including Finland, Norway, Estonia, and Latvia, also followed suit. When China's capital market was established in the early 1990s, it achieved full dematerialization of securities, leading internationally.

The "Revolution" of New Financial Infrastructure Brought by Blockchain Technology

In the traditional financial infrastructure framework, the functions of securities registration, clearing, and settlement provided by Central Securities Depositories (CSD), Securities Settlement Systems (SSS), Central Counterparties (CCP), and Payment Systems (PS) all use third-party bookkeeping. These central institutions increment or decrement the balances of securities or funds accounts on a central server to complete the transfer of securities and funds.

In contrast, in a blockchain-based financial infrastructure framework, wallet addresses replace accounts, and customers do not need to open accounts at specific central institutions. Their private keys are generated locally, from which public keys are derived, and then transformed into wallet addresses, effectively allowing individuals to create their own accounts. This is the primary difference. Secondly, distributed ledgers replace central ledgers. Each customer has their own ledger, and everyone shares the ledger information. The ledger is akin to information disclosure in the securities market: open, transparent, and traceable. Moreover, everyone can participate in bookkeeping and become a bookkeeper. Thirdly, in terms of value representation, Unspent Transaction Outputs (UTXO) replace account balances, representing a claim to value agreed upon by the public rather than a number recorded in a third-party ledger. Finally, in addressing the "double spending" problem of value transfer, consensus algorithms replace third-party endorsements, utilizing economically incentive-compatible designs to solve the fraud issue in the absence of a trusted intermediary.

In the era of paper media, the form of securities was paper certificates, based on "words"; in the electronic era, securities became dematerialized, based on "third-party electronic bookkeeping"; in the digital era, the form of securities is trusted digital certificates, based on "digits," which we can call "digital securities." They do not rely on third parties; the distributed ledger of digital securities itself serves as the CSD, SSS, and is a natural transaction reporting repository (TR), and can even function as a PS. In addition to securities registration and settlement, smart contract technology can be applied to encode the current business logic of securities trading and CCP into code on the distributed ledger of digital securities, enabling decentralized asset trading and central clearing directly on the chain. This represents a completely new financial infrastructure that integrates securities trading, CSD, SSS, PS, CCP, and TR.

It is still difficult to conclude whether the new financial infrastructure based on blockchain is necessarily superior to traditional financial infrastructure; at least in terms of performance, there is ongoing debate. However, it is undeniable that it indeed provides us with a completely different technological solution for financial infrastructure compared to the central model. In certain aspects, its advantages are significant.

For instance, the system's resistance to attacks and robustness. When node failures occur, as long as the nodes required by the consensus algorithm can operate, the availability of the blockchain system will not be affected. Regardless of how long the system is down, validating nodes can recover. Compared to the single point of failure risk of a central server, blockchain systems have advantages. In recent years, trading systems of exchanges have frequently gone down due to hacker attacks or technical failures, such as the Toronto Stock Exchange, Tokyo Stock Exchange, Singapore Exchange, Bombay Stock Exchange, and NASDAQ. The most severe incident occurred in August 2020 when the New Zealand Stock Exchange faced network attacks for five consecutive trading days, forcing multiple trading interruptions. In contrast, the completely open and exposed Bitcoin network has been running since 2009 without downtime due to network attacks, demonstrating high stability.

Another advantage is the system's openness and inclusiveness. Traditional financial infrastructure is not only closed but also fragmented, leading to low efficiency in information exchange and high costs. The new financial infrastructure based on blockchain is not restricted by traditional account systems and closed networks, offering stronger financial inclusiveness and the ability to connect various parties in the same network, integrating various financial infrastructure functions with characteristics of unity, seamlessness, ubiquity, and inclusiveness. It can play a positive role in scenarios with high fragmentation and significant pain points, such as retail, cross-border, and over-the-counter transactions.

Concept of New Financial Infrastructure Based on Blockchain

The new financial infrastructure based on blockchain has attracted widespread attention in the securities industry. For example, the Australian Securities Exchange plans to adopt a blockchain-based system to replace the existing electronic settlement system. The Swiss Stock Exchange has proposed establishing a blockchain-based digital asset exchange (SIX Digital Exchange, SDX). The Depository Trust and Clearing Corporation (DTCC) in the United States has conducted experiments on post-trade processing of securities repurchase transactions based on blockchain. Germany's national blockchain strategy proposes starting with digital bonds to promote the issuance and trading of securities based on blockchain technology. However, compared to the booming global wave of digital currencies, the application and exploration of blockchain technology in the securities industry appear relatively tepid.

