The Disruptor, Disrupted? Nasdaq Wrestles with Blockchain
Blockchain technology has the potential to take over much of Nasdaq’s core trading operations. How can it respond?
“… the opportunities we can envision blockchain providing stand to benefit not only our clients, but the broader global capital markets.” — Bob Greifeld, Nasdaq Chief Executive
Dole Foods, a California agricultural producer, was sued by its shareholders for ‘sandbagging’ when going private in 2013[i]. The Delaware courts determined that shareholders should be compensated for $2.74 per share. Despite only having 36,793,758 shares outstanding, the company received reimbursement requests from the holders of 49,164,415 shares. Where did the 12,370,657 new shares appear from? In the days leading up to the sale, shares continued to be exchanged and ‘shorted’, and since there was a lag between the execution of the transaction and the transfer of share ownership, multiple parties could claim to hold the shares simultaneously. Nobody, including the judges in the subsequent lawsuit, could determine who actually owned the company’s stock at the precise moment that counted. Ultimately, the excess claims were settled out-of-court between Dole, the Depository Trust Committee and the brokers.
The Dole Foods case demonstrates the limitations of current securities exchanges. The problem was that within the complex supply chain of stock transfers, duplication of ownership was possible. Blockchain technology could solve this issue, as well as improve cost profile, security, and transparency. Nasdaq is threatened by these shifts, and is aiming to capitalize on them.
Blockchain and Securities Supply Chain
Although a stock transaction can be completed within microseconds, the settlement — transfer of ownership of the stock — can take “as long as a week”[ii], and involves a supply chain with a series of counterparties outside the exchange, including brokers, depositories and custodians.
Blockchain technology could cut out the need for many of these intermediaries[iii]. The blockchain is a distributed ledger that allows for trustless, immutable and transparent tracking of digital asset ownership. Crucial to blockchain technology’s potential in exchanging securities are ‘smart contracts’, programs that combine the transfer of ownership with the transfer of value. That is, a blockchain-based network will only move money once the equivalent service (for example, the owner of a security being updated in the ledger) is completed. This ‘trustless’ attribute — where buyers and sellers no longer need escrow-like services to hold materials in the short-term — it is argued[iv], cuts out the need for ‘middlemen’ in digital asset supply chains, and this is a significant concern for Nasdaq.
Nasdaq’s Response: The World Is Not Enough?
Nasdaq has made several moves to capitalize on these opportunities. First, operationally, they hired a Vice President of Blockchain Strategy and advertised for blockchain developer roles[v]. Second, they are building new business models around blockchain. In late 2015, they created a new share ownership system for a private company, Chain.com[vi]. Paper share certificates were replaced by digital certificates, built on a private blockchain. By creating a blockchain-based trading platform for non-cryptoassets, this could establish Nasdaq as the blockchain-trading market leader. Third, they are integrating blockchain into their core business model. In 2016 they investigated the use of blockchain for shareholder proxy voting[vii], and most recently in November 2017 they created an exchange traded fund-like blockchain Smart Beta product[viii].
Although the most responsive of the stock exchanges to the threats and opportunities of blockchain, Nasdaq could still be doing more. First, they could invest in more blockchain startups or cryptoassets. This would provide a hedge against the growth of blockchain. Second, they could start a cryptoasset retail trading platform, to compete with Coinbase, Bitfinex, and others. This would allow them to capitalize on the potential for crypto-based protocols that will not need to IPO in the future. Finally, Nasdaq could expedite the shift to blockchain-based systems by encouraging publicly listed companies to open up their share registers to the blockchain. This would ensure that Nasdaq were right at the center of the approaching shift.
What next?
As with elsewhere in the blockchain space, many questions remain unanswered. Will blockchain-based solutions permeate the market? If they do, will an incumbent like Nasdaq be in a position to dominate, or will an innovative startup without Nasdaq’s institutional baggage be better positioned to do so? Perhaps most importantly of all, does the ‘blockchain revolution’ have substance, or is it, as Jamie Dimon described bitcoin, “a fraud”[ix]?
[i] Levine, Matt, Dole Food Had Too Many Shares (2017). Bloomberg News. https://www.bloomberg.com/view/articles/2017-02-17/dole-food-had-too-many-shares
[ii] Iansiti, Marco and Lakhani, Karim R., The Truth About Blockchain (2017). Harvard Business Review. https://hbr.org/2017/01/the-truth-about-blockchain.
