HashKey: A Comprehensive Overview of the Current Status and Challenges of Global Securities Asset On-Chain

*This article was published on May 6, 2020, by ChainNews, authored by Qian Bojun, * employed at HashKey Capital Research

This article mainly explores the practices of securities asset on-chain in the international capital market. Globally, major stock exchanges are actively building blockchain platforms to explore the application of securities asset on-chain technology. Through this article, we provide an overview of the latest developments and application practices of blockchain in major overseas exchanges, and analyze the regulatory challenges related to securities on-chain.

Overall, the blockchain-based solutions of stock exchanges in various countries mainly aim to improve the securities trading process for end investors and intermediaries, including reducing transaction costs, lowering risks during the trading process, and enhancing the investment returns for participants.

The article is divided into two parts:

• The first part introduces practical cases of securities on-chain from major global exchanges, including Nasdaq's blockchain-based securities issuance and trading management system Linq, the Moscow Exchange's digital asset trading platform D3Ledger, Deutsche Börse's Blockbaster project and securities tokenization platform Daura, the Tokyo Stock Exchange (JPX) reconstructing the trading matching process using blockchain, Canada's Jasper project, and research from the Abu Dhabi Exchange.
• The second part analyzes the regulatory factors that need to be considered for securities asset on-chain.

I. Stock Exchange Practices of Securities On-Chain

Nasdaq's Blockchain-based Securities Issuance and Trading Management System Linq

In May 2015, Nasdaq announced the establishment of Linq, a private equity trading platform based on blockchain technology. Linq serves as a platform for issuing Pre-IPO stocks, aiming to facilitate the tokenization of shares in the private securities market and eliminate barriers between information and platforms. In May 2017, Nasdaq announced a collaboration with Citibank to launch an automated trading settlement solution based on Linq. This solution utilizes Citibank's cross-border payment network, combined with Linq's underlying blockchain technology, to achieve cross-border multi-party trading and real-time settlement in the private market.

In the private equity trading process of startups, the confidentiality of equity information can lead to information asymmetry, making it difficult for investors to fully grasp the risks. Once a company successfully goes public and issues an IPO, due diligence requires historical records of all equity transactions, and managing this in a traditional paper-based manner can prolong the audit process, ultimately affecting the IPO timeline.

Private market trading can utilize Linq to transmit trading information to Citibank's cross-border multi-currency processing platform CitiConnect, which is then sent to Citibank's payment platform WorldLink to complete the fund settlement. Companies conducting Pre-IPO can view the issuance of share certificates, the validity of certificates, and other information such as asset numbers and share prices on the system; they can also search for certificates or view the shares held by investors in the company.

The Linq platform has two main features:

• Enhancing settlement efficiency. Traditional private companies handling their share transactions need to go through various non-standardized systems, involving a lot of manual operations and non-electronic work, which can lead to many human errors.
• Increasing liquidity in the private equity market. Linq covers a large customer base, expanding the audience for Pre-IPO investments, and Nasdaq's private equity market can achieve an online stock management solution, allowing private companies to manage assets and stock plans more efficiently, reducing early-stage funding pressure on startups.

Link between Linq platform and Citibank's cross-border payment system

II. Moscow Exchange's Digital Asset Trading Platform D3Ledger

In 2019, the National Settlement Depository (NSD), part of the Moscow Exchange, launched the tokenized asset custody platform D3ledger. D3ledger provides token custody and clearing, covering assets including digital currencies and tokenized securities. The main chain of D3ledger uses Hyperledger Iroha as its underlying architecture. Currently, known projects on D3ledger include tokenized securities issued by a small health insurance company, as well as Bitcoin, Ethereum, and ERC-20 tokens.

Both the coupon and payment sides of transactions on D3ledger use a token paradigm, with funds and securities recorded on the same blockchain. After both parties confirm the transaction instructions, clearing and settlement are conducted through atomic settlement, allowing for the simultaneous transfer of securities and funds. To issue tokens on D3ledger, multi-signature smart contracts are required, freezing Bitcoin or ERC-20 tokens on the public chain, and utilizing bi-directional anchoring across chains to issue tokens on the D3ledger network. The process does not involve fiat currency inflows or outflows.

From the perspective of issuing traditional depositary receipts, D3ledger acts as both a depositary receipt exchange and a depositary institution, while public chains like Bitcoin and Ethereum serve as custodians. D3ledger does not require the involvement of a physical custodian, thereby reducing credit risk from custodial institutions.

