06 August 2024
Ian Simpson | 32 min read
Digital capital market infrastructure lays a foundation for a new evolution in finance – one that combines proven parts of traditional structures and the potential of new technology like blockchain and DLT. This transition has has many layers – as well as challenges and opportunities.
But what efficiencies does digital capital market infrastructure actually bring? What links remain between the “old and new” worlds – with exchanges, central securities depositories (CSD) and other elements of the ecosystem? And how do changing regulations and technological innovations promise to alter the landscape overtime?
In Part 1 of this RULEMATCH Spot On episode, Ian Simpson speaks to David Newns, Head of SIX Digital Exchange (SDX) for an in-depth discussion of SDX’s development and operations, perspectives on the current state of digital assets and SDX’s place in the wider world of digital capital markets.
Episode show notes:
(1:31) – What is SDX exactly?
(2:50) – Equal regulation as the foundation of SDX
(6:30) – How Switzerland (and SDX) have benefited from crypto
(11:05) – The advantages of regulation
(12:35) – The why and how of dual asset listings
(17:44) – Why bonds and how successful they are on SDX
(20:05) – Digital bonds in financial products
(22:50) – (Digital) securities equivalence and why it’s useful
(25:38) – Digital central bank money – the missing component
(25:59) – Why capital markets need riskless digital money
(30:37) – The key considerations for building a blockchain-based capital market infrastructure
(36:17) – Moving forward towards “digital supremacy”
(36:50) – Intermediated (dematerialized) securities in the digital assets space – and why Switzerland is good at them
(39:45) – Central securities depositories (CSD) on the blockchain and collateral mobilization
(42:54) – “Borrowing” DeFi use cases for regulated financial services
(43:52) – Privacy, settlement finality and other considerations for use of a private blockchain
(50:44) – The use cases for instantaneous (precision) settlement and its potential downsides
(55:07) – Details on the trading and settlement processes of SDX
(58:29) – (No) needs for a Central Counterparty Clearing House (CCP)
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Episode transcript:
David Newns:
We do expect that ultimately all assets will essentially be digital assets and will live on blockchain. So one of our primary roles is to enable the transformation of the Swiss financial center into that tokenized and blockchain-based future that I believe lies ahead of us.
START OF FULL EPISODE:
Ian Simpson:
Hello and welcome to another episode of RULEMATCH Spot On, the only podcast focused exclusively on the institutional crypto and digital assets industry.
I’m your host Ian Simpson. And if you want to know what banks hedge funds capital market infrastructure providers asset managers and others are doing in crypto and digital assets and how they’re doing it. This is the place for you.
My guest today is David Newns. He is Head of the SIX Digital Exchange SDX and Chairman at AsiaNext.
David spent quite a few years working for State Street where he was Global Head of Global Link Execution Services. And perhaps interesting to note that before that he worked for several years at MicroStrategy, a company which some people know from the crypto or should we say Bitcoin space.
David, welcome to RULEMATCH Spot On.
David:
Thank you, Ian. It’s a pleasure to be here.
Ian:
Just to start out, David, I think it would be interesting for our viewers and especially for who are outside of Switzerland and maybe aren’t familiar with the ecosystem to understand in particular what SDX, the SIX Digital Exchange, is and maybe also importantly what it is not.
Can you just give us some details on that?
David:
Absolutely Ian.
So what SIX Digital Exchange is, is a fully regulated financial market infrastructure provider and that is a CSD, which is the Central Securities Depository and an exchange.
Uniquely, that’s built on top of blockchain infrastructure – the first of its kind in the world.
So first we were granted a license to operate a CSD and an exchange on blockchain. And we’re part of SIX Group, which is the infrastructure provider for Switzerland.
SIX Group provides the stock market, the central securities depository, the traditional world, the repo facility for the Swiss National Bank, the Interbank Clearing Platform, so the RTGS platform that the market uses here.
And somewhat uniquely, it’s still member-owned.
So, SIX itself is owned by the 100-plus banks here in Switzerland.
Ian:
And looking at the ambition of SDX, and I actually remember being at one of the first events when it was announced several years ago, it seemed like the overall ambition, long -term ambition, of course, was to build something up to the same standard, the same level as the SIX Swiss exchange as it is now, run it in parallel and eventually transfer over.
Is this part of the overall vision of the digitalization of capital markets as we talk about them?
David:
Absolutely. I believe that we’re both a catalyst for that, that digitalization of capital markets and we’re a vehicle to enable that to happen.
And also, we are the future of capital markets here in Switzerland in that we do expect that ultimately all assets will essentially be digital assets and will live on blockchain.
So one of our primary roles is to enable the transformation of the Swiss financial center into that tokenized and blockchain-based future that I believe lies ahead of us.
Ian:
That’s very, very interesting.
You mentioned, of course, that SIX being member-owned and that applies also to SDX.
So that obviously implies a buy-in from those members to catalyze and move the space forward as capital markets become more digital and evolve, right?
David:
Yes, and it’s a very interesting setup as a result because you have this ability to essentially orchestrate that migration. The members themselves can leverage SIX and also have obviously a significant say in to what we do and what our prioritization is.
