Robert Bose, CTO of LedgerEdge evaluates distributed ledger technology as the basis of seeing a shared version of the truth in corporate bond trading
The efficient market hypothesis in financial economics states that asset prices reflect all available information. In reality, all markets are inefficient, no one has perfect information, and users compete in a complex system. Distributed ledger technology (DLT) allows us to reimagine the status quo and create new, better marketplaces.
Market participants must trust the system rules and enforcement to trust that the system is working as expected, others are following the rules, and they are seeing the right version of the truth. With complex markets and products, this is a continuous challenge.
Traditionally, legal contracts have been used to protect counterparties. If there is a dispute about the terms of the transaction, there is a clear resolution mechanism. Social mechanisms also exist in addition to legal settlements. Business actors involved in long term cooperation understand that it is in their interest to abide by the agreed terms to ensure future cooperation. In game theory terms, future expectations of reward outweigh the short-term benefit of “cheating.” This is why people choose to pay for their milk from the supermarket rather than run away with it each time. Can we more deeply incorporate this feedback mechanism into market systems?
In financial markets today, players who add value to the ecosystem are not necessarily rewarded, while those who take advantage of the system don’t always pay a fair price. There are rules to punish bad behaviour, but nothing more nuanced than a penalty box or ban. In our mind, this is all sticks and no carrots.
As they exist today, legal and social systems are not fast or nuanced enough for the demands of modern markets. As the WSJ notes, the future of markets is digital. The awesome advances of internet connectivity and ever smarter applications sets the scene for new ways of competing and working. The technology now exists to assess user behaviour with nuance, rewarding value contributors and nudging bad actors toward collaboration.
A distributed ledger is simply a decentralized ledger, where the correct version of the truth is shared asymmetrically with multiple entities. The technical design of a decentralized order book makes it impossible for any single party to change another party’s perception of the entire market. Further, it allows the system operator to cede ownership and control of data to the users.
There is no denying that a decentralised network of peer-to-peer sharing has better application in some arenas than others. When the cost of decentralisation is high, and the benefit is relatively low or widely shared — as is the case in social media — it is hard to organize around a DLT architecture. The corporate bond market is a perfect fit because users want control of their data and value seeing the correct version of the truth.
Distributed ledger technology allows for automatic enforcement of the agreements made in the marketplace through a set of programmed codes and smart contracts which run automatically on pre-defined conditions. The end user is prioritised over the system, but at the same time it is the users that underpin the system.
The Corda DLT system takes this model one step further. Corda allows bilateral sharing of the DLT between two counterparties, hence in the highly price sensitive bond market a price contributor can be sure of who is seeing their data.
At LedgerEdge as we roll out powerful new capabilities, it is important to build in compliance and workflows that actually make sense for institutional trading. We have designed for this by working with the market from Day 1.
We are focused on user control, clarity, and better execution today — this is a consensus mechanism fit for the 21st century.