III. Deutsche Börse's Blockbaster Project and Securities Tokenization Platform Daura

Blockbaster Project

Starting in 2016, the German central bank, Deutsche Bank, and Deutsche Börse began experimenting with the Blockbaster project. The Blockbaster project is built on a blockchain platform developed by Digital Asset (DA). The underlying architecture of the platform is Hyperledger Fabric. The Blockbaster project has three research objectives: first, to study the feasibility and reliability of blockchain-based transfers; second, to analyze the costs of blockchain-based clearing mechanisms; and third, to evaluate the efficiency of blockchain-based financial transactions.

The research includes three aspects: first, testing the entire process of blockchain securities issuance, clearing, and redemption; second, fund transfers; and third, fund settlements. The experiment covered 1,000 users, 500 securities, and 200,000 transactions. Among these, 200,000 transactions were categorized into three types: DvPs (delivery versus payment), FoPs (free of payment), and cash transactions.

The experiment demonstrated that the logic of blockchain-based post-trade processing is sufficiently robust and feasible. The experiment completed these transactions in 35 minutes, with an average throughput of 95 transaction requests per second, and transaction intervals within 2 milliseconds, indicating that on-chain clearing efficiency is adequate. The Blockbaster experiment identified several drawbacks of blockchain-based clearing systems: first, transaction conflicts. A certain number of transaction conflicts occurred during the experiment, but they were within acceptable limits, mainly happening in DvPs and cash transactions. Second, the system's energy consumption is high. Blockchain-based clearing systems can lead to high CPU usage and frequent system delays.

Daura

Daura is a securities tokenization platform established by Swisscom. At the end of 2019, Daura, Deutsche Börse, and the European Futures Exchange successfully tested blockchain-based financial post-trade services. This experiment involved three parties.

• The European Futures Exchange acted as the payer, utilizing the Corda platform for fund tokenization. The European Futures Exchange transferred funds (Swiss Francs) to a token account under the Swiss National Bank, triggering the Corda platform to issue an equivalent amount of tokenized funds to the European Futures Exchange's token address.
• Falcon Private Bank and two other banks acted as the coupon payers, using the Daura platform to tokenize securities. The securities tokenization process complies with the depositary receipt issuance process, with the Daura platform serving as the depositary institution.
• Custodigit acted as the custodian, providing security solutions and key custody services.

In this experiment, the coupon and payment sides used two different blockchain systems (Corda and Hyperledger Fabric), representing a cross-ledger DvP. The experiment utilized " cross-chain secure settlement " for incremental settlement, ensuring the atomicity of the settlement process.

On-chain securities trading settlement of Daura

IV. Tokyo Stock Exchange JPX

The Tokyo Stock Exchange conducted a conceptual experiment on the application of blockchain technology in inter-institutional securities trading matching. A total of 26 financial institutions participated in the experiment. JPX's traditional securities trading matching involves four steps: first, initiating the trade; second, both parties confirming the trade, including transaction details and commissions; third, the buyer allocating the transaction commission to the seller's account and notifying the seller; fourth, both parties verifying the transaction data, and if correct, the matching is successful. Subsequently, once the entrusted bank confirms the transaction results, bilateral settlement data will be automatically generated. Due to the complexity of transaction details, traditional securities trading often requires frequent communication and confirmation before the trade, resulting in low matching efficiency.

In this experiment, JPX reconstructed the trading matching process using blockchain. Both buyers and sellers reached a consensus on commission calculation and logic beforehand, forming a smart contract on the blockchain. Neither party needs to calculate the commission themselves, reducing the chances of mismatches. The entrusted bank can query the contract data on the blockchain on a per-transaction basis, enhancing the efficiency of information exchange between buyers and sellers. If the entrusted bank confirms the transaction details, it can link directly with the central custodian settlement institution, eliminating the need for frequent data transmission updates between the buyers and sellers and the central custodian settlement institution.

JPX's blockchain-based trading matching solution

V. Canada's Jasper Project

In October 2018, the Bank of Canada, TMX Group, and the non-profit organization Payments Canada announced the completion of testing for the real-time securities settlement project " Jasper Project ". The Jasper Project achieved fund and securities tokenization in real-time securities settlement and can practice DvP in clearing. The Jasper Project is divided into four phases, with the fourth phase jointly released with the Monetary Authority of Singapore's Ubin project, which will not be discussed here. The following analyzes the research results of the first three phases of Jasper.
Phase 1 & 2

The primary research objectives of the first and second phases of the Jasper Project were to test the feasibility of payments and settlements based on blockchain. Phases 1 & 2 studied three main functions of blockchain-based fund payments: the generation, transfer, and redemption of tokenized funds, with the following steps:

1. After the Bank of Canada generates tokenized funds, it sends the tokens to the omnibus account of the bank nodes on the blockchain.
2. Bank A sends tokens point-to-point to Bank B for transactions via the blockchain.
3. Before the end of the day, Bank B needs to send the tokens back to the Bank of Canada and exchange them for cash, with the Bank of Canada holding or destroying the tokens and recalculating the circulating tokens.

