Market Design For Trading With Blockchain Technology
University of Toronto
University of Toronto – Department of Economics; University of Toronto – Finance Area; University of Toronto at Mississauga – Department of Management
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May 27, 2016
An intrinsic feature of blockchain technology is the so-called distributed ledger, which involves maintaining a decentralized record of all transactions for a security. A distributed ledger allows anyone with access to it to identify asset holdings by (anonymous) identifiers. In this paper, we argue that the mapping between identifiers and end-investors should be a market design choice. We capture features of blockchain technology in a theoretical model of intermediated and peer-to-peer trading, and we study the impact of the usage of identifiers and the corresponding transparency of holdings on trading behavior, trading costs and investor welfare. We find that, despite the risk of front-running, the most transparent setting yields the highest investor welfare. In the absence of full transparency, for low levels of liquidity in the intermediated market, welfare is highest if investors are required to concentrate their holdings under single identifiers.
Market Design For Trading With Blockchain Technology – Introduction
Since the second half of 2015, “Blockchain” has been the buzzword in the financial press; see Figure 1 for an illustration. The reason for the buzz is that people came to realize that blockchain technology has the capacity to be as disruptive to the financial industry as the internet was to offline commerce. The internet enables producers (e.g., airlines) to sell goods and services (e.g., flight tickets) to consumers by cutting out profit-seeking retailers (e.g., travel agencies). Blockchain technology enables people to exchange sensitive information and financial claims (e.g., money, stocks, bonds, property ownership) without involving rent-seeking intermediaries (e.g., banks) that act as keepers of information. Indeed, Blythe Masters, the inventor of credit default swaps, described the blockchain as the “financial challenge of our time” and urged bankers to pay as much attention to this technology as they should have to the internet in 1994.1 During a panel at the 2016 AFA meetings, Michael Casey from MIT’s Media Lab described blockchain technology as the most significant change to the operation of financial institutions since the Medici in the 15th century.2
So what exactly is blockchain technology? The World Wide Web is the technology that enables the frictionless transfer of information; the Blockchain is the technology that enables the frictionless transfer of value. In essence, the blockchain is a ledger of all transactions for an item that is kept not in a (private) database, library, or filing cabinet, but in a public, distributed, commonly accessible network. Transactions are verified by linking ownership of transacting parties to so-called public keys, which can be thought of as (anonymous) identifiers. Verification of transactions occurs via so-called proof-of- work protocols where multiple parties compete to verify for a fee.3 Historically, non-cash financial transactions have required banks or investment dealers to serve as “trusted third parties”. These third parties ensured that the counterparties of a transaction had the cash and the security. Blockchain technology instead allows true “end-investor”-to-“end-investor” transactions, facilitated by decentralized proof-of-work verification protocols, without a “trusted third party,” which, after all, is a rent-seeking intermediary.
At this point, there is little knowledge as to the economic impact of this technological transformation, but there is wide consensus that this technology will be adopted in the near future.4 Blockchain technology has a number of intrinsic organizational features that have the capacity to change the nature of financial interactions and that raise interesting and important questions in particular with regard to optimal market design. In this paper, we discuss the critical organizational features that relate to counterparty transparency, and we provide a theoretical framework to help understand their impact on economic welfare. Since the technology has not been widely used with the exception of bitcoins and some small-scale experiments,5 there is no meaningful data to perform empirical studies.
Much of the discussion and the interest with regard to its implementation relate to the possibility of significant post-trade clearing-and-settlement efficiency gains because with the blockchain, the transaction and the settlement are the same. From a market design perspective, however, it is much more interesting how blockchain technology can affect the pre-trade market organization. One intrinsic feature of a distributed ledger is that it has the capacity (and one can argue the objective) to remove information frictions. As part of the verification process of transactions, verifiers check that the selling party in a transaction owns the item (e.g., the share), and thus ownership is linked to a public identifier (or, in terms of the technology: a public key). These identifiers are anonymous in the sense that they cannot be traced back to a person or institution by anyone other than the identifier’s owner. The ability to directly attribute ownership to an (anonymized) identifier contrasts today’s world, where the trusted third party (and only this party) can make the connection to the seller and can verify ownership.
Alas, it is not clear how much of this ownership information will and should be revealed in the final implementation of blockchain technology. For Bitcoins, for instance, holdings are transparent to all members of the Bitcoin network. Financial institutions, however, are likely deeply skeptical about this degree of counterparty transparency, and they are working on blockchain solutions to limit knowledge of holdings to verifiers only.
Our goal in this paper is to provide insights that help understand and determine optimal market design of counterparty transparency, and we provide a theoretical framework 4See, for instance, Bali and Roche (2015): The TABB Group predicts that blockchain technology to analyze settings with different levels of counterparty transparency. We model the trading of financial securities, and we differentiate between small “retail” investors and large, institutional investors, where our focus is on the latter. There are (at least) two ways to restrict transparency about the total size of one’s holdings. The first is to limit the investors’ ability to view the information that is attached to the public keys. The second is to allow investors to create multiple keys or, in the extreme case, implement a “one share – one key” system (instead of “one entity – one key”) so that the size of an investor’s holdings cannot be inferred from the holdings that are attributed to each key.
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