The financial markets are not only changing internally but also externally as blockchain starts to change the infrastructure landscape. The falling fee for investment management is creating a more accountable financial industry and forcing the stock market to also question its broader role in the society. Blockchain eliminates the third party. Stock Exchanges are third parties. The idea of long-term stock exchange, raised by Eric Ries in “The Lean Startup” was never so relevant. The author explores the historical context of stock exchanges and why they are not ready for the impending change. The foundation stones of the stock exchange business like liquidity and price discovery are worth revisiting in the blockchain context. The exchanges should get ready for disruption in their space and beginning of the evolution of the stock exchange business in possibly less than a decade.

Implosion Before Disruption

Before we talk about Blockchain disruption, let us talk about the implosion happening on Wall Street. The Realization that stock picking is dead [1] after decades of Active underperformance [2] has made beating the market an adventure sport, where only a few succeed. There was only one Peter Lynch [3], the active management is set to become 65% of the overall market [4], the high fees are gone [5] and if this was all not enough we have the ‘Do Nothing Strategy’ from Nevada’s Pension Fund Manager, Steve Edmundson who slashed the fee for external managers by nearly a 10th from an average USD 120 million to USD 18 million [6]. All this leaves little for the yachts and barely little for the golf club. Above all this, the technology is killing the incentive to make markets. It is the rise of the ‘Buy Side’ [7] and Virtu’s of the world, which never lose [8]. Basically, the party is over.

Dystopia to Utopia

It is not the first time that the need for a quarter over quarter earnings growth and short-term stakeholder appeasement has been challenged. The more the short-term greed, the worse the consequences. The Long-Term Stock Exchange (LTSE) mentioned by Eric Ries in ‘The Lean Startup’ is a utopia [9]. The focus on short-term profitability based on “Vanity Metrics” works against long-term thinking. Ries suggests, “Innovation Accounting”. This is all wishful thinking Eric as before we build the LTSE we have to unshackle the current markets from its dystopian functioning, which according to Hammer and Champy can never be gradual, it has to be dramatic [10]. This is where technology comes in, a step before the blockchain disruption.

The Illusion of Critical Mass

Mergers are generally an extension or indication of an impending crisis. The very fact that the industry is embracing mergers is to defend against the fear of Change. As the saying goes, “Stupid takeovers did more damage to investors than did all the dot-coms combined.” [11] Another bout of crisis and we will see a bigger rush to merge and more consolidation in a landscape with few players. The strategy of takeover is foolhardy because the market dynamics are changing and critical mass is an illusion.

Exchanges have been on a buying frenzy. Derivatives [12] exchanges and a host of other market participants including data providers, clearing houses, and indexing companies have been scooped up over the last few years. Currently, only 10% of LSE’s and Deutsche Börse’s revenues come from trading [13]. The belief that this was good for business and created a much-needed backward and forward integration, a one-stop shop was all well-intentioned but again, poorly timed.

Fleeting Liquidity

The primary role of a stock exchange is price discovery. Market players bid and ask betting on an asset price leading to price discovery. Speculators create divergences which arbitrageurs capture, creating a market for hedgers.

Even if there are various business pipelines, the stock exchange business of today survives on liquidity. This is why exchanges compete for liquidity, which is another name for trading volume. The bigger the trading volume the better the solvency of the exchange. The size of listings is connected to traded volume and the reason for stock exchange mergers. Trading volume falls when the markets crash. Wealth erosion leads to poor market sentiment, stagnant markets and hence a decrease in trading volume.

A lot of this liquidity comes from HFT (high-frequency trading), which is automated. This was a last minute question I asked my fellow speaker at the Princeton – UChicago 2013 quant conference. Why cannot quants build low-frequency trading (LFT) systems for the global investors? Why are quant systems skewed to HFT? The question is still relevant and with companies like Virtu who plan a USD 2.5 billion IPO. The HFT space is crowded. This is why traders are losing their jobs as algorithms have crowded out supposedly smart humans. The few who were left are facing legal suits [14]. What can be automated is emotionless. It has no love. It can shift from one exchange to another, create an exchange of itself, or just shift to the blockchain. Arbitrageurs are market makers who have an ability to make or break an exchange today. If arbitragers decide to participate in new blockchain based exchanges, liquidity can just pack overnight and leave. Liquidity has no allegiance.

