Our global financial market infrastructure (FMI) is underpinned by a number of systems that are the glue that holds our financial markets together.
The U.S. Federal reserve defines them as the “multilateral systems among participating financial institutions, including the system operator, used for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions.”
FMIs are made up of the following systems:
- Payment Systems
- Central Securities Depositories (CSD)
- Securities Settlement Systems (SSS)
- Central Counterparties (CCPs)
- Trade Repositories
The roles of these can be illustrated when one organisation purchase a security such as a derivative from another:
- Central counterparties guarantee the terms of the trade between participants
- Securities settlement systems update the ownership records of the security from the seller to the buyer
- Central securities depositories continues to safeguard the security
- A trade repository stores a record of the transaction
- A payment system is used to settle the funds associated with the transaction
The mechanics of how these systems interplay with one another to facilitate a transaction as illustrated above is well understood within TradFi. However, what is less clear is how the roles of these systems will evolve in the context of blockchain and web3 technology.
Having a tokenised asset existing on a blockchain removes much of this complexity, allowing the role of these various FMIs to be taken care of at the smart contract layer.
For instance, if we consider what happens using a decentralised exchange such as Uniswap, where an organisation can take Ether or a token and exchange it for another one such as USDC or Polygon’s MATIC.
The trade, token settlement and payment take place in an atomic transaction with the asset going from a Uniswap liquidity pool into your crypto wallet, with the transfer recorded on-chain.
In the context of this example we can see how much of the traditional FMI moves on-chain.
- Ether is our payment system
- The Ethereum network in the case of Ether, and the smart contracts that defined the tokens being traded are the equivalents of the central securities depository
- The smart contract performs the securities settlement
- The smart contract guaranteed by the Ethereum network acts as the central counterparty
- The activities are recorded on the blockchain which is our trade repository
It is this ability for much of the FMI to shift to on-chain (a decentralised FMI or dFMI) which demonstrates how much potential blockchain and DLT technology have in this space and there is so much investment into it.
However, just because it’s possible to simplify the securities settlement lifecycle with smart contracts and public blockchains, it doesn’t mean that it will play out this way.
Centralised cryptocurrency exchanges such as Binance, Coinbase and FTX account for the lion’s share of cryptocurrency trading activities. In the centralised crypto exchange model, these exchanges have become the central counterparties and securities depositories, as they hold crypto assets on behalf of their customers.
It is also at their discretion how much of the settlement and trade activities are recorded on-chain. Payments in fiat onto their platforms use traditional financial payment rails.
When an individual or institution trades a token via a crypto exchange, they are taking on additional FMI risk as much of the infrastructure is controlled by the exchange.
Having so much systematic risk within a single institution does seem untenable when we’re considering that web3 networks are considered to be the future of financial markets, not the past. I’d envisage that in order for these blockchain rails to support not just a $1tn ecosystem, but $100tn+, which is where we need to be to bring much of TradFi on-chain, centralised crypto exchanges in their current mode won’t support this.
Exactly how this evolves is likely to be influenced by regulation, and it’s hard to imagine centralised crypto exchanges not being regulated in a manner dissimilar to conventional exchanges — unless they can demonstrate that they are appropriately using the underlying blockchain in their core operations to facilitate custody and settlement of these assets.
Decentralised exchanges and other parts of the DeFi ecosystem do not have these same challenges with much of the traditional FMI activities taking place on-chain. However, due to this radically different approach, adapting our existing or creating new regulatory frameworks is going to take some time.
Whether or not these traditional FMIs should move onto public blockchains is a topic for another day. But regardless of where it ends up, the lack of regulation around public blockchain infrastructures for institutions will hamper broader adoption in the developed world.
In addition to protecting the end users of financial services, regulation needs to ensure that platforms don’t just have KYC, but also monitor activities for AML, counter-terrorism financing and politically exposed persons. Exactly how or if this can be implemented for applications running on public blockchain networks remains to be seen.
Already we can see that some blocks being created on Ethereum are OFAC compliant
— but it seems more logical for the regulation to be focussed on the smart contract layer over the underlying blockchain layer if the blockchain is to be a true internet settlement layer.
This debate did illustrate the challenges facing the future decentralised FMIs (dFMI). There is widespread awareness across the industry of the potential benefits DLT and blockchain technologies bring to the table. However, there is still a significant gap between the highly regulated financial industry and the largely unregulated DeFi industry.
How close true dFMIs can come to public blockchains will be dictated by the speed with which regulation can embrace this new paradigm. Regardless of the potential efficiencies, this technology can bring to the table, it will take time for regulators and central banks to become comfortable with it.
Hence it’s likely to still take years rather than months, as much as many of the community is excited about it. In my mind, the only way technology could potentially leapfrog this process, is if alternatives to fiat currencies were widely embraced.
However, whilst individuals are free to pick and choose how they engage with fiat currency alternatives such as cryptocurrencies, large organisations do not have the same freedoms. Given that they drive a significant portion of the overall activity taking place on FMIs, without their buy-in, there’s unlikely to be a significant shift in the FMI that drives much of our day-to-day commerce and financial activities.