[iii] Pilkington, Marc, Blockchain Technology: Principles and Applications (2015). Research Handbook on Digital Transformations. https://ssrn.com/abstract=2662660.
[iv] Lee, Larissa, New Kids on the Blockchain: How Bitcoin’s Technology Could Reinvent the Stock Market (2016). Hastings Business Law Journal.
[v] Buntinx, JP, NASDAQ Is Hiring A Blockchain Developer For Their Linq Project (2016). The Merkle. https://themerkle.com/nasdaq-is-hiring-a-blockchain-developer-for-their-linq-project/.
[vi] Nasdaq, Nasdaq Linq Enables First-Ever Private Securities Issuance Documented With Blockchain Technology (2015). http://ir.nasdaq.com/releasedetail.cfm?releaseid=948326.
[vii] Rizzo, Pete, Nasdaq to Launch Blockchain Voting Trial for Estonian Stock Market. Coindesk. https://www.coindesk.com/nasdaq-shareholder-voting-estonia-blockchain/
[viii] Chaparro, Frank, There could soon be a new way to bet on the rise of blockchain (2017). Business Insider. http://www.businessinsider.com/blockchain-index-nasdaq-reality-shares-2017-11
[ix] Noonan, Laura, JP Morgan’s Jamie Dimon calls bitcoin ‘a fraud’, ‘worse than tulip bulbs’ (2017). The Financial Times.
Great article, Sasha! Like you, I think blockchain presents a very important opportunity to revolutionize clearing & settlement in the securities market. The industry broadly has been moving towards innovation with the goal of minimizing settlement times; when I first started working the standard was ~T+3, but many asset classes have since moved to T+1. If we move fully to T+0, i.e. instantaneous transfer, this has implications for the funding and cash management strategies of broker dealers in particular. Two considerations come to mind immediately; the need for massive credit facilities with lending institutions to cover timing differences in securities and cash flow through the trading party’s account, or an even greater reliance on margin trading.
Very interesting article Sasha. I found this especially interesting after our discussion in Fin today about Bitcoin. I think the Dole example is a great example of why blockchain makes a ton of sense for Nasdaq to use in clearing in settlement. However, I believe that it might be premature to start a competitor to Coinbase to trade cryptocurrency. While they could totally miss the boat on a competitive cryptocurrency marketplace, there is so much uncertainty around where current cryptocurrencies are headed in the next few years. The resources required to develop such a marketplace are not worth the risk of the market completely collapsing.
NASDAQ should focus on their core trading operations and implement blockchain to ensure they do not fall behind other exchanges and lose relevance. Down the line, should many cryptocurrencies prove to have more long-term sustainable value, I think they have a reasonable shot at using their resources and trading expertise to compete with the Coinbases of the world.
This article is fascinating for two reasons: it reveals an aspect of the blockchain that is virtually unknown to the layperson, and because it marries the intricacies of the blockchain to a transaction whose security is so fundamental to the savings of many people. I honestly had no idea that the blockchain’s permanent ledger could be put to such broad uses beyond crypto-currency, but Sasha’s effort here is the foundation of a fantastic thought exercise. Moreover, I think Sasha has hit upon the tip of a very large iceberg in terms of long-term security in a digital world. One of the biggest threats to the future of digital security will be the rise of quantum computing, and it’s possible that the global transparency offered by the blockchain could be the ultimate defense against computers that can so readily crack encrypted standards. As an investor, I’m quite taken with the idea of the blockchain’s promise to remove transaction middlemen from the process, and to ultimately reduce cost. Great article on a wild topic.
Intriguing read, Sasha, many thanks for the time and research you put into this. Like, TJ, I too was not aware blockchain technology could be used in securities transactions. While I am aware that a stock market exchange such as NASDAQ can buy other exchanges, as NASDAQ has done [1], I was intrigued to read your first recommendation for NASDAQ: investing in cryptocurrency startups or assets. I agree that this would be a good hedge against missing out on the growth of blockchain, but would argue that clear rules of engagement need to be set, as NASDAQ would then act as both market maker and player.
[1] Wall Street Journal, ‘Nasdaq Lands OMX for $3.7 Billion; Are More Merger Deals on the Way?’, https://www.wsj.com/articles/SB118007353287814521, accessed December 1, 2017