When it comes to their journey and how they wish to adopt digital assets and how they need to overcome the hurdles that exist out there.
The role that we play as well in terms of the relationship with the central bank as a provider of the repo facility and as a provider of the RTGS platform, the technology provider, they operate these systems – it’s also really critical because if you look at this, and I’m sure we’ll get onto this later when we talk about central bank digital currencies, not only is it the case that we can help further the ambitions of our members, the banks, and market participants, but we can also provide an environment in which a policymaker, central bank, such as the can actually explore what tokenization might mean for them and their role in both supporting that transition – as well as exploring technology, understanding the risks and the benefits associated with that.
But with a vehicle, again, that they can use that is in production, that’s always going to be there, where there are existing members who can then participate in the initiatives that they are using to bring themselves forth and to establish understanding and learning on their side as well and push the needle forwards when it comes to how they wish to interact with capital markets and support those into those capital markets in the future.
Ian:
Because of course it doesn’t make sense to just have something top-down if the people who are using it, you know, don’t want to or can’t or it doesn’t make sense for what they…
David:
I think that’s actually, that’s a very interesting point or a sort of a way to visualize it because you can’t do things top-down in capital markets.
You really have to think about how to do things completely from the bottom up. You need to have the “most firmest” of foundations.
If we look at, you were saying, what is…
You asked a question, I did not answer it. Which is is SIX Digital Exchange, what is it not?
So it’s not a crypto exchange. On the FMI side, at the moment, we do not do, we don’t offer a trading platform for cryptocurrencies.
If I look at the heritage of cryptocurrencies and the evolution of that particular space – what’s fascinating is that it’s from the perspective of the capital markets, we see that as being, and it’s not mine, this is not my metaphor, this is Rene from Standard Chartered saying, “It’s a big R&D shop.”
What we see sort of happening over there as it were, that we can take learnings from.
It’s been a massive development effort in terms of new and innovative technologies.
Some of the most substantial breakthroughs, you think, in terms of innovation and invention in the 21st century have occurred in that world.
But that world historically has not been regulated and has not been approaching the technology directly from the perspective of regulation, whereas in capital markets, specifically the financial market infrastructure everything that we do has always come from the regulated context out, as it were.
So we start with, at the very basis, and this is back to your “top-down versus bottom-up” metaphor, we need to think about building an architecture from the ground up.
And in fact, you might even go even further and say it’s from the substructure up, because we need to start with effective, clear, regulation in capital markets.
In Switzerland, we’ve had that for many years.
Switzerland has, I think one of its great benefits has been that we have an informed and effective regulator in FINMA who has significant capacity when it comes to their understanding of digital assets.
Also, the way that market participants can interact with FINMA, I think, is in a very constructive fashion.
And I think as a result of that, we’ve had innovation here in Switzerland that I would argue is the envy of the world when it comes to how far we’ve taken crypto.
If you look at the Crypto Valley, it is an unknown thing. If you talk to people in the crypto sphere, they are very aware of Crypto Valley.
We have a number of foundations here for blockchains. We have the Web3 Foundation.
The Crypto Valley Association itself is a great articulator and a supporter of the industry overall.
So, FIMMA enabled that to exist and thrive, which is a great start, and the capacity of knowledge, understanding, engineers, and so on.
It meant that the deployment of digital assets in the regulated space was much easier, as it were, because we had this developer community that was already there and this understanding.
But simultaneously, the regulations as they applied to capital markets and to digital securities could also be seen and effectively implemented by FINMA.
We could have informed conversations with them when we wish to take that forward, roll out a regulated piece of blockchain infrastructure, which was a great, which was an enormous and very significant component on top of that sort of foundational layer of regulation.
Now you need to have regulated blockchain and the license that we were granted, or licenses, in 2021 to operate a central securities depository and an exchange based on blockchain technology.
Those licenses are identical to the ones that are granted to the traditional FMI, the traditional CSD and exchange at Six Group.
But they are unique in that they’re being applied to blockchain.
And it was only because FIMMA had this depth of understanding of blockchain and awareness of both the opportunities, but also the risks associated with that, that we could have that conversation with them, get them comfortable that we had addressed the risks, and we could actually discharge our responsibilities when it came to an operator of a CSD and exchange, based on that new technology.
Ian:
So you mentioned that, right, the regulation at the same level as the SIX Exchange as it is now.
That’s both the trading and the CSD in one.
Obviously, it’s an advantage, it’s regulated.
Are there any disadvantages to being under that regulatory regime or do you think that is a good fit for how things will be going forward?
David:
So for what we need to do.
I think it needs…
We’re fortunate here in that I do not believe that’s any way a disadvantage for the specific role that we are and the specific product set that we are providing to the market.
You do not want to have a different set of regulations that cover digital securities and we’re talking about here fixed income and equity, for instance, versus their traditional counterparts because ultimately you don’t want to confuse an investor at the end of the day.
“Well, this is one thing, this particular kind of financial instrument, but because this other one is digital, it’s completely different.”
Because when it comes to holding those in your portfolio, it’s going to cause some confusion and a challenge to accommodate if – because the underlying technology varies – you have to perceive the financial instrument as being somehow fundamentally intrinsically different.
