Part 1: The Case for Market Decentralisation

This article is Part 1 in a series. Read the rest here:

• Part 2: How Trust Makes Traditional Financial Systems Inefficient
• Part 3: Blockchain’s trustless guarantees

Financial instruments can be seen as a combination of a few components. First, there are the rules (or contract) that describe how the instrument works; then there’s the accounting of selling them and keeping track of who owns them; and finally there’s the process of paying out what is required to all the people who own them during the life of the instrument, according to its rules.

From a technological view, the first bit is relatively easy. The instrument contract can be structured for the issuer by a suitable legal firm. The rest of the components, however, have traditionally proved much harder to implement. Taking a look at the disconnected technological structure of the traditional financial markets, it is not hard to see why.

LAYERS OF INTERMEDIATION

Financial instruments must be held by their owners. This is done through a securities or brokerage account (a special type of bank account) at a financial institution like a bank. Practically what this means is that in different banking institutions, in different proprietary systems, a number is stored for an asset holder saying how much of a particular instrument they hold.

In addition to this system of accounts, a single venue is required where the issuer can sell the instrument on the primary market. and then where holders can find each other to buy and sell the instrument to each other on the secondary market. This is realised through another proprietary system owned by another company known as an exchange. A potential investor needs to find a way to access that exchange. Since direct access to the exchange system is not typically possible, the investor will need to have an account with a broker who trades on their behalf on the exchange… via yet another system.

In this condensed description of the process, there are already at least three completely different proprietary, closed-off systems that are owned and operated by different companies. That’s three layers between issuer and investor, three layers between buyers and sellers. In reality this picture is significantly more complicated with more companies and proprietary systems (such as clearing houses, among many others) coming between the different sides and players in the market.

Consider the challenge presented to the issuer of a bond when the time comes to find out who owns the instrument at any single point in time, so that interest payments can be made to them. They not only need to find the current list of owners across multiple banks; they also need to know which bank account to pay for each of the owners’ interest payments (since often the account that holds the bond cannot hold fiat currency as well).

This challenge is further complicated by the fact that the instrument can change hands freely in the secondary market!

This is typically dealt with in the traditional financial markets world by appointing another company with another proprietary system to maintain a register of current asset holders, and to stop trade a few days before a payment needs to be made in order to ensure that the register is up to date before determining who to pay.

WHY NOT ONE SYSTEM TO RULE THEM ALL?

The inefficiencies present in traditional financial markets prompt the question: Why hasn’t a single company developed a unified system that could do everything, thereby eliminating costly intermediaries?

The short answer is that that would be bad. We shouldn’t want that, particularly if such a company were to be built atop the current technology used by the market.

In support of this assertion, let’s fill in the details a little further of what it would look like if the entire market was contained within a single company using incumbent technology. In this world, a single, private, for-profit company responsible only to the board of directors and shareholders would be in complete control of all of our assets. We would be forced to have an account at this company (i.e. you couldn’t choose your own bank) and we could never withdraw our money to keep it in our own safe if we wanted to.

To see how much we have, we would need to log into their system and trust that what we see is correct.

Imagine if something extreme were to happen and their system broke down. Perhaps for days or weeks, we wouldn’t be able to access our funds while they rebuilt the system. Or rumours could start to circulate that the company was enriching itself by taking the last decimal off every client account. In these kinds of situations, we would have little to no recourse. All of the evidence that we owned something would be on the inside of their computer system. We would not be able to see what was going on inside it (it’s their private computer system, after all) and we wouldn’t be able to move our money elsewhere in protest.

Ultimately, it’s a question of trust. It is very difficult to put our trust in a single, all-powerful company. Without competition, the checks and balances distributed across the traditional financial system, trust breaks down very quickly. While dystopian, this thought experiment is a very useful exercise, as when we look at the pros and cons of such a system, we can imagine how a new, better, financial system could look.

Read more articles in this series:

• How Trust Makes Traditional Financial Systems Inefficient
• Blockchain’s trustless guarantees