It should be noted that the exploration of new financial infrastructure based on blockchain in the securities industry is just beginning. How should it be constructed? How should the technical solutions for different types of securities be designed? How should corresponding business processes and operations be carried out? What are the key points? How can blockchain technology play a positive role in specific scenarios? Will traditional financial infrastructure institutions cease to exist? What are the new roles? What are the risk points of the new financial infrastructure? How should it be regulated… These questions remain unclear. Therefore, a systematic and complete theoretical framework is needed to guide the practical exploration of new financial infrastructure based on blockchain. This section proposes a basic framework concept for new financial infrastructure based on blockchain.

DLT-CSD Ledger

As a new generation of value registration and exchange technology, blockchain technology is most likely to be applied first in the field of securities registration and settlement. This means maintaining the existing processes of securities trading and clearing, with the front end still managed by the stock exchange and the central counterparty (CCP) responsible for clearing, while the back end is transformed into a blockchain-based securities registration and settlement system (referred to as "DLT-CSD"). This is the basic framework. The basic framework makes minimal changes to the existing financial market infrastructure landscape. The DLT-CSD ledger can include at least eight types of nodes: securities registration and settlement institutions, stock exchanges, securities companies, commercial banks, securities issuers (listed companies), investors, central banks, and securities regulatory authorities, possessing the same financial infrastructure functions as traditional CSDs, but with a fundamental change in implementation.

Securities Custody and Securities Accounts

Securities held by investors should be fully custodied in the CSD when listed for trading. In the traditional CSD model, the CSD opens accounts for each investor, and the securities held by investors are reflected as account balances on the CSD ledger. In the DLT-CSD model, traditional securities accounts are transformed into wallet addresses, and securities correspondingly become encrypted digital assets stored on a distributed ledger. Encrypted digital assets point to the investor's wallet address, which can only be accessed with the investor's private key. The private key is highly confidential, derived locally through elliptic curve algorithms, from which a public key is generated, followed by two hash operations, and then a data encoding integration produces a long number, which is the wallet address.

Securities Registration and Settlement

Securities registration is the recognition of securities holdings, including initial registration, change registration (i.e., securities settlement), and exit registration. First, regarding change registration, traditional CSDs record the ownership and changes of securities through increments and decrements in account balances, while in the DLT-CSD ledger, the flow of digital assets represents the flow of value, with digital securities directly flowing point-to-point without relying on third-party intermediaries. The specific process is as follows: the party transferring the securities first obtains the wallet address and public key of the receiving party, encrypts the securities transfer message using the other party's public key, then signs it with their own private key and broadcasts it across the network. Once the network receives the securities transfer information, consensus verifies which address issued the securities transfer message and to which wallet address it is intended to be transferred. Finally, the receiving party uses the private key of their wallet address to unlock the securities transfer message and obtain the securities.

For initial registration and exit registration, to ensure the implementation of relevant regulatory policies for public offerings and securities registration, the DLT-CSD can adopt a dual-signature mechanism. This means that the securities issuer can only initiate initial registration and exit registration after obtaining signatures from two of the securities issuer, securities regulatory authority, and notary. However, change registrations initiated by trading transfers or non-trading transfers do not require signatures from the securities regulatory authority and notary.

Centralized trading transfers do not change the existing post-trade settlement business chain. After trading orders are cleared by the CCP, they are sent to the DLT-CSD ledger, where settlement participants sign to confirm and submit securities transfer instructions to the DLT-CSD ledger for change registration. The DLT-CSD system and PS system achieve the atomicity and finality of securities settlement and funds settlement through a securities-funds payment mechanism (which will be elaborated on later).

Corporate Services

Traditional CSD services for listed companies include securities holder register inquiries, rights distribution, online voting services, etc. In the DLT-CSD environment, these services can be automatically executed by smart contracts. The securities issuer, as a ledger node, automatically obtains the register of securities holders; similar to initial registration, the securities issuer uses the dual-signature mechanism to distribute dividends and other rights; since the distributed ledger itself is a voting system, online voting can be directly conducted on the DLT-CSD ledger.

Conclusion

Under digital technology, the new financial infrastructure based on blockchain is feasible and controllable, with more precise regulation, thus it is standardized. Blockchain ledgers are difficult to forge, hard to tamper with, and are traceable and easily auditable, making them transparent. They make financial services more freely open and vibrant, and they are based on trusted technology, with strong fault tolerance and resilience. Therefore, it meets the five standards of "standardized, transparent, open, vibrant, and resilient" for new financial infrastructure, with unlimited potential and promising prospects.