And if a part of this liquidity is married to HFT, the balance LFT-based liquidity driven by the Active Managers is at God’s will. If the Nevada Passive, ‘Not Do Anything Strategy’ is just a bellwether for what is coming, exchanges cannot rely much on LFT liquidity. It is everyone on his own. Maybe Edmund is the only one who will survive this change because there are only two options to survive the ongoing change, either do nothing and let the change happen around you or run hard to embrace new technology.

Smart Money Has No Religion

Geographical biases used to be a behavioral bias. Just like liquidity, the smart money has no religion. If sex shops bingo and sewage can define a new era of pension portfolios [15] then to believe that the global investor is tied to a geography or an asset class is a chimera. Marketplaces have to become more fungible and through mergers give it a short-term advantage, the exchange business is inherently fragmented at a geographical level, at an asset level, and at an instrument level. The 150-year-old thinking is an ingrained culture now and to expect it to express nimbleness in face of changing technology is like expecting elephants to fly.

Above this, liquidity has been given the top shelf space irrespective of the traded asset quality. Not favoring innovation, and long-term thinking has created an infrastructure that cannot be overhauled overnight. The next big drawdown in the next few years will bring out these structural failures. Moreover, the expectation of excess returns is going to make it even harder for the stock exchanges as smart money will abandon geographical biases or asset preference for alpha. There could be larger shifts away from Equity as an asset class. It will be a rude awakening to realize that low fee and liquidity do not automatically lead to smart money stickiness. In the end, gravity will catch up as exchanges realize that the “Rich Get Richer” phenomenon is not robust and is accompanied by the “Rich Get Poorer” too. [16]

Exchanges go bust too. Nasdaq was lucky to see its revival after the 2000 tech bust but Neuer Markt was not so lucky and closed in 2002 [17]. Exchange consolidations happened in India, happened in Europe and it is not going to stop here. Stock exchange systems are inefficient, they are fragmented, they are not one-stop-shop solutions, they are based on liquidity and not on innovation, more on HFT than LFT, driven by risk transfer and not by the risk management or should I say there is limited focus on risk reduction. A stock exchange was never supposed to think how it can contribute to risk reduction. Should risk reduction be the job of the stock exchange? We may lose ourselves in this debate but the fact of the matter is that not thinking about such questions is the reason why the new train is harder to catch.

Stock exchange business can only grow so much organically. The need for a global exchange does not just hinge on equities. The global exchange also needs to integrate asset classes something like the merger of CBOE and NYSE. The Fruit Basket Paradox [18] has created many more challenges for the incumbents. The first mover advantages are slowly disappearing.

Blockchain Disruption

Greed and fear used to pay a transaction cost, now they can choose not to. Blockchain eliminates the third party. No third party means circumventing Google, Uber, Airbnb altogether [19]. Stock Exchange is also an intermediary. It could charge a cost to be a counterparty to all trades but blockchain is about eliminating the counterparty. [20] While exchanges were buying clearing houses and adding revenue lines outside trading fee, the blockchain innovation with its distributed ledger has jumped many steps ahead. Asset managers are now looking to use Blockchain to cutting out any middlemen. [21]

Agreed that blockchain has to acquire critical mass too but the idea that there is no transaction cost, there is no intermediary, there is trust, there is transparency, trade is the settlement, [22] there is safety are the pre-steps to the idea of market making and price. If one adds quantum computing (more as an ally than as a challenger) [23] than you have a speed of transaction that creates a new age stock exchange, which is so different from the current players. We may not have to wait for this disruption for 10 years, the reality could take half the time.

New Markets – 2030

For me, there is no fintech in 2030. I wrote about it in the ‘Architecture of Data’ [24] that fintech will be just tech, like finance will just be science [25]. The idea that the system drives human behavior rather than vice versa will be clearer. Liquidity will be assumed and innovation will be at center stage. There will be set off new competing global exchanges which are cross-asset, cross-style, cross instrument, with competing global methodologies. Finally, exchanges will not just be about HFT but also LFT investment technologies, where an investor from Mongolian stock exchange could participate in the Smart Beta Canadian Bonds. The name of the exchange might be blockchain 3.0.