Ian:
And we’ll get to the products in just a second, but on that point, I’ve noticed some of the products listed on SDX are dual listed, right?
You are listing on the regular exchange and on SDX at the same time. Is that also the reasoning behind the same level of regulation?
David:
So if you couldn’t, if you didn’t have the same level of regulation, you couldn’t achieve that.
I think there’s a number of reasons why that’s really important.
One, as I mentioned before, you don’t want to have the underlying technology to dictate what the financial instrument actually is, how it behaves and how it can sit in a portfolio.
The digital securities that are issued on SDX are legally identical to traditional securities and therefore you can have this dual listing structure.
But why do you need to have them dual listed is a really important question, I think.
If you imagine we have this regulation at the foundation, almost like the underlying substructure.
You then can deploy a regulated blockchain.
And a regulated blockchain means that market participants can carry out regulated activities on that, knowing that they are compliant with the regulations.
That’s what they have to do.
They have no choice. They have to do that. That’s not a discretionary sort of option.
But what you also need is interoperability with the traditional infrastructure because you don’t want to have a situation where – when I’m issuing a digital bond, as I mentioned on the investor side – it can’t be worse than or different to a traditional bond in terms of the financial aspects of it.
As an issuer, you don’t want to be issuing a bond where the price you get for that bond is going to be different, higher, “worse than” the price that you’re going to get for a bond in the traditional world.
Because then why would you issue?
Because you’re specifically trying to, now it’s got a purpose which is to raise capital and you want to raise capital at the lowest possible price.
So if I can’t reach the largest amount of liquidity as an investor base when it comes to issuing that bond, I will not get the best price for that bond.
And since my primary concern is raising capital, that’s a big problem.
The first bond that SIX issued on the platform was a dual tranche bond.
We had a digital tranche and a traditional tranche.
So, we issued simultaneously on SDX and on SIS, the traditional infrastructure.
But the ability to move that bond backwards and forwards was really complicated.
It took days actually to detokenize and then create the bond on the other side. And it had two ISINs.
And for those of you who aware of what an ISIN is, that’s a pretty significant thing.
Basically means it’s a completely different something. It’s a completely different instrument. It’s not the same bond.
And that makes life very difficult for bank treasuries as well as for investors when it comes to actually holding that.
So that lack of fungibility, despite it being theoretically the same issuance, is a big problem.
And the lack of liquidity that the digital had meant that to go to the market again and go, “OK, who’s going to issue the next one?”
The idea that you would issue a bond to just the members and the underlying investors on SDX, not be able to reach the investors that exist on the traditional infrastructure was a big non-starter.
So in fact, our members came back to us and said, “Here’s a shopping list of requirements for scaling and for further issuances on the platform.”
And one of the top prerequisites was you need to build to actually list on SDX on the blockchain, but also somehow enable that to reach the investor base of those members who were not on the SDX platform because we only had Credit Suisse, ZKB and UBS at point in time.
The dual listing structure was the answer to that and a bridge between the two pieces of infrastructure.
So we have a bridge between SDX and SIS. You issue on SDX, but the bond can then be immobilized in SDX and made available on SIS as well – move backwards and forwards completely seamlessly.
So that process is one that happens in seconds rather than in days now.
And there’s one ISIN, regardless of whether it’s on SDX listed or SIS or SSX listed.
That’s the notion of dual listed, natively digital bonds, which is a standard way that we issue bonds on the platform today.
It was extremely novel at the time and is very much the way we expect that all bonds in this sort of, at this point in time where we’re migrating from digital to traditional to digital, that sort of structure enables that migration because it lowers the friction that would otherwise impede adoption.
Because as an issuer, you have an equivalent instrument to a non-native digital instrument.
Ian:
So we’ve talked about the bonds and how that works a little bit in detail.
We’ll go into some more topics for the infrastructure itself.
I mean, actually quite successful what you’ve done so far.
The news came out that there has been over one billion issued on SDX. And recently, let me get the numbers right if I can, a seven-year, 200 million Swiss franc bond from the World Bank was issued on SDX.
Just stepping back – why did you start with bonds and what was kind of the reasoning behind that?
David:
Absolutely. think we’re now up to 1.4, so it’s moving quickly.
Bonds are a relatively simple instrument to start with. There’s a constant supply. So unlike IPOs of equity, for instance, there is a regular issuance cadence associated with bonds.
So as a sort of ammunition to try things out and to move forwards in terms of adoption and understand what the requirements are from a technical perspective, legal perspective, regulatory perspective and so on, and for our members to sort of understand and get their hands used to it, this is technology, bonds are a great, sort of barrel of unending instruments that can be issued.
There is that.
They also lend themselves very well in the digital context to use cases down the line.
So there’s an expectation that we will be providing, and we can get onto this a little later, functionality that can enable collateral mobilization more effectively on blockchain and high quality collateral, high quality liquid assets, are typically bonds.
So not only are they really useful in terms of this supply of ammunition for trying things out, but also there’s very clear future use cases that we are intending to deploy which will leverage bonds.
Ian:
Okay, very, very interesting. Just one thing that comes to mind now, bond ETFs or bond products, even actively managed ones are somewhat popular.
