Blockchain Smart Contract Potentials To Substitute Securities Trade Aspects

By Othman Darwish

Introduction

This is a proposed solution to fully automated stock exchange market based on Ethereum blockchain innovated  technology using smart contract and distributed ledger technology DLT. Smart contract is a computer program that performs as digital asset  and  is able to substitute  today securities financial instruments. Ethereum is an open source  decentralized  computing  platform that runs Smart Contract. Blockchain is a database of a distributed ledger that hold digital assets information (aka Smart Contract). By using  Ethereum  network, all middlemen are removed and users ( issuers and investors) are allowed to interact with each other directly. This solution will reduce time, cost and operational risks, it will also automat censorship, and more importantly, insure transparency and trust between all the parties involved in the interaction of that network.

 The ability of digitizing financial assets to secure, trustworthy and programmable form is valuable since it opens opportunities towards improving the financial services processes and businesses.        

Executive Summary

Smart Contract is one of the most exciting topic of blockchain and distributed ledger technology at the moment, they have the potential to radically change the way we conduct businesses. Smart contract is a computer program that control digital asset, it can facilitate the automatic payment of dividends, stock splits and liability management, also it reduces counterparties and operational risks. Smart Contract aims  to digitizing existing asset; when asset is digital, financial services become software, and here is the value and innovation behind this technology. Financial services are one of the last industries that is going to be truly transformed into software; we've seen this happened to music, publishing, telecommunication, and finally, the cryptography breakthrough is at the heart of the financial services, which means that security trade will become a program .     

In nutshell , the security trade workflow started when the investor wants to buy securities from the market place, the order is placed into Exchange via an intermediary, this intermediary is called a broker. The broker is a special entity that is authorized by the Exchange to buy  securities on behalf of others   and on behalf of itself, and there are strict requirements  to become a broker and there are sets of compliances to make sure that a broker is performing a good role on behalf of the investors. Once  the order  is placed into the market  via a broker, the Exchange receives  a buy order. Similarly the Exchange receives a sell order into the same manner. Throughout the day, the Exchange will be holding lists of buy and sell of different quantities of securities at different target prices, The Exchange attempts  to perform automatic matching based on price, product, quantity and so on, when it finds a match, it will send back an order confirmation of the details back to the broker, and the broker in turn will forward those details to the investor. This process is termed as trade execution  cycle process.After the Exchange confirmed the trade, it works hand in hand with the clearing house. A clearing house is a special institution that is introduced in the settlement cycle to safely guard the interest of the buyer and seller, it effectively guarantees the trade on behalf of them. The clearing house becomes materially important for much larger quantities of trades, where billions and billions of dollars are being exchanged, here the clearing house takes the owner ship of the trade and splits it into two separate trade legs;  one leg is for the buyer to the seller,  and the other leg is for seller to the buyer. Doing so, it legally transfers the title of that shares for that period of time, this is purely to become guarantor  for  the safety of the investors.

Throughout the  trading day, there are numbers of trades that are coming through from the Exchange, and the clearing house is responsible for performing netting . A netting is a number of trades with same counterparty,  and for the same product, trades can be grouped together and netted into single transaction rather than multiple. At the end of the day, the clearing house will create one net figure for the settlement obligations of that counterparty and send through the counterparties nominated custodian or nostro agent. At this point in time, the investor will have a locked trade, in other words, the trade is being matched and confirmed on the Exchange waiting for settlement. In U.S. ,  settlement normally needs  T + 3, while in European standard it is T +2 , so two to three days  are required to pay for the securities.

Other intermediaries involved in trade cycle are the registers (or stock transfer agents), they work on behalf of a company and are responsible for maintaining a register of shareholders and keeping it up to date, if the company is going to pay dividends, those registers are responsible for the dividends distribution. The intermediaries also include the central securities depository (CSD). CSD is a financial organization that acts as custodian of custodians that hold securities, so that the ownership can be easily transferred through book entry rather than the transfer of the physical certificate, this allows brokers and financial companies to hold their securities at one location so that they can be available for clearing and settlement.