Phase 1 used Ethereum as the underlying architecture, and the test results proved that Ethereum was insufficient to support the operation of the payment system. The main risks included three aspects:

1. Poor data transparency, with high privacy costs.
2. Liquidity risk. Each node cannot know the status of unconfirmed transactions of others.
3. Poor finality of settlement, leading to transaction failures. However, the success of the test was that the payment system was highly usable and had lower operating costs compared to traditional methods.

The failure of Phase 1 can be attributed to platform architecture issues. Phase 2 switched to Corda as the underlying platform, using the UTXO data structure. A notary role was added to both parties' transactions to achieve point-to-point fund transfers. Phase 2 incorporated a liquidity saving mechanism (Liquidity Saving Mechanism, LSM) into the payment system to address payment congestion issues.
The LSM solution in the Jasper Project involves adding inhale and exhale mechanisms on the Corda platform. Before the matching cycle begins, banks submit payments to a queue. These payments are not immediately added to the ledger but are queued until the matching cycle starts. The matching cycle consists of two main steps: first, during the inhale phase, the system requires participating banks to send a certain amount of tokens to the Bank of Canada account and verify them on-chain, with the number of tokens determined by an algorithm. Second, during the exhale phase, netting is performed to return excess tokens to the bank accounts.

Before the end of a matching cycle, banks can freely input or remove payments from the queue. However, the LSM mechanism on the blockchain has a single point of failure issue, and its operational efficiency and reliability are still insufficient. In the results of Phase 2, the privacy and stability of transactions were higher than in Phase 1, and liquidity risks were also alleviated. However, compared to centralized systems, the complexity of the aforementioned LSM significantly increases, and large payment systems may increase operational risks.

Phase 3

The main research objective of Phase 3 was to achieve securities settlement DvP. The roles involved in the experiment were: 1. The Canadian Depository for Securities (CDS) responsible for securities tokenization. 2. The Bank of Canada responsible for fund tokenization. Both tokenization processes comply with the generation process of digital depositary receipts (DDR): tokens represent a 1:1 equivalent of funds or securities existing in the trader's account. Phase 3 securities settlement belongs to single-chain DvP, meaning that both the coupon and payment sides use the same blockchain and deliver on a per-transaction full amount basis.

Asset tokenization process of the Jasper Project

The Phase 3 experiment yielded two conclusions: first, blockchain-based clearing and settlement systems can better integrate CSD and LVTS (Large Value Transfer System), achieving per-transaction full settlement without significantly increasing daily transaction volumes. Second, there is a loose coupling relationship between the systems, allowing for high scalability. By integrating backend systems, economies of scale can be expanded, reducing costs for participants. However, compared to traditional centralized clearing and settlement systems, the Jasper Project has some issues.

First, due to the use of per-transaction full settlement, liquidity for participants may be restricted. Second, the Jasper Project experiment could not determine whether blockchain could save costs in multi-asset settlements. Finally, in terms of data processing, the parties involved in the settlement may become aware of each other's private information, which is not an issue in traditional central settlement.

VI. Abu Dhabi Exchange

At the end of 2019, the Abu Dhabi Exchange and the International Securities Services Association (ISSA) released a report on digital assets based on blockchain. The report outlines key points regarding the issuance, settlement, custody, and other services of cryptocurrency assets.

Securities Asset Issuance

The report summarizes three conclusions regarding the issuance of securities assets based on blockchain:

1. Theoretically, blockchain-based securities asset issuance can bring higher efficiency to the market, but due to regulatory non-standardization, whether blockchain can improve the efficiency of securities issuance remains to be discussed.
2. Securities asset on-chain provides an important investment channel for alternative non-financial assets, including fragmented and scaled investments, requiring regulatory expansion.
3. Smart contracts are the most important mechanism in the securities issuance phase. New functional roles may emerge in the primary market, such as smart contract verification services.

Securities Asset Clearing

Blockchain-based securities asset clearing methods can be divided into two types: off-chain clearing and on-chain clearing, which are introduced separately below.

• Off-chain Clearing

Off-chain clearing means that the coupon side is in a token paradigm, while the payment side is in an account paradigm. Off-chain clearing can be divided into the following two methods:

• The first is real-time clearing. This method clears through the RTGS system and is suitable for large transactions within the business cycle. The coupon side's blockchain system can confirm in real-time whether the payment side has sufficient funds to clear the transaction. While the payment side transfers funds to the coupon side's account via RTGS, the coupon side transfers the on-chain securities to the payment side's on-chain address, achieving real-time clearing.
• The second is conditional clearing, suitable for small or non-business cycle transactions. The difference from real-time clearing is that conditional clearing only involves book-based clearing and does not possess finality. This can create counterparty credit risk.