I’ve seen some things in the news recently that those are becoming more and more popular.
How would a digitalized bond issued by SDX operate within a fund structure or something like that?
Is that possible at this point?
David:
It absolutely could be, and it may well be that that’s happening today. Because again, if we go back to this idea of the legal, similitude or whatever, the fact that it’s the same digitally versus traditionally, it means that these bonds can be used in the same context that traditional bonds can be used.
And if you look at, again, this sort of, progress that we’ve been making as we’ve gone along, we sort of checked all the boxes around, you know, is this genuinely the same as a traditional bond?
The second bond, I think, that was issued on the platform, by the City of Lugano, in 2022, one thing that was critical about that was that not only did Moody’s determine that its risk weighting, that its rating should be the same as its traditional equivalent should have been issued on the traditional infrastructure, which was a major process.
Ratings normally happen after issuance, but in this instance, it was a multi-week process, I think four weeks-worth of work with Moody’s, the City of Lugano and SDX to ensure that the underlying technology didn’t somehow impinge upon the risk rating and the answer was satisfactorily, “No it doesn’t.”
But that also meant that all subsequent issuances could follow the same – they didn’t need to go through the same process.
Very grateful to Paolo Bortolin, the deputy CFO of City of Lugano for his patience and his pioneering spirits when it came to getting that through the door – and repeat customer now actually, in the case of City of Lugano.
But that meant, not only was that a major step forward, but also the SNB deemed that bond to be eligible for inclusion in the SNB’s collateral basket.
So you could then use it for repo.
And it is used, and we know from conversations that we’ve had in the marketplace, that it does indeed, as do the other digital bonds, appear as collateral for repo.
That is obviously a critical component, again, of the capital market infrastructure in Switzerland or indeed in any economy.
So to answer, a long way to answer your question, yes, I would be.
I don’t see any reason why not, because these are identical to their traditional equivalents.
If we think again about that metaphor of building up foundations, where you have the regulatory foundation layer at the sub-layer, then you have this regulated blockchain infrastructure.
There is a interoperability component which is also critical. That interoperability both in terms of working with traditional infrastructure, so you have these bridges.
So whilst we’re migrating, these instruments can flow backwards and forwards, but also that the instruments themselves can do that because they are considered identical.
And we’re heading as we build that up and then add on more. And on that network of participants that we’ve now onboarded onto the blockchain infrastructure, you have a network by which these bonds can be issued, traded and settled and custodied amongst a large variety of members.
When that network reaches a certain size, you’ve kind of really achieved what we might call digital securities equivalence, in that you can do everything with a digital version of an instrument that you can do with a traditional world, with one exception – which I’m sure we’ll get onto – which is you need to have this magical central bank digital currency component.
But there’s all this building work that needs to go on just to get to the not very exciting sounding “equivalence.”
Because all you’ve done now is build…
Ian:
You’ve got back to zero.
David:
Back to zero.
This is back to the question around “top-down versus bottom up.”
You have no choice whatsoever but to start at the bottom and build up to that level.
Because only then, having done all that work on the foundational components, can you actually build a superstructure of blockchain which is enabling use cases that you previously could not access because the technology that exists in traditional infrastructure does not facilitate the broad array of use cases that we have available within blockchain technology.
Ian:
We touched on how the banks and the people are interacting with these and I also have another question about the bonds and the issuance but let’s go first to the next things coming up. You alluded to collateral and collateral mobilization and things like that.
People might be thinking also of tokenized equities or other products.
What is now the next step, assuming that things move forward from bonds from here?
David:
Absolutely. So we might want to touch a bit on this sort of missing component as well, is so the something that those who are not familiar with financial market infrastructure may be unaware of or not fully understand the significance of is central bank money.
In the principles of financial market infrastructure, which the BIS have published and which FMI’s follow, there is a principle which is, I think it’s principle seven – which I have tattooed on my forearm, which is that “Whenever possible, systemically important transactions should take place in central bank money.”
The reason for that is that central bank money is the only form of riskless settlement asset that there is in the world today.
So all other forms of money…money that isn’t issued by the central bank, have risk associated with that because those forms of money are issued by commercial banks.
Therefore, there is a counterparty risk associated with that.
When you are conducting transactions that are considered systemically important, so wholesale transactions, and those are transactions that occur between banks and typically for purposes of payments between banks or the settlement of securities transactions.
These should take place in central bank money so that you have the maximum surety of settlement finality.
So the transactions that underpin your entire financial services sector that goes all the way up to retail and in consumers transferring money to other consumers, ultimately those transactions between individual human beings “part and parcel,” go all the way down the stack until the banks of those individuals – assuming they’re not the same bank – that transaction will ultimately be settled.
That liability that’s now being generated between one bank and another bank is settled in central bank money because that transaction is not allowed to fail.
If that transaction fails, the whole edifice all the way up to consumers begins to sort of teeter and doesn’t have that sort of that confidence.
That’s one important factor, which is just for absolute surety that this whole edifice is built on the right foundations.
The other aspect of it is that if I hold tokens that represent a settlement asset on my balance sheet, to facilitate these transactions if those tokens are commercial bank money, that’s not considered riskless as an asset.
