Table Of ContentQian YAO
Blockchain-based
New Financial
Infrastructures
Theory, Practice and Regulation
Blockchain-based New Financial Infrastructures
Qian YAO
Blockchain-based New
Financial Infrastructures
Theory, Practice and Regulation
QianYAO
TechnologySupervisionBureau
oftheChinaSecuritiesRegulatory
Commission(CSRC)
Beijing,China
ISBN 978-981-19-4842-8 ISBN 978-981-19-4843-5 (eBook)
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Preface
The oldest equity certificate was, to our knowledge, first issued by the Dutch East
India Company on September 9 in 1606. It was printed on paper with a list of
investors, the issuer name, the par value and the signatures of relevant persons. It
wasacontractandwrittenproofofshareholders’interests.
The disadvantage of materialized securities is that the settlement of securi-
ties requires physical movement, which involves a series of operations, including
printing, storage, transportation, delivery, stamping and endorsement. It is a long
process with many steps and low efficiency. As the securities trading volume
expandedrapidly,thesettlementofpapersecuritiesincreasinglyexceededcapacity,
culminatinginthePaperworkCrisisinthelate1960s.Theyear1968witnessed16
millionsharestradedperdayontheNewYorkStockExchange(NYSE)onaverage,
eighttimesthedailyaverageof2millionsharesin1950.Theslowsettlementprocess
resulted in a large number of orders not being settled on time. The NYSE had to
reduceitsdailytradinghoursandcloseeveryWednesdaytohandlethebacklogof
paperwork.
ToaddressthePaperworkCrisis,thesecuritiesindustriesinEuropeandtheU.S.
createdacentralsecuritiesdepository(CSD)systemandasecuritiesnomineeholding
system. A multitiered third-party book-entry system was adopted to settle paper
securitiesonanimmobilizedbasisatamuchhigherefficiency.However,securities
werestillmainlyinmaterializedform.Thehighcost,risksandinefficiencyassociated
withpapersecuritiesremainedunresolved.
Thedematerializationofsecuritiesbecamepracticallypossibleinthelate1980s
when the costs of computer storage and communication dropped significantly.
Starting from the issuance of securities, paper certificates became replaceable by
electronic book entries to enable efficient electronic processing throughout the
process. Australia launched a reform to dematerialize securities in 1989. The UK
issued the Uncertificated Securities Regulations in 1992, 1995 and 2001. Finland,
Norway,Estonia,LatviaandLithuaniamadesimilarmoves.Establishedintheearly
1990s,China’scapitalmarketboasteditsworldleadershipinthedematerialization
ofsecuritiesfromtheverybeginning.
v
vi Preface
Advancesininformationtechnologynotonlyhaveafar-reachingeffectonback-
end securities registration and settlement but also have spurred in-depth reform of
front-end securities trading technology, tools, means and mechanisms. For a long
time, the stock exchanges mainly adopted the “open outcry” approach to trading,
whichinvolvedshoutingandusinghandsignalsonthetradingfloorasamethodof
communication.Nowtradingoccursbasicallythroughautomaticmatchmakinginthe
computersystem.TheapplicationofinformationtechnologygavebirthtoNasdaq,
the world’s first all-electronic stock exchange, and shaped the trends toward elec-
tronic,onlineanddiversetradinginsecurities.Attheendofthetwentiethcentury,the
unconventionalsecuritiesmatchmakingtradingsystembasedentirelyoninformation
technologymushroomed,increasinglyeatingintothemarketshareofconventional
stockexchanges.In2017,forexample,theNYSEandNasdaqhadmarketsharesof
only13.3%and14.1%,respectively.However,alternativetradingsystems(ATSs),
includingthedarkpoolandelectroniccommunicationnetwork(ECN),tookthebulk
ofsharesasmainstreamvenuesforsecuritiestradingintheU.S.
Electronic trading has further promoted advanced trading techniques based on
computer algorithms, such as programmed trading, quantitative trading and high-
frequencytrading.Tradersregardadvancedinformationtechnologyasanecessary
weaponandhaveeventhrownthemselvesintoan“armsrace”.Toreducetheorder
transmissionspeedto14.65msec,ahigh-frequencytradingcompanyspentUSD300
million laying a 1,300-km fiber-optic cable connecting the data center in southern
ChicagoandthestockexchangeinnorthernNewJerseyin2009.
Somehavesaidthatifthedematerializedelectronicprocessingofsecuritieswas
thefirstfinancialmarketinfrastructure(FMI)revolutionbroughtaboutbyinforma-
tion technology, the digital, decentralized processing of securities is probably the
secondsuchrevolution,triggeredbythenew-generationinformationtechnology.
Thenew-generationinformationtechnologyhereprincipallyreferstoblockchain
technology.Blockchaintechnologyoriginatedfromtheglobaltidalwaveofdigital
currencies in 2009. However, its influence has now gone far beyond digital
currencies. Fundamentally, it has created a new type of value registration and
exchangetechnology,representinganotherleapforwardfollowingelectronicledger
technology.
FMIs,asdefinedinthePrinciplesforFinancialMarketInfrastructures(PFMI),
include the CSD, securities settlement system (SSS), central counterparty (CCP),
paymentsystem(PS)andtraderepository(TR).Itprovides securitiesregistration,
clearingandsettlementservicesinthird-partybook-entryform.Centralinstitutions
such as CSDs, SSSs, CCPs and PSs transfer securities and funds by crediting or
debitingsecuritiesaccountsorcashaccountsonthecentralserver.
InthenewFMIsbasedonblockchain,however,thewalletaddressreplacesthe
account.Aclientdoesnotneedtoopenanyaccountwithaspecificcentralinstitution.
Hisorherprivatekeyisgeneratedlocallyandisverysecret.Then,apublickeyis
derived from the private key and converted to a wallet address. That is, a person
opens an account with himself. This is the first difference. Second, a distributed
ledger replaced a central ledger. Each client has a ledger, with ledger information
co-owned and shared by all. Like information disclosure in the securities market,
Preface vii
the ledger is open, transparent and traceable. Everyone can test and validate the
ledgerinformation,andeveryonecanentertransactionsintotheledgerandbecome
abookkeeper.Third,astotheformofvalue,theaccountbalanceisreplacedbythe
unspent transaction output (UTXO), which is a consensus-based claim for value,
ratherthananamountrecordedinathird-partyaccountbook.Finally,theconsensus
algorithmreplacesthethird-partyendorsementinaddressingthe“doublespending”
probleminvaluetransfer.Aneconomicincentive-compatibledesignisemployedto
addresspotentialfraudthatmightoccurintheabsenceofatrustedintermediary.
Inthepaper-basedera,securitiestooktheformofpapercertificates.Intheelec-
tronic era, securities are dematerialized and in electronic book-entry form. In the
digital era, securities are in the form of digital certificates, and the author calls
them“digitalsecurities”.Digitalsecuritiesdonotdependonanythirdparty.Their
distributedledgerisitselfaCSDandSSS,aTRandevenaPS.Inadditiontosecuri-
tiesregistrationandsettlement,smartcontracttechnologycanbeusedtoencodethe
currentsecuritiestransactionsandtheCCP’sbusinesslogicinthedistributedledger
ofdigitalsecuritiesusingcertainalgorithms,thusdirectlycarryingoutdecentralized
asset transactions and CCP settlement on the chain. This is a brand-new FMI that
integratessecuritiestrading,CSDs,SSSs,PSs,CCPsandTRs.
Atpresent,itisstilldifficulttoconcludewhethertheblockchain-basednewFMIs
are definitely more advantageous than the traditional FMIs, at least in terms of
performance. Although it is still in the development stage as an emerging tech-
nological model, it undeniably provides a technological solution for FMIs that is
totallydifferentfromthecentralmodel.
The advantages are apparent in certain aspects, such as the anti-attack features
androbustnessofthesystem.Whenanodefails,theavailabilityoftheblockchain
systemwillnotbeaffectedaslongasthenodesnecessaryfortheconsensusalgorithm
keeprunning.Validationnodesarerecoverableregardlessofthedurationofsystem
downtime.TheblockchainsystemhasadvantagesovertraditionalFMIs,wherethere
isasinglepointoffailure(SPOF)riskinacentralserver.Exchangeshaveseentheir
tradingsystemsgodownfromtimetotimeinrecentyearsduetohackerattacksor
technicalfailures,suchastheTorontoStockExchange,theTokyoStockExchange,
the Singapore Exchange, the Bombay Stock Exchange and the Nasdaq. The most
serious incident occurred in August 2020 when the New Zealand Stock Exchange
was hit by cyberattacks for five consecutive trading days, forcing several trading
suspensions. In contrast, the fully open and “naked” Bitcoin network system has
neverbeendownduetocyberattackssinceitscreationin2009.
Another example concerns system openness and inclusiveness. The traditional
FMIsarebothclosedandfragmented.This“beggar-thy-neighbor”moderesultsin
low efficiency and high cost of information exchange. The blockchain-based new
FMIsarenotrestrictedbythetraditionalaccountsystemorclosednetwork,demon-
stratingmorefinancialinclusion.Itconnectsallentitiesinanetworkandintegrates
variousFMIfunctions,featuringunity,seamlessness,universalityandinclusiveness.
Itcanplayapositiveroleinretail,cross-borderandover-the-counterscenarioswith
ahighlevelofsegmentationandsignificantpainpoints.
viii Preface
Overall, given digital technology, the blockchain-based new FMIs not only are
feasibleandcontrollable,butalsoallowbetter-targetedsupervision.Therefore,they
are disciplined. The blockchain ledger is not easy to forge or tamper with. It is
traceableandeasytoauditandthustransparent.Moreover,itmakesfinancialservices
morefree,openandvibrant.Itisalsobasedontrustedtechnology,highlyfaulttolerant
and more resilient. Therefore, they are a new type of FMIs that are “disciplined,
transparent, open, vibrant and resilient”, showing unlimited potential and bright
prospects.
Theblockchain-basednewFMIshaveattractedmuchattentioninthesecurities
industry. For example, the Australian Securities Exchange has planned to replace
itsexistingelectronicsettlementsystemwithablockchain-basedsystem.TheSwiss
StockExchangeproposedcreatingaSIXDigitalExchange(SDX)usingblockchain
technology. The Depository Trust and Clearing Corporation (DTCC) of the U.S.
conductedatestonblockchain-basedpost-tradeprocessingofsecuritiesrepotrans-
actions. Germany’s national blockchain strategy is to start with digital bonds to
promote blockchain-based issuance and trading of securities. Compared with the
globalfrenzyarounddigitalcurrencies,however,theapplicationandexplorationof
blockchaintechnologyaresomewhatlackinginthesecuritiesindustry.
Inthesecuritiesindustry,theexplorationofblockchain-basednewFMIshasjust
begun. How should it be built? How can technological solutions be designed for
differenttypesofsecurities?Howcanrelevantbusinessprocessesandoperationsbe
carriedout?Wherearethekeypoints?Howcanthepositiveroleofblockchaintech-
nology be unleashed in specific scenarios? Will traditional FMIs disappear? What
are their new roles? What are the risk points of new FMIs? How should they be
supervised?Therearenoclear-cutanswerstothesequestions.Therefore,asystem-
atic,completetheoreticalframeworkisneededtoguidethepractice,explorationand
supervisionofblockchain-basednewFMIs.Thisisthepurposeofthisbook.
Financialinfrastructure(FI),asimilarconcepttoFMI,referstothehardwarefacil-
itiesandinstitutionalarrangementsforfinancialoperations.AccordingtotheWork
PlanforCoordinatedSupervisionofFinancialInfrastructurejointlyissuedbythe
People’sBankofChina(PBOC),theNationalDevelopmentandReformCommis-
sion (NDRC), the Ministry of Finance (MOF), the China Banking and Insurance
Regulatory Commission (CBIRC), the China Securities Regulatory Commission
(CSRC)andtheStateAdministrationofForeignExchange(SAFE)inMarch2020,
China’sfinancialinfrastructurescoveredbycoordinatedsupervisionincludesixtypes
offacilitiesandtheiroperators,namely,thefinancialassetregistrationanddeposi-
torysystem,theclearingandsettlementsystem(includingthecentralcounterparty
thatconductscentralizedclearing),tradingfacilities,thetraderepository,important
payment systems and the basic credit reporting system. Compared with the FMI
definedinthePFMI,financialinfrastructureshaveabroaderscopetoincludetrading
facilities and credit reporting systems in addition to CSDs, SSSs, PSs, CCPs and
TRs.Therefore,thisbookexaminesnotonlytheblockchain-basednewFMIs(i.e.,
CSDs,SSSs,PSs,CCPs,TRs),butalsobroaderdigitalfinancialinfrastructure,such
astrustedidentity,digitalcreditreportinganddecentralizedfinance(DeFi).
Preface ix
Thisbookconsistsofeightchapters.Chapter1mainlyintroducestheenvisaged
framework and key considerations. First, a basic framework is proposed based on
applyingblockchaintechnologyonlytosecuritiesregistrationandsettlementwithout
changing the existing securities trading and clearing process. It is continuously
expandedtointegratesecuritiestrading,CCPclearingandPSsintothedistributed
ledger of digital securities. Then, an in-depth study is conducted on the design of
keyelements,includingdeliveryversuspayment(DvP),settlementrisk,settlement
period,liquidity,privacyprotectionandperformance.Thischapteralsodiscussesthe
newrolesoftraditionalFMIs.
Chapter2introducesblockchain-basedcross-borderFMIs.Atpresent,thecross-
border depository receipt (DR) business faces a conflict between efficiency and
security. This chapter proposes a blockchain-based new DR solution, manifesting
thepotentialforusingblockchaintechnologyintheFMIfield.Inaddition,usingthe
hashedtimelockcontract(HTLC)astheunderlyingtechnologyintheDRscenario,
specific processes and operations are proposed for DvP, delivery versus delivery
(DvD) or payment versus payment (PvP) and other exchange-of-value methods.