Blcokchain technology is fundamentally influencing the way that our economy, financial  ecosystems and businesses is functioning, and able to change our concept of trade ownership and trust. This technology already exists and it is called cryptocurrency. People think of Bitcoins as it is  only a virtual money or a transactions system; however, when somebody looks closer to the blockchain or the distributed ledger (as some economists name it ) which is the technology behind the Bitcoin payment network,  you will see that some  monetary aspects and processes could  be substituted by this breakthrough innovated  technology.Traditionally, securities trades follow complex structure of intermediaries, trades are recorded in bookkeeping , we use third parties and middlemen we trust to facilitate  and improve our transactions . In contrary, Blockchain distributed ledger can run in a public/private network  of computers to maintain collective bookkeeping, this bookkeeper is a digital ledger which is fully distributed across the network nodes, each node of the network owns a full copy of the blockchain, the cryptography ensures that these nodes automatically and continuously agree about the current state of the ledger for every transaction in it. If anyone attempts to corrupts a transactions, the nodes will not arrive to consensus and hence will refuse to incorporate the transaction in the blockchain. In this way, every node has access to single source of truth, this is why we can always trust the blockchain; Accordingly, relaying on trusted custodian financial entities to transfer the ownership of asset is questionable.Moreove,  smart contract which is a computer program that controls digital asset and runs inside blockchain, it is able of documenting, transmitting and securing the entire contractual relationships by issuer and investor,  the smart contract can immediately transfer asset into program, the program in turns - as legal contract - can  run its code and evaluate its terms and conditions, and accordengly, determine the ownership of the asset. By this, the smart contract offers potential to streamline the whole trade cycle processes by providing an end-to-end  digitized workflow between the buyer and seller, this is in near real time where t trade date plus zero days  ( T + 0 ) is required for securities settlement, it also offers the ability to automate the payment of dividends and enable more accurate proxy voting. Thus using a programmable contract - as a legal and secure asset - will result in eliminating counterparty and operational risk created by intermediaries. Thus, the complex hierarchy of  brokers , custodians, CSDs and registers would collapse, or at least their functions and need will be revised.On the other hand , smart contract could be used as a digital identity to securely define the identity of the buyer or seller, it enables individuals to own and control their digital identity that contain reputation, data and digital assets. This allows individuals to choose what personal data to disclose to counterparties,  this gives enterprises the opportunity to seamlessly know their customers, rather than expensive and time consuming Know Your Customer (KYC) processes that lack completeness.   

The Proposed Solution

This proposal suggests a solution to automate securities trade using Ethereum Smart Contract, it concentrates on how to apply this technology to perform  the exchanging of common equities stocks instruments; for that a network that acts as a virtual permissioned  private security market is built, with access is limited only to the authorized members, so that those only can  join and participate in this network. The membership authorization process is out of this proposal scope.

The suggested solution is purely conceptual solution that's target is to illustrate that this technology is able to automate securities trade processes and cycles; thus, the financial market impact and legislation issues  are out of this proposal scope.

For the members to interact with the network (the virtual stock market), a special software is used to produce what we call the "Stock Wallet". The Stock Wallet provides members  the ability to interact with the network, and perform various transactions operations on digital asset information stored in the block chain. It acts as a computing node in the network which will mainly participate in holding and verifying  database information, this information is a full copy of the ledger (aka blockchain) which is securely  protected by the cryptography and synced with all  participating nodes in the network at any point of time; in other words,  whenever a user transact a Smart Contract (perform transaction on his/her Wallet), the local blockchain copy of that Wallet is verified and got updated, then  marked as not confirm transaction, the Wallet software then propagate that transaction for all participating network nodes, at this point in time,  all network nodes participate in validating  that transaction, if all nodes agreed on that transaction (consensus), then the transaction become confirmed one and added to immutable blockchain data block. The Wallet can be hosted in an authorized businesses firms  computing machines or even on a permessioned  users'  smart phones.

When a company issued a stock in primary market, it first need to transform those stocks to digital asset of Smart Contract form, and register them in blockchain database, this operation is called the Smart Contract deployment.  Once a Smart Contract is deployed it will hold a set of properties; some of these  properties have immutable nature (cannot be altered during Smart Contract life time) such as, issuing company, stock name and type; other properties could be adjusted as a result of transacting a Smart Contract during its life time such as prices, owner, dividend rate... 

Each Smart contract expose as set of stoke exchange  services which could be executed (transacted)   according to predefined service privilege, for example the sell request  service operation could be executed only by stock owner, change ownership operation could be only executed by the central bank, and  get price operation could be executed anonymously by any investor.  Another powerful  feature of Smart Contract is Events, events could be fired by Smart Contract to announce a change on its state, concerned parties (for example investors) could subscribe to those events and immediately got notified whenever an event is fired, for example if an investor is interested in stock of a specific type, he/she can subscribe to all Smart Contact of that stock type, and thus we'll be notified about all sell requests along with the proposed prices.

The bellow proposed tables summarize the Smart Contract properties, operations and events. Table 1 lists properties along with their transacted (modifiable) nature, those properties are updated as a result of executing Smart Contract operations as listed in Table 2. Table 2 lists a set of operations along with privileged parties allowed to execute them. Table 3 lists a set of events which are going to be fired or trigged as a result of executing Smart Contract operations, those events  could be subscribed by the interested parties in order to be notified about the pending  (waiting for an action) transactions at their side.        

