Yao Qian from the Science and Technology Bureau: Blockchain technology and the reform of new financial infrastructure

Yao Qian Director, Science and Technology Regulatory Bureau, China Securities Regulatory Commission

In the paper media era, the form of securities is paper-based vouchers, based on “characters”; in the electronic era, securities are paperless, based on “third-party electronic bookkeeping”; in the digital age, the form of securities is credible Digital certificates, based on “digits”, can be called “digital securities”. Digital securities distributed ledger itself is CSD, SSS, it is a natural transaction reporting database (TR), or even PS, it can also carry out decentralized asset trading and CCP clearing on the chain, which is a brand-new financial infrastructure .

Blockchain technology originated in the global digital currency wave that began in 2009, but its impact on finance has far exceeded the digital currency field. Fundamentally, it has created a new type of value registration and exchange technology, which is another major leap in ledger technology after the electronicization. If the paperless and electronic business processing of securities is the first financial infrastructure revolution brought about by information technology, then the digitalization and decentralized business processing of securities may be the second financial infrastructure revolution brought about by information technology. .

Information technology progress and the development of paperless and electronic securities

The oldest verifiable stock in the world was issued by the Dutch East India Company on September 9, 1606. It is printed on paper and contains information such as the investor roster, issuer, amount, etc., as well as the signatures of relevant personnel. This is a paper contract for shareholders’ equity, based on the establishment of a letter.

The disadvantage of paper securities is that the settlement of securities requires paper movement, which involves a series of operations such as printing, storage, transportation, delivery, stamping, and endorsement, with many steps, long processes, and low efficiency. With the rapid growth of securities trading volume, paper securities settlement became more and more inadequate, and finally the Paperwork Crisis in the history of securities broke out in the late 1960s. In 1968, the average daily stock trading volume of the New York Stock Exchange was 16 million, which was 8 times the average daily average of 2 million shares in 1950. Slow delivery processing has resulted in a large number of orders not being delivered in time. The New York Stock Exchange had to shorten the daily trading hours and closed the market for one day every Wednesday to deal with the backlog of paper documents.

In order to solve the paper-based operation crisis, the European and American securities industry has established a Central Securities Depository (CSD) system and a securities nominal holding system to realize the non-mobile delivery of paper securities through multi-level third-party bookkeeping. Greatly improve the efficiency of securities settlement. However, the securities are still mainly paper-based, and the costs, risks and efficiencies related to paper-based securities still exist.

By the end of the 1980s, the cost of computer storage and communication had fallen sharply, and paperless securities became possible. From the beginning of the issuance of securities, electronic account book records can be used to replace paper vouchers, and the entire business process adopts efficient electronic processing. In 1989, Australia initiated the reform of paperless securities. In 1992, 1995 and 2001, the United Kingdom successively issued three “Paperless Securities Acts” to carry out the reform of paperless securities. Other countries include Finland, Norway, Estonia, Latvia and so on. When China’s capital market was established in the early 1990s, securities were completely paperless and it was in a leading position in the world.

The new financial infrastructure “revolution” brought by blockchain technology

In the framework of traditional financial infrastructure, the securities registration, securities registration provided by the Central Securities Depository (CSD), Securities Settlement System (SSS), Central Counterparty (CCP), and Payment System (PS) The clearing and settlement functions all adopt the form of third-party bookkeeping. Central institutions such as CSD, SSS, CCP, PS, etc., calculate the increase or decrease of the balance of the securities account or capital account on the central server, thereby completing the transfer of securities and funds.

In the blockchain-based financial infrastructure framework, the wallet address replaces the account. Customers do not need to open an account in a specific central institution. The private key is generated locally, and then the public key is derived from it, and then the wallet address is transformed into the wallet address. Opening an account by yourself is the main difference. Second, the distributed ledger replaced the central ledger. Every customer has a ledger, and we all share and share ledger information together. Ledgers are like information disclosure in the securities market, open, transparent, and traceable. And everyone can participate in bookkeeping and become a bookkeeper. Third, in terms of value form, unspent transaction output (UTXO) replaces the account balance, which is the right to claim value after unanimous public consent, not the number of third-party account records. Finally, in solving the “double-spending” problem of value transfer, the consensus algorithm replaces the third-party endorsement. It uses economic incentive compatible design to solve the problem of fraud in the absence of a credible middleman.