I have to hold cash on my balance sheet to offset against that risk…
Ian:
Capital requirements….
David:
Capital requirements.
The more tokens I need to hold, or the more amount of tokens I need to hold, the bigger the capital charge is for holding those.
So, if you imagine that I’m trying to get my members to transact on SDX, but I’m having them transact in a stablecoin, or some such digital currency, or digital form of cash, but they have to hold cash against that, then the more activity, the more capital is required.
So immediately you see this does not scale.
This is not something that’s going to be able to be adopted in that sort of wholesale environment because the actors, those involved are going to end up with a ballooning of capital requirement and a capital charge.
There’s that aspect of it as well.
So there’s both the sort of the structural aspect and then there’s the scaling aspect, which are both which are interrelated, obviously.
There’s also the fact that if the market moves through to become more and more orientated around blockchain and token-based money, or tokenized money, tokenized everything, then for the central bank to actually be able to conduct monetary policy effectively, it will need a form of token-based central bank money just to ensure that it can continue carry out monetary policy operations.
For the central bank’s perspective, it’s also important that both to support but also to participate in and to help maintain the integrity and the stability of financial markets and to able to execute monetary policy, it will need a form of tokenized central bank money should the world move in this direction.
So lots of reasons for there to be…there needs to be some form of tokenized central bank money on blockchain.
Ian:
So basically, in a nutshell, you’re saying that this piece of the central bank digital currency is the intermediate step that needs to happen before the wider use cases of other things beyond what’s come first with bond and so on and so forth can develop and be adopted by more and more members and bring everybody into the ecosystem.
David:
It’s hard to say what is, how and what it is actually, it’s a catalyst on the one hand because… security, I wouldn’t call it a security blanket, but a reassurance that there is now this instrument as
So it gives you, as a member joining SDX, say if you’re a large bank and you’re thinking “How will I leverage this technology…?”
Then you’ll quickly start thinking, “Well, I need to choose a platform that is going to be here to stay, that clearly has a future. And now which one is that going be?”
That’s one thing, because there are other ways that you could potentially leverage blockchain technology.
But you’ll start sort of going, “Well, it really needs to have, you know, be in a jurisdiction where the regulations support it. So I can’t be building out some exciting sort of blockchain-based trading platform in the US instance right now.
Ian:
Or the Bahamas.
David:
Or doing it in a jurisdiction where I could do it, but there isn’t a regulator who has quite a, not quite so much credibility, and is able to enforce regulation in the way that the SNB can.
So you need to have confidence about the regulator. The regulations need to be clear.
But also these, you start going, are those pieces in place?
Because before you know it, you’re actually just checking off the box of like, “Do you have the right regulation? Is there a regulated, licensed blockchain that exists so I can actually conduct my activities on that infrastructure in a way that again means that I trust the counterparty will deliver the service and that I will not, I will be able to be in compliance myself and also I trust the counterparty to deliver because I know it has the appropriate control environment, the license is dictated and so on and so on.”
So that gives you the confidence.
But then you’d also say, “Functionally, what I do on that, where’s the interoperability? Where’s the liquidity?”
Because if it’s going to depend entirely on instruments that have only been issued on that blockchain, then that might be too limited in terms of instruments.
But if it’s got interoperability with traditional infrastructure and can, for instance, tokenize as SDX can any instrument that’s available on the digital infrastructure and then hold that as a token on that blockchain or that’s another massive checkbox.
But also “When I’m transacting on that platform, do my activities scale?”
If transacting means that I’m having to hold a form of tokenized deposit or I’m having to hold some sort of stablecoin, then that will come with significant constraints because now I’ve got this potential capital charge that I’ve got to think about.
And then before I know it, my treasury is going to go, “It’s really expensive what you’re intending to do over there from a capital perspective.”
And capital is a scarce resource that we need to be very careful about.
But when you’re doing your stuff there and not doing it on traditional infrastructure, you have this massive issue. The question will be, “Well, what form of settlement asset exists on that blockchain that will prevent that particular circumstance, that scenario from occurring?”
And really, you’re quite limited in terms of what solutions you have.
So you have a CBDC.
There are alternatives to that that are limited in some pretty substantial way to a CBDC, but I do believe potentially can give you a stopgap.
A trigger mechanism is another one where transactions ultimately trigger the RTGS system to do the settlement.
You don’t keep the cash on a chain.
The problem with that is that we are trying to keep all the assets on the same chain so that we can carry out activities that leverage the blockchain infrastructure’s inherent innovative functionality such as being able to do composability to actually program activities on chain.
And that only really works if you have both the investment token and the settlement token on the same blockchain.
It might get you forwards a little bit having a trigger mechanism, but ultimately you’re still going to have to want cash on chain at some point.
And then there’s forms of synthetic CBDC, which I think are highly innovative and certainly again move the needle, but also have limitations.
And they’re typically a little bit less (maybe) substantial compared to sort of just massive counterparty risk or at least that being a massive issue.
Because in a synthetic CBDC, efforts are taken to ensure that there’s a notion of “bankruptcy remoteness,” but there typically other issues arise and they’re typically related to liquidity risk.
There are scenarios in which you may not be able to de-tokenize, go back to the token issuer and turn those tokens back into cash.
