Exploring the combination of decentralising exchanges. Why make stock markets decentralised? What are its benefits and why blockchain might not needed to be used.
What is Decentralisation?
Decentralization or decentralisation is the process by which the activities of an organisation, particularly those regarding planning and decision making, are distributed or delegated away from a central, authoritative location or group.
What is an Exchange?
An exchange is a marketplace where cryptocurrency, securities, commodities, derivatives, bonds and other financial instruments are traded. The core function of an exchange is to ensure fair and orderly trading and the efficient dissemination of price information for any securities trading on that exchange. (source )
A Decentralised Stock Exchange will enable all the investors to directly trade with each other without any need for a central institution to approve ownership of the stock.
There are quite a few very successful Decentralized Exchanges (DEX) but they enable peer-to-peer trade for cryptocurrencies. There still lacks its implementation with normal stock, futures and bonds. But first we need to understand how normal stock exchanges like BSE, NASDAQ, or HKSE work.
Firstly there is no direct way for you, a retail investor, to trade on the free market. For most investor they need to use the bank (with Demat account in India) or intraday trading apps like Robinhood, Groww, Zerodha, etc. To buy shares of a company (could be futures or any commodity) you deposit funds in the exchange, which will give you the shares. But the exchange does not just issue shares, there must be seller, who is willing to sell. The exchange just enables both to trade at a fair price for which the exchange takes a % cut. On a more technical level any US based stock exchange has issued physical shares , but they do not move those and change its ownership, but rather just maintain an electronic leger which says who owns what, and hence, the actual owner of the shares. If confused, yes this could in theory cause massive problems if that single point of failure is somehow affected or exploited. There are other exchanges in the world that do other things which just involves even issuing the shares electronically.
Although the governments and traditional institutes are not too happy: with the rise of apps – giving retail investors ability to directly participate and, with problems with such exchanges in India and Robinhood having to stop trading of highly volatile stocks.
As mentioned above there are several flaws in this system. Mainly being the brokerage fee that is taken from you. Unless you are really big hedge fund or a bank yourself there is no direct way to trade in the market. This is where the crypto-community jumped in. Because even in cryptocurrencies peer-to-peer trade is becoming increasingly difficult with most exchanges like Coinbase maintaining your private keys (think of it like a massive passphrase to verify your ownership of account). Along with that, the Gas fees (the $ that is charged to transact with another person) is increasing too. Which led to the development of decentralised exchanges. These allow P2P transfer of crypto (at least as of now), generally with help of smart contracts. But, this would still result in high scalability problems (along with increase in time of settlement) whichhas led to some centralisation and hybrid solutions.
These “offline DEXs” basically act kind of like a central authority to facilitate quick trades which is then pushed to the bigger chains’ (usually Ethereum) smart contracts. like a “relay” More info on the topic
This tech could be easily transferred onto traditional exchanges which trade Gold, Oil future, stock, private equity etc.
Japan’s SBI Holdings has reportedly partnered with Sumitomo Mitsui Financial Group (SMFG) to launch a digital stock exchange slated for spring 2022. (source ) There are several advantages which are offered by DEXs like Privacy, Security, True Ownership, etc. but major disadvantages include speed of settlement, fees and scalability.
According to me all of these problems could be avoided if we do not use blockchain. After all blockchain is not the only way to achieve decentralisation. Most of popular validation methods like Proof-of-stake , Proof-of-work heavily depend on the purchase parity of the individual. If he has more money he can mine more or stake more. The simplest way to remove such parity is to not reward the validator.
Let us consider the decentralised network to be a Direct Acyclic Graph , used by the popular token iota . To participate in the network and do a transaction you simply need to validate two or more transactions. There is no incentive for reward. Decentralized exchanges are built to give retail investors power, and with use of blockchain, I believe it won’t be achievable due to mining; unless the blockchain is centaralised (which we do not want). Using DAG even high frequency trading could be enabled. Anyone who wants to trade any volume will not need servers, but just their phones could be enabled to do the same.
Countries in India should actually jump of this trend as it could also incentivise companies to join the chain without any fees. Also, the friction for a startup to easily raise funds will be heavily reduced. Although, it is undeniable that this will work only after approval from government authorities and validation check for any company that wants to get listed.