In the paper media era, the form of securities is a paper certificate based on “character”; in the electronic era, securities are paperless and rely on “third-party electronic bookkeeping” as the basis; in the digital age, the form of securities is credible Digital certificates, based on “numbers”, we can call them “digital securities”. It does not rely on third parties. The digital securities distributed ledger itself is CSD, SSS, a natural transaction reporting database (TR), or even PS. In addition to securities registration and settlement, smart contract technology can also be applied to code the current securities trading and CCP business logic on the digital securities distributed ledger, and implement it with algorithms, so as to directly carry out decentralized asset trading and centralization on the chain Liquidation of both parties. This is a brand new financial infrastructure that integrates securities trading, CSD, SSS, PS, CCP, and TR.

It is still difficult to judge whether the new financial infrastructure based on blockchain must have more advantages than traditional financial infrastructure, at least in terms of performance, there are constant controversies. But it is undeniable that it does provide us with a financial infrastructure technical solution that is completely different from the central model. In some respects, its advantages are significant.

Such as the anti-attack and robustness of the system. When a node failure occurs, as long as the nodes necessary for the consensus algorithm can operate, the availability of the blockchain system will not be affected. Regardless of the length of the system downtime, the verification node can be restored. Compared with the single point of failure risk of the central server, the blockchain system has more advantages. In recent years, due to hacker attacks or technical failures, downtime of exchange trading systems has occurred from time to time, such as the Toronto Stock Exchange, Tokyo Stock Exchange, Singapore Exchange, Bombay Stock Exchange, and Nasdaq. The most serious was the cyber attack on the New Zealand Stock Exchange for 5 consecutive trading days in August 2020, and trading was temporarily interrupted many times. The completely open and bare Bitcoin network system has not been downtime due to cyber attacks since its operation in 2009, and it is highly stable.

Another example is the openness and inclusiveness of the system. The traditional financial infrastructure is not only closed, but also divided, beggars neighbors, low efficiency of information exchange, and high cost. Blockchain-based new financial infrastructure is not restricted by the traditional account system and closed network, has stronger financial inclusiveness, and can connect all parties on the same network, integrate various financial infrastructure functions, and have a unified, Seamless, ubiquitous and inclusive features. It can play a positive role in retail, cross-border, off-market and other scenarios with a high degree of segmentation and significant pain points.

Conception of a new financial infrastructure based on blockchain

The new financial infrastructure based on blockchain has attracted widespread attention in the securities industry. For example, the Australian Securities Exchange plans to replace the existing electronic settlement system with a system based on blockchain technology. The Swiss Stock Exchange proposed the establishment of a digital asset exchange (SIX Digital Exchange, SDX) based on blockchain technology. The Depository Trust and Clearing Corporation (DTCC) has launched a blockchain-based post-processing trial of securities repurchase transactions. Germany’s national blockchain strategy proposes to start with digital bonds to promote the issuance and trading of securities based on blockchain technology. However, compared with the raging wave of global digital currency, the application and exploration of blockchain technology in the securities industry is slightly deserted.

Yao Qian from the Science and Technology Bureau: Blockchain technology and the reform of new financial infrastructure

It should be said that in the securities industry, the exploration of new financial infrastructure based on blockchain has just begun. How should it be built? How to design technical solutions for different types of securities? How to carry out the corresponding business processes and operations? What is the key point? How to play the positive role of blockchain technology in specific scenarios? Will traditional financial infrastructure institutions cease to exist? What is the new role? Where are the risks of the new financial infrastructure? How should it be supervised… These issues are still unclear. For this reason, a systematic and complete theoretical framework is needed to guide the practical exploration of new financial infrastructure based on blockchain. This section proposes the basic framework of a new type of financial infrastructure based on blockchain (see Figure 1).