So that causes problems again.
If you’re choosing a blockchain or choosing where to actually innovate, then this last piece that comes into play, the CBDC, as you say, that gives you confidence because this whole infrastructure you have now, it’s like looking at a building site and seeing that they’ve done the foundations as opposed to looking at a building site going…
Ian:
There’s just a hole…
David:
There’s not even a hole.
There’s just a field. I’m not going to construct my skyscraper on that.
I know that will be an expensive and dangerous disaster.
So we have completed the foundation building and now are actually deploying the superstructure.
And the superstructure is where you get what I would call that “digital supremacy.”
So now the instruments you’re issuing digitally and the activity you’re conducting digitally will be superior in terms of what you can access in terms of functionality, in terms of use cases, than that which you can access in the traditional world.
We can get onto that if you want…
Ian:
Let’s get to that maybe in the next step, but first let’s dive down a little bit deep into the rabbit hole to understand some of the mechanics, so then maybe we can understand better how that will work.
So on SDX, a few topics that would be interesting probably for listeners to understand “under the hood.”
You mentioned operating the exchange and the CSD under one roof, under one regulation.
There is the concept from traditional finance of intermediated securities, and I understand that you carry that concept over into what you do at STX.
Can you just explain to us what that is, how it works and why maybe you keep that process in this setup as well?
David:
Absolutely. what we have in Switzerland on the traditional FMI are “dematerialized, intermediated securities,” which is a fancy way of saying there’s no bit of paper.
There’s no certificate.
We’ve dematerialized that certificate.
The record is only electronic, and it’s intermediated in that the end investor acquires the instrument through an intermediary through a broker, and then it’s held at their custodian.
That works really well when transposed onto digital.
The difference being that the record of that dematerialized intermittent security only ever exists on the blockchain.
So the instrument itself isn’t a tokenized certified security, so there isn’t something else, somewhere else that is the original certificate that’s been immobilized and then there’s a token issued.
The record on the ledger is the security.
That’s where the ownership actually is related to. That’s what we have.
We had that in Switzerland for a great number of years.
That was not by design. It just happens to be the most advanced form of traditional security. This was not the case in Germany until relatively recently.
So they couldn’t do the same things we could do in Switzerland with applying the regulations straight to blockchain because they didn’t have this concept of dematerialized over there.
That’s also, relatively recently, that also came into law in Germany and they can now have similar (sort of) things.
They can exploit the blockchain in similar ways, again, leveraging their traditional securities.
Yes, that’s the way that the vast majority of the securities market works here, where you don’t as an investor directly access the financial market infrastructure yourself, you do it via an intermediary.
And the CSD sits in the middle of that as well.
Ian:
Is that still needed actually in that sense?
David:
The interesting thing here is the CSD is now distributed.
It’s a distributed centralized securities depository – clearly an oxymoron.
Each of our members runs a node on our network, and that node, they can only see the records of the central securities depository that are related to their customer holdings and their transactions.
So they have a view of that, essentially, as a sort of virtual ledger which exists distributed across all the different nodes.
So what you can then do with that, essentially, you now have this distributed database that everyone has a copy of.
There is now…Instead of everyone having to reconcile their database that contains information about the holdings that are related to them as a member, that database is held, they have, they hold that database themselves.
So they don’t have to reconcile an internal database with that database, they hold that database themselves.
When it comes to use cases such as collateral mobilization, we all (all members) share the same version of the truth.
This is what underpins the concept of a distributed ledger and blockchain technology is that we all share the same truth.
It’s what’s called a state machine – as opposed to a stateless situation.
We all know the stateless system at any one time, which means that I can instantaneously go, “I have instruments that I wish to immobilize here so that you can lend me instantaneously tokens off the back of that.”
So collateral mobilization, so that means I will…
“So here are some bonds I want to, that I will immobilize as collateral for you lending me Swiss francs.”
And instead of that being, “I send you information about my holdings, you recognize that they’re there, you tell me to immobilize them, I then prove that I’ve immobilized them.”
And that process taking hours potentially in the most advanced systems, and just to be clear, Switzerland has probably the most advanced example of this in the world.
In other jurisdictions, this can take days. If you can immobilize that instantaneously, then you can achieve what is possible over periods of hours, instantaneously.
So if you want to get funding and you need it like in the next few minutes, then this facility can be achieved through this technology.
But it’s not…
And there are other ways you could potentially do that, but that’s one of the benefits.
This notion that we can all agree on the state of the system.
So, I can show you what I have, and you can instantly verify that because you also have the ability to view exactly the same information at exactly the same time.
Ian:
This would be, shall we say, analogous to what some people in the crypto space with the smart contract are doing for decentralized lending and things like that.
David:
Exactly, the same thing as that.
So we can…so back to Standard Chartered of Rene’s perspective that R&D happens in the crypto world and we kind “borrow” all their ideas or “steal” them and repurpose them for ourselves. is a bit absolutely.
So if you look at the use cases around the sort of instantaneous borrowing and lending facilities that exist in DeFi, yes, we can now achieve that.
As a result of that giant building effort, we can achieve that but in a completely regulated context with safe and trusted counterparties, where ultimately the underlying investor has protection because of that edifice of regulation etc. regulated counterparties and so on.
