Applying blockchain for primary financial market: A survey

IET BlockchainVolume 1, Issue 2-4 p. 65-81 REVIEWOpen Access Applying blockchain for primary financial market: A survey Ji Liu, Corresponding Author Ji Liu jliu3872@uni.sydney.edu.au orcid.org/0000-0002-6120-1282 School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, Australia CSIRO DATA61, Sydney, New South Wales, Australia Correspondence: Ji Liu, School of Electrical & Information Engineering, The University of Sydney, Building J03, Sydney, NSW 2006, Australia. Email: jliu3872@uni.sydney.edu.auSearch for more papers by this authorZheng Xu, Zheng Xu China Reinsurance (Group) Corporation, Beijing, China Chinese Academy of Fiscal Sciences, Beijing, ChinaSearch for more papers by this authorRuiqiang Li, Ruiqiang Li School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, AustraliaSearch for more papers by this authorHang Zhao, Hang Zhao School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, AustraliaSearch for more papers by this authorHongbo Jiang, Hongbo Jiang Block.Test.io, Boston, Massachusetts, USASearch for more papers by this authorJinhui Yao, Jinhui Yao Block.Test.io, Boston, Massachusetts, USASearch for more papers by this authorDong Yuan, Dong Yuan School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, AustraliaSearch for more papers by this authorShiping Chen, Shiping Chen School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, Australia CSIRO DATA61, Sydney, New South Wales, AustraliaSearch for more papers by this author Ji Liu, Corresponding Author Ji Liu jliu3872@uni.sydney.edu.au orcid.org/0000-0002-6120-1282 School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, Australia CSIRO DATA61, Sydney, New South Wales, Australia Correspondence: Ji Liu, School of Electrical & Information Engineering, The University of Sydney, Building J03, Sydney, NSW 2006, Australia. Email: jliu3872@uni.sydney.edu.auSearch for more papers by this authorZheng Xu, Zheng Xu China Reinsurance (Group) Corporation, Beijing, China Chinese Academy of Fiscal Sciences, Beijing, ChinaSearch for more papers by this authorRuiqiang Li, Ruiqiang Li School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, AustraliaSearch for more papers by this authorHang Zhao, Hang Zhao School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, AustraliaSearch for more papers by this authorHongbo Jiang, Hongbo Jiang Block.Test.io, Boston, Massachusetts, USASearch for more papers by this authorJinhui Yao, Jinhui Yao Block.Test.io, Boston, Massachusetts, USASearch for more papers by this authorDong Yuan, Dong Yuan School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, AustraliaSearch for more papers by this authorShiping Chen, Shiping Chen School of Electrical & Information Engineering, The University of Sydeny, Sydney, New South Wales, Australia CSIRO DATA61, Sydney, New South Wales, AustraliaSearch for more papers by this author First published: 24 September 2021 https://doi.org/10.1049/blc2.12009AboutSectionsPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinked InRedditWechat Abstract In financial market, especially primary market, it is very costly and difficult to make a deal due to discovery difficulty, information asymmetry, lack of trust, complicated trading process and low liquidity. Blockchain is an innovative technology enabling new business models of distributed data storage, point-to-point transaction and decentralized autonomous organizations via consensus. The unique features of blockchain, ‘decentralization, highly transparent, enhanced security and immutability of information’, make it a good solution candidate to meet the needs of private equity exchange. This article focuses on analysing the technical basis of the blockchain financial model and the typical application scenarios of the blockchain in the financial market. It discusses the importance of applying key blockchain technology to the financial market, especially in the primary market. Research has found that the development of blockchain technology, especially the maturity of stabilized token technology, makes it possible for blockchain to become a supporting technology to support the next generation of infrastructure in the future financial market. At present, blockchain technology has been concentrated in the issuance, registration, clearing, settlement and derivatives management of private equity and other over-the-counter securities. The use of blockchain to build a decentralized primary market has not received enough attention in research and practice, and the use of blockchain technology to establish a primary market with diverse distribution methods is still in its infancy. On this basis, this article further analyses the current problems and the possibility of solving these problems in the application of blockchain in the primary market and points out several interesting directions for future research in this field. 1 INTRODUCTION According to market functions, financial markets are divided into primary and secondary markets for share exchange [1]. Primary market investment covers all stages of equity investment before initial public offering (IPO) of its equity, including venture capital (VC) and private equity (PE), while the secondary market is one in which shares are traded among investors under standardized supervision. In other words, trading shares of a company before IPO is regarded as primary market, and trading shares after IPO is named secondary market. Regardless of academically or in the industry, there are plenty of studies for the secondary market. However, there are relatively less studies for the primary market. The size of primary market is large. From the ‘McKinsey Global Private Markets Review 2020’ [2], it shows that total global PE market transactions in 2019 plateaued at 1.47 versus 1.49 trillion USD in 2018. Before 2019, the amount of global PE market transactions has grown 12% annually, from 2013 to 2018. However, the primary financial market has been never as booming as its cousin (i.e. the