Yao Qian from the Science and Technology Bureau: Blockchain technology and the reform of new financial infrastructure

DLT-CSD ledger

As a new generation of value registration and exchange technology, blockchain technology is most likely to be the first to be applied in the field of securities registration and settlement. That is to keep the securities trading and clearing process unchanged, the front-end is still in charge of trading by the stock exchange, the central counterparty (CCP) is responsible for clearing, and the back-end is transformed into a blockchain-based securities registration and settlement system (“DLT-CSD”). This is the basic framework. The basic framework has made minor changes to the existing financial market infrastructure structure. The DLT-CSD ledger can contain at least 8 types of nodes such as securities registration and settlement institutions, stock exchanges, securities companies, commercial banks, securities issuers (listed companies), investors, central banks, and securities regulatory authorities, which are exactly the same as traditional CSD The financial infrastructure function of China has only undergone a fundamental change in the form of realization.

Securities Depository and Securities Account

All securities held by securities holders shall be kept in CSD when they are listed for trading. Under the traditional CSD model, CSD opens an account for each investor. After securities depository, the investor’s securities rights and interests are reflected in the account balance on the CSD ledger. Under the DLT-CSD model, the traditional securities account It becomes the wallet address, and the securities correspondingly become encrypted digital assets stored on the distributed ledger. The encrypted digital asset points to the investor’s wallet address, and only the investor’s private key can be opened. The private key is very secret. The public key is derived from the elliptic curve algorithm locally, and then the hash operation is performed twice, and then a data is encoded and integrated to generate a long digit, which is the wallet address.

Securities Registration and Settlement

Securities registration is the determination of securities holdings, including initial registration, change registration (ie securities settlement) and withdrawal from registration. Let’s talk about change registration first. Traditional CSD records the ownership and changes of securities through the increase and decrease of account balance. In DLT-CSD ledger, the flow of numbers is the flow of value, and digital securities are directly flowed point-to-point without relying on third-party intermediaries. The specific process is: the coupon payer first obtains the wallet address and public key of the coupon recipient, encrypts the securities transfer message with the other party’s public key, then signs it with its own private key, and broadcasts the entire network. After the entire network receives the securities transfer information, the consensus verifies which address the securities transfer message was sent from and which wallet address it wants to transfer to, and finally the securities collector uses the private key of its own wallet address to unlock the securities transfer report Text, obtain securities.

For initial registration and exit registration, in order to ensure the implementation of relevant regulatory policies such as public offerings and securities registration, DLT-CSD can adopt a dual signature mechanism. In other words, the securities issuer can initiate initial registration and withdraw from registration only after being signed by the securities issuer, the securities regulatory authority, and the notary. The registration of changes initiated by transaction transfer or non-transaction transfer may not be signed by the securities regulatory authority and notary public.

The centralized transaction transfer does not change the existing post-transaction settlement business chain. After the transaction order is cleared by the CCP, it is sent to the DLT-CSD ledger, and the settlement participant signs and confirms it, and submits the securities transfer instruction to the DLT-CSD ledger for change registration . The DLT-CSD system and the PS system use a bond payment mechanism (explained in detail later) to realize the atomicity and finality of securities settlement and fund settlement.

Company Services

The services provided by traditional CSD for listed companies include securities holders’ register query, rights distribution, online voting services, etc., while in the DLT-CSD environment, these services can be automatically executed by smart contracts. The securities issuer, as the account book node, automatically obtains the register of securities holders; like the initial registration, the securities issuer uses a dual signature mechanism to distribute dividends and other rights; since the distributed ledger itself is a voting system, it can be Online voting is directly carried out on the DLT-CSD ledger.

Concluding remarks

With digital technology, the new financial infrastructure based on blockchain is feasible and controllable, and the supervision is more precise, so it is standardized. The blockchain ledger is not easy to forge, hard to tamper with, traceable and easy to audit, so it is transparent. It makes financial services more free, open, and more dynamic, and it is also based on trusted technology, which is fault-tolerant and more resilient. Therefore, it is a new type of financial infrastructure that meets the five criteria of “standardization, transparency, openness, vitality, and resilience”, with unlimited potential and promising prospects.

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