Ian:
Let’s talk about then the layer that we’re talking about here that’s enabling this, blockchain.
I think it’s a pretty well-known fact that you use a private blockchain to do this, Corda, and maybe you weren’t involved right at the beginning in the design of that and the choices of that, but what are the considerations?
For the actual DLT blockchain layer, Corda in this case, privacy being one, but are there some other considerations that make that particular flavor of blockchain useful for what you’re doing?
David:
Absolutely. So we have a highly effective partner in R3, which I believe has been a huge innovator in this space.
Really drove adoption forwards and specifically because there are requirements that the capital markets have that are relatively challenging to achieve on DLT and blockchain technology.
Privacy is one of the biggest ones is that… Yes, having a distributed ledger is great, but as per my example, you should only see the holdings that are yours.
You shouldn’t be able to see everyone else’s holdings in the context of capital markets.
I can give you an unfair advantage over your competitors in that instance. So being able to reveal information is important, but also just as important is being able to prevent individuals or parties from seeing information that they shouldn’t be able to.
So having confidentiality of transactions and privacy of holdings is really, really important in the capital market context.
Functionally, that’s really a key.
There are issues around concepts such as settlement finality.
Settlement finality, which means that all parties agree the transaction is complete. That is a critical idea or concept within capital markets.
We shouldn’t be in any disagreement as to whether something is done and transfer ownership can now either has also been completed or can commence depending on where we are in that transaction and settlement cycle.
So settlement finality is absolutely critical. What you have on public chains tends to be more probabilistic rather than deterministic when it comes to settlement finality, which is a massive “no -no.”
Can’t have any vagueness when it comes to “Is this done?”
From a risk perspective, an everything perspective, that’s one of again, one of the sort of cornerstones of capital markets is that: as an FMI, we own settlement finalities.
It’s up to us to know.
And the central securities depository is where that finality is recorded.
So that is the golden source of who owns what securities in a capital markets context.
A public chain has massive limitations about that due to the way the consensus mechanisms work.
In addition, we can go into…there’s a whole challenge around things like MEV.
So the way that validators can essentially reorder transactions at all and the scurrilous activity that that can potentially lead to, which has actually happened.
We know that has occurred, that does occur, has occurred in the public chain space.
There’s a whole…and it can go on.
There’s lots of reasons…
And there’s performance reasons with some chains and then there’s things…and there’s stability reasons.
There’s security issues.
Now all of this kind of is trumped by the fact that as a financial market infrastructure provider, the regulator requires that we own the risk parameter around technology that we’re using to discharge our obligation to actually deploy functionality that the license enables us to avail ourselves of.
And there is no legal entity that I could even outsource to in the case of a public chain where I can say, and I’m depending upon this organization and here is my SLA between myself and that organization which runs this public blockchain.
There is no such thing in a decentralized blockchain that you can actually do that, with that concept that exists very firmly within the regulated world.
Where risks within a capital market structure that have been recognized should have some ownership, especially when it comes to licensed activities being discharged so that the regulator can go…can actually give…to associate risk and responsibility and ensure that there is ownership of those risks.
So that’s all very difficult to do on a public chain.
And certainly, it’s a private permission ledger is far more digestible for a regulator when it comes to handing out a license.
That having been said, we are extremely excited about what we can use public chains for.
And I think there’s a tremendous amount of innovation that’s going on in the public chain space that is addressing some of these issues associated with…that prevent capital markets adopting this infrastructure.
So R3 themselves have innovation and functionality that enables connectivity to public chains.
So interoperability is…
One way of approaching this is that you take your private-permissioned ledger and have it interoperate with public chains so that you can potentially move assets or carry operations backwards and forwards between public and private-permissioned.
And then there are entire innovations, new chains such as Canton, which is designed from the ground up to address the needs of regulated capital markets.
It’s almost like it’s gone through a shopping list what it needs to do to achieve adoption by capital markets all the way up to the recently announced, the validator foundation that it has, whose name escapes me.
But the relationship with the Linux Foundation and so on to ensure that the governance of that chain is friendly to market participants and regulators.
So there’s another aspect…
Ian:
The DLT/blockchain as I understand it, you use it at SDX, not just for the CSD side, but also for the settlement in the trading side, correct? (Correct me if I’m wrong.)
So there’s a certain article from the Financial Times I found very interesting recently, talked about exactly what you just said, the problems with public blockchains, and was actually focusing on the problems of tokenization as well.
But then coming to the topic of atomic settlement or instantaneous settlement, which is enabled by DLT technology like this.
However, at the same time, it potentially cuts out some other advantages of the way the markets work today with T+1, T+2 settlement, netting and so on and so forth.
Obviously, the decision has been made at SDX to go with atomic settlement.
What do you think about those trade-offs between instantaneous versus capital efficiency?
David:
The atomic settlement structure, that is something that I don’t believe lends itself to high-frequency trading, active trading generally.
My background before I joined SDX, I was very heavily involved in trading platforms, MTFs and CEFs, independent trade sort of, and self-supervised unlicensed platforms. very much so.
And half of those were specifically geared around high frequency trading.