Two points need to be noted: first, according to the report's research, both off-chain clearing methods currently struggle to achieve multilateral net settlement. Second, off-chain clearing does not have significant advantages in efficiency and cost savings, with traditional central clearing systems being more efficient.

• On-chain Clearing

On-chain clearing involves both the payment side and coupon side clearing transactions on the blockchain, both belonging to the token paradigm. The clearing process does not need to involve traditional fiat currency systems. On-chain clearing requires tokenized funds and tokenized securities to participate. The ideal tokenized funds are central bank-issued stablecoins, with credit risk decreasing from commercial bank-issued stablecoins to non-bank institution-issued stablecoins. On-chain clearing can be divided into two types: single-chain DvP and cross-chain DvP, with specific mechanisms detailed earlier.

Two points need to be noted: first, on-chain clearing can achieve real-time delivery versus payment, but the increased efficiency may offset the additional liquidity consumed. Second, whether on-chain clearing can achieve finality depends on the nature of the blockchain, as public chains may have forking possibilities.

Other Securities Related

Corporate shareholder resolutions can affect tokenized securities, such as issuing dividends or stock splits. Assuming a company issues tokenized cash dividends, the specific steps are three.

• Step 1: The company calculates the total cash dividend and distributes it to the token issuer (depositary institution) account.
• Step 2: The token issuer notifies token holders of the dividend issuance and compiles the shareholders' wallet addresses.
• Step 3: The token issuer distributes stablecoin dividends to the token holders' cash wallets.

The issues involved in the distribution of tokenized dividends mainly include three: first, the clearing dates for tokenized dividends and physical dividends may not synchronize. The clearing schedules for tokenized securities (T+0) and physical securities (T+2) cannot align, leading to arbitrage opportunities between token and physical securities regarding interim dividends and taxes. Second, the anonymity of public chains makes it difficult to trace the ultimate beneficiaries of shares. Third, cash dividends can be paid in fiat currency or tokenized cash, presenting regulatory challenges.

VII. Regulatory Issues Related to Securities On-Chain

Securities Registration, Trading, and Settlement

In terms of functional changes, the current securities infrastructure includes payment systems, central securities depositories (CSDs), securities settlement systems, central counterparties (CCPs), and other institutions. With the addition of blockchain, the functional scope of securities infrastructure will change. The most affected will be securities registration and settlement companies. Functions such as physical fund custody and settlement may be replaced by blockchain.

From a regulatory perspective, tokenized securities need to consider the following issues in registration, trading, and settlement: first, the control rights of transaction records; second, the information that transaction records must cover and the nodes authorized to view the records; third, the standards for market participants; fourth, the manner in which transaction records are presented to regulators; fifth, how to generate abnormal report records in the blockchain; sixth, how to maintain and store transaction records; seventh, clarifying the boundaries of transaction execution, clearing, and settlement, as well as applicable regulations; eighth, whether the management of quotation platforms complies with auditing and regulatory systems.

Tokenized Securities Identification

Securities asset on-chain involves multiple cross-border regulatory technical issues. First, the definition of token types is ambiguous, as many tokens possess more than one nature. The classification of tokens at the legal level varies across countries, which can be reflected in three aspects:

1. First, legal obligations. The legal obligations of token holders, issuers, and pledged assets are recognized differently in various countries.
2. Second, the nature of tokens. The classification of payment-type, security-type, or functional-type tokens has not been unified across countries.
3. Third, how tokens are protected within property rights.

Secondly, securities trading involves issues of cross-jurisdiction. Token issuers may have different legal entity recognitions in different jurisdictions. If the token issuer and token holder are in different jurisdictions, it must be determined whether the issuance is legal for the relevant receiving party.

Thirdly, the progress of blockchain technology development varies by country. As noted in the pilot studies of various stock exchanges, securities asset on-chain needs to be paired with fund on-chain to maximize its effectiveness. Some countries have begun testing central bank digital currencies, while others have not, which may affect the standards for securities asset on-chain.

VIII. Customer Data Privacy

In a blockchain-based securities trading environment, customer information and transaction records may be shared among various parties on the network. Even if some data is encrypted, vulnerabilities exist. Both the SEC and FINRA have specific requirements regarding customer privacy. Securities on-chain need to consider the following potential regulatory issues: first, how brokerages establish security measures related to customer data privacy; second, the access permissions for data at various nodes on the blockchain; third, how to handle conflicting requirements from different jurisdictions.