In the last article, we explored how cryptocurrency exchanges and traditional stock exchanges differ. The FinTech world is not limited to cryptocurrency, though, and plenty of other concepts and processes in finance has been digitised and provided by FinTech firms.
In this article, we will focus on how FinTech is changing capital markets and whether FinTech firms will be disruptors or collaborators.
The Traditional IPO and Contemporary Funding Practices
Traditionally, the IPO was how the public gained access to equity in a company. A long and thorough process, weaved through various companies and organizations, the IPO was expensive, time-consuming, and restricted to large investors with access to the primary market. Those big investors could dump their shares into the secondary market immediately thereafter, where everyone else would buy them up, leading to a quick profit for the big players from the primary market.
In the 2010s, a new concept appeared: the ICO – Initial Coin Offering. Some ICOs still required large initial investments with USD-equivalents of tens of thousands of dollars just to enter. However, plenty of other ones had initial investment thresholds far lower, perhaps a few tens of USD equivalent. Many ITOs (initial token offerings) also followed this concept of low-buy-in thresholds, especially on the Ethereum platform.
The number of ICOs has multiplied exponentially over the last couple of years, and there have been plans of billion-dollar ICOs (like Telegram’s). However, government regulation of ICOs is still a grey area and how future regulation may affect them has warded off major private companies from “going public” via ICO. Regulatory investigations are currently underway, too, keeping some companies away from the space until the legal implications are clearer.
So publicly-sourced funding is one major area where FinTech could complement traditional exchanges, especially for smaller companies that need smaller amounts of funding. But whether ICOs will replace IPOs remains anyone’s guess, highly contingent on how regulation moves forward. We have explained a lot more about ICOs here.
Capital Markets Infrastructure (CMI)
CMI is the core business of the traditional exchanges and brokers. Buyer-seller matching, recording, regulatory compliance, liquidity support, transparency, and settlement. All of these concepts and processes are currently performed by a wide array of companies and organizations, and this fragmentation causes the environment to be difficult and expensive to navigate – thus the high commission fees and long waiting periods for trading (notably in settlements). It also relies heavily on all the participants working well, accurately, and honestly.
Cetent Securities (PDF) and Deutsche Börse (also PDF, more explanation) have published a report on the impacts of FinTech in capital markets, and their first theme is infrastructure. McKinsey identifies similar areas of impact and confirms the Cetent/Deutsche Börse report. Much of the experimentation is centred around streamlining settlements, compliance, and nontraditional fundraising (ICOs).
Blockchain and distributed ledger technology (DLT) are the main drivers for change in the traditional CMI, with transparency, centralization, and settlement efficiency the main goals. Early testing is underway, and the Australian Stock Exchange (ASX) has announced it will replace its current clearing and settlement system, CHESS, with a private DLT in the near future.
By leveraging DLT, exchanges will be able to easily track who owns what at all times and make trading transparent. It isn’t without its drawbacks, though, which could include panic selling when the market notices big participants are selling their stakes in any particular company. Of course, there might be restrictions on what information is made public and what remains for exchange-eyes only, a policy decision that could limit these kinds of panics.
Blockchain for CMI has plenty of test cases outside Australia, too. JSX (Japan) is exploring blockchain for low-volume market settlement and has published several working papers on the subject. KSX (Korea) partnered with a FinTech firm and implemented a full exchange on blockchain for startup financing and trading. NASDAQ developed Linq, a private blockchain, and the exchange has partnered with Citi to bring even more blockchain development to the financial world.
Exchanges in Germany, India, Chile, Russia, Canada, and the UK are also all experimenting with blockchain use. Everyone seems to understand the technology will change finance, but the world is still determining what works best and what is better left to other technologies.
Rather than using FinTech to augment existing infrastructure for equity issuance, trading, and post-trade activities, some crypto and traditional stock exchanges are partnering and work in collaboration to build entirely new exchanges. One example is the aforementioned KSX initiative (whose website, unfortunately, seems to be only in Korean for now).
Another, more recent development comes from Malta, an EU member state, which has recently enacted legislation favourable to FinTech, earning (or promoting) the nickname “Blockchain Island”. Neufund, a subsidiary of the Malta Stock Exchange, has partnered with Binance, one of the world’s most prominent cryptocurrency exchanges, to build a global, decentralized market for trading equity via tokens. One of the biggest goals is to bring regulation to the platform (in comparison to other DEXs like EtherDelta, where anyone can list anything they want).
RegTech (regulation technology)
Another point in the Deutsche Börse and Cetent Securities report is “post-trade digitization”. This includes recording and settlement, but it also includes regulatory compliance. Using AI, Big Data, and DLT, FinTech is looking to automate compliance assurance and regulations, and ferret out illegal trading.
One interesting way RegTech is envisioned to deployed is via security tokenization, whereby equity is tokenized into digital assets that are subsequently traded. This tokenization can then be used as a means to track trades and essentially outsource compliance. Every trade will be verified to be compliant, such as for KYC and AML regulations, and if it is not, it will be halted. The exchanges, brokers, and clearing houses will no longer be solely responsible for maintaining compliance records, and a third party whose business is focused on leveraging AI and Big Data can share the burden.
FinTech – a threat or a companion?
It seems FinTech is not a threat to the traditional exchange but instead a good partner. The exchanges certainly are not shying away from the new technology, and they seem to be looking to collaborate with smaller, specialized firms to build their proprietary blockchains and tech rather than compete directly. The incumbent financial institutions, like investment banks, are also exploring blockchain and other financial technology uses.
On the other hand, exchanges do fear traditional tech companies and their behemoth sizes. Small FinTech firms are unlikely to have the insights that are available to Google simply because Google has more proprietary data by orders of magnitude. Since machine learning tends to work better with huge amounts of data, it seems reasonable that Microsoft, Amazon, Google, et al. will be able to build smarter machines using their own data while the small startup will only be able to access much smaller chunks of data. Still, it may be that the tech giants will eventually partner with the finance giants to bring automation and efficiency to all sorts of financial areas, notably for infrastructure and its associated activities.
It could also happen that a startup completely disrupts the space with a revolutionary new innovation, leaving Big Tech and Big Finance scrambling to keep up. Only the future can tell us what lies in the future, but we can be almost certain FinTech will be changing who participates in markets and how those markets are operated.
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(This article has been originally written for MasterInvestor.co.uk)