In that world, it simply doesn’t work without netting.
There’s not enough liquidity in the world to actually manage the settlement of the transactional flow that goes through HFT for foreign exchange, for instance.
So I don’t believe that atomic settlement is a universal sort of panacea for all settlement context.
What I tend to think of atomic settlement as not so much like is it T+0, T+1, T+2 or atomic, which one is best.
Atomic is more to a point-in-time settlement – is precision settlement.
So it’s saying, for example, for…around this notion again of borrowing and lending, being able to actually say that at that particular point in time, I need to be able to be sure of the transaction.
It will occur then, and ownership will be transferred then. So to be able to say that 11:05 tomorrow morning, the transaction will happen.
That’s what I think is more interesting for us, that sort of that confidence you get around that, than it is around, I am now moving from all my highly liquid equities now transacting HFT style but settling atomically.
No way.
The pre-funding requirements are insane.
Also when it comes to actually being able to do that, facilitate the transactions.
And then subsequently, there’s an enormous amount of efficiency that comes through netting that exists today that even T+0 enables significant amounts of efficiency around.
In the future, I have no doubt that we will have settlement windows that will be available.
That requires more infrastructure than we have today related to settlement and clearing, but something that we’re very much looking into as facility in the future.
The specific use cases and even the instruments that we’re focusing on here, they do not trade frequently.
So they don’t have this need for us to worry so much about that the settlement being inefficient because we don’t support netting.
I think it’ll also show that moving trading into this context, sort of high frequency trading of liquid instruments, probably quite a long way down the line, because the benefits around that when it comes to leveraging blockchain for trading are less obvious than they are for these less frequently traded instruments, but ones that are used in these contexts – the contexts of collateral mobility, because they’re considered to be high quality liquid assets.
Ian:
And when we talk about that process, we don’t have a graphic or a diagram for our viewers and listeners, but just walk us through the actual process of the trading.
So there’s a trade match, You use a central limit order book?
David:
Correct.
So we actually use the same infrastructure as.. So we say, provided…that you guys at RULEMATCH use, we use a Nasdaq engine for the matching process.
But the matching process also includes leveraging the blockchain to determine the availability of the assets so that we can…so that the trade, so the matching and trading is all one indivisible matching/trading/settlement, all one indivisible step.
Ian:
Right. And that blockchain bit at the beginning is part of the risk assessment?
David:
Exactly. So it’s all, it’s not, well, it’s part of the “Can this match occur?” sort of process.
So again, unlike trading in high frequency where you begin to measure latency matching in single digit microseconds, we’re talking about this will be, it’ll take a second to actually carry out this activity, which is two, three orders of magnitude slower than HFT is typically associated with or expects in any way, shape or form.
Again, does not lend itself to every use case.
And I think that’s also what people really need to understand when talking about where blockchain comes in.
It doesn’t sort of wipe away the existing world.
It fits in to areas where it can bring significant advantage and coexist alongside for the foreseeable future the traditional infrastructure, which again is why this interoperability is so critical between what we’re building on the blockchain side and traditional infrastructure, because there will be so much interaction and activities – that make no sense to migrate across anytime soon – will stay where they are in the traditional ecosystem.
It’s a completely different story when it comes to the active trading of cryptocurrencies, which actually, although it sounds like you’re doing something related, because it’s got a blockchain involved in there, as you are fully aware, it is totally different.
That’s just trading a pair – which then kicks off a whole process which is still the same, looks very very similar to the traditional sort of FX.
Ian:
The infrastructure is totally old fashioned.
David:
Exactly, and a bit old fashioned but also highly optimized.
I mean it’s…and we’ve seen both the matching speeds have become literally unbelievably fast because you don’t know what it means to match in single digit microseconds, nothing in your normal world happens at that speed that you’re aware of, can’t be consciously aware of things that happen at microsecond speeds.
And then all the optimization around settlement is something that’s taken us years in the market to actually arrive at.
On the FX side and transposing that onto crypto is a challenge, right?
It’s really actually taking the best of breed from the institutional space and somehow getting that to work in crypto is the challenge there, I think,
Rather where we’re coming in the other direction from security is going, “We can do all this transformative activity, leveraging technology in these areas, but they don’t look much like the challenges that we have over there.”
Ian:
So one term I have not heard you talk about in this entire discussion and also how you operated SDX is a CCP.
So is the idea of the setup at SDX really, I mean, there is no CCP?
David:
Not for this. This is what’s also interesting.
Is that, no, because there’s no kind of counterparty risk associated with the transactions that are occurring because the indivisible nature of that match/trade/settlement process – there is no need for a CCP to step in and actually facilitate the trade.
Nor is there any notion of bilateral counterparty risk that the CCP obviates or eliminates.
So for atomic you could absolutely see that a CCP would be a way to facilitate any T+0,T+2 and so on and again so down the line.
Would I expect there to be integration to some form of CCP?
Absolutely, because that certainly is one direction you could take.
The one direction of travel you could go in to facilitate that non-atomic settlement for those use cases where that will be required.
Ian:
David Newns, thank you very much for joining the podcast. Look forward to future conversations sometime soon.
David:
Thank you, Ian. It’s been an absolute pleasure.