Table 1: Smart Contract (Stock) Properties 

Property	Is transacted ( modifiable ?)
Issuing Company	No
Stock Name	No
Stock Type	No
Price	Yes
Dividend Rate	Yes
Dividend Yield	Yes
Owner	Yes

Table 2: Smart Contract (Stock) Operations   

Operation (financial Service)	Privileged Party
Get Price	Investor
Buy Request	Investor
Buy Approval/Rejection	Buyer custodian bank
Sell Request	Owner
Sell Approval/Rejection	Owner
Change Owner Ship	Central Bank
Adjust Dividend  Rate	Issuing Company
Adjust Dividend Yield	Issuing Company
Pay Dividend	Issuing Company
Start/End  Voting	Issuing Company
Vote	Owner

Table 3: Smart Contract (stock) event

Event (notification)	Subscriber (consumed by)
Buy Request	Investor/Custodian bank
Sell Request	Investor/Custodian bank
Change Owner Ship	Buyer custodian bank  to debit it account Seller custodian bank  to credit it account
Pay Dividend	Central bank to debit issuing company custodian bank and credit Owner custodian bank settlement account . Company custodian bank to debit company account. Owner custodian bank to credit owner account.
Vote	Issuing Company to select board of directors

Effectively, securities trade will be executed directly between the seller and buyer, custodian banks will book-keep these trade transactions by debiting/crediting their customers, and the central bank will perform near real time settlement and automate the ownership  transfer of the contracts.  

  Figure 1: Securities Trade Execution Using Smart Contracts

Security Trade Exchange Scenarios

Execute  buy operation scenario   

The Investor in one of the scenario, using his wallet application that runs on his  computing node (computer or smart phone), can monitor (through subscription) to "Sell Request" events  that are executed in the network, the sell requests are displayed to him in an aggregated form  that summarizes sell stocks transactions requests. The sell transactions requests include the stock quantities and prices, and are grouped by companies stocks types ... Alternatively, in another scenario, the investor can instantiate a "Buy Request" on the target stocks along with proposed prices and quantities. These two scenarios are elaborated by the next paragraphs.

 Execute "Buy Request" when supply of stocks is available

Here, the investor selects quantities of stocks and create a "Buy Request", at this point in time, all Smart Contracts of the corresponding stocks will be transacted by the resulted buy requests, these requests will be logged as not confirmed transactions, after that, the wallet application will  propagate the resulted buy requests to all of the participating nodes in the network, so that all of the receiving nodes will participate in validating those requests, and if all of the nodes agree on thier validity (aka consensus), the transactions will be accepted and become a part of the immutable  synchronized blockchain block information data.

 As a result of the above consensus on the validity of the buy requests of the investor, the custodian bank of the investor (buyer) will receive his customer buy requests, the bank in turn will perform the required financial validation, and accordingly, he either accepts or rejects the operation. Whatever was the bank action, it will be propagated to all network nodes, verified and logged in the blockchain  database .

If the investor custodian bank rejects the transactions (or some of them), the corresponding Smart contract buy request status will be released allowing other investor to execute new buy requests on them , such bank rejected requests could be a target for further auditing operations.

If the investor bank accepts those transactions, the central bank would be notified, so that he can perform any further validations, and then, upon his approval, the following actions take place:

• ·         Transfer ownership operation  for that contract, effectively the buyer will be the new owner of that contract.
• ·         Perform near real time settlement on the transaction counterparty (debiting the buyer custodian bank and crediting the seller custodian bank settlement account). 
• Meanwhile, the seller custodian bank will be notified of the change in the ownership that is previously executed by central bank,  and accordingly the seller custodian bank will credit the investor seller account and debit the buyer custodian bank by agreed on contract price value.

   Execute "Buy Request" when no supply of stocks is available

The buyer investor can instantiate a "Buy Request" on target stocks along with proposed prices and quantities, stock holder will receive these buy requests from the different investors and they have the option to accept the requests of the most suitable prices. When a seller investor approves a particular investor buy request, the workflow continues in the same manner of the previously mentioned sequence of work; approving/rejecting buyer custodian bank transactions, changing the ownership of the contract by the central bank along with performing the settlement on the transaction  counterparty bank, and finally  notifying the seller custodian bank  to debit the buyer bank and credit the seller customer account.

Execute "Sell Request" Scenario

Sell operation can be performed as a result of the buy operation requests as mentioned above, or it can be instantiated separately (with no demand). The same activates would be executed; from debiting/crediting buyer/seller at their custodian bank, debiting/crediting counterparty settlement bank, and changing the ownership of the contract at central bank .

Execute "Pay Dividend" Scenario

When a company declares dividends, it will execute "Pay Dividend" operation on their issued contracts, as a result of this operation, the central bank will be notified to perform settlement between the contract issuing company custodian bank and contract owner custodian bank. In the same way, the company custodian bank and the contract owner bank will be notified to perform debit/credit  bookkeeping entries on the corresponding accounts.

Execute "Vote" Scenario

With Smart Contract, voting processes will be streamlined, in a more effective and transparent manner.  When the issuing company declares the start of the voting, along with the nominated officers and board of directors OBDs, the smart contract owner will have the ability to elect and make up the board of directors.