Such ideas are widely applicable to various cross-border transactions and securi-
tiessuchasfunds,securitizationandderivativesinvolvingachangeintheformof
underlyingassets.
Chapter 3 introduces blockchain-based FMIs for exchange-traded derivatives.
Tradinginexchange-tradedderivativesisdifferentfromspottradingandhasitsown
specialinstitutionalarrangements,suchasmark-to-market,marginsystemandforced
liquidation.BasedonChapterOneandChapterTwoandtakingHTLCastheunder-
lyingtechnology,thischapterfurtherexploreshowtocarryoutopeningpositions,
end-of-day settlement of margin, forced liquidation and settlement at maturity for
exchange-tradedderivatives,suchasfuturesandoptions,undertheblockchain-based
technologicalframework.
Chapter 4 introduces blockchain-based over-the-counter FMIs. The over-the-
counter(OTC)markethasobviouspainpoints,suchasfragmentedregistration,low
transferabilityofproducts,lowefficiencyofinformationexchange,nontransparency
ofthemarketanddifficultyinlook-throughsupervision.Blockchaintechnologynot
onlynaturallyfitsintothedecentralizedornoncentralizedcharacteristicsoftheOTC
market,butcanalsoeffectivelyaddressitspainpointsanddifficulties.Thischapter
providesanin-depthanalysisofspecificproblemsexistinginChina’sbondmarket,
regionalequitymarketsandassetmanagementmarket,amongotherOTCmarkets,
andproposesrelevantblockchain-basedsolutions.
Chapter5introducesblockchain-basedFMIsforOTCderivatives.Theregulatory
reforminthewakeofthe2008internationalfinancialcrisisfurthercomplicatedthe
businessprocessofOTCderivativesandincreasedbusinesspressure.Thischapter
studies how to address the pressure from the derivatives business itself and strin-
gent supervision and proposes two solutions. The first is a blockchain-based OTC
derivativesinformationexchangeplatform.Thesecondisablockchain-basedOTC
derivativestradingplatform.Giventheirconditionalpaymentorsettlementcharac-
teristics, OTC derivative contracts can be programmed into smart contracts. Thus,
x Preface
“smartderivativecontracts”aredeveloped.Thischapterdiscussesthespecificimple-
mentationapproachandrelatedlegalissuesandproposestheconceptofsmarttrade
repositories.
Chapter6introducesablockchain-basednewPS.TraditionalPSshavepainpoints,
especiallyinregardtocross-borderpayment.Bitcoininnovationhascreatedanew
paymentmodel,triggeringalarge-scaleexperimentindigitalcurrenciesaroundthe
world,includingbothprivatedigitalcurrenciesandcentralbankdigitalcurrencies.
The author innovatively proposes a prototype system design of the central bank
digitalcurrency(CBDC)with“OneCurrency,TwoDatabasesandThreeCenters”,
atwo-tieredarchitecturewithbankaccountsanddigitalcurrencywalletsinparallel
useandaCBDCsolutionbasedonindirectholding.Inaddition,theauthorconducts
anin-depthstudyonthedigitaldollarplanintheinitialdraftoftheU.S.Coronavirus
Aid,Relief,andEconomicSecurityAct(“CARESAct”)andthedigitaleuroreportof
theEuropeanCentralBankanddiscussesthekeyissuesregardingCBDCresearch
anddevelopmentfromsevenaspects.
Chapter 7 mainly introduces trusted identity, digital credit reporting and DeFi.
Digital identity and digital credit reporting are important digital financial infras-
tructures. This chapter proposes a blockchain-based trusted identity system and a
blockchain-based decentralized credit reporting model that does not rely on any
specifiedinstitution,namely,digitalcreditreporting,andprovidesacomprehensive
discussionondecentralizedfinance.
Chapter8discussesthesupervisionofblockchain-basednewFMIs.Blockchain
technologydoesnotchangethepublicpolicyobjectivesforFMI.Blockchain-based
new FMIsarestillsubject tocompliance, safetyand efficiency requirements. This
chapter provides a comprehensive assessment of the applicability of the PFMI to
them and, in particular, analyzes the new FMIs’ legal basis, off-chain governance
andsystemsecurity.
Hopefully,thisbookwillbehelpfultothedevelopmentofnew-generationfinan-
cialinfrastructuresinChina.Duetothelimitationsoftheauthor’sknowledge,there
areinevitableomissionsanddeficienciesinthebook.Anycommentsandsuggestions
arewelcome.
Beijing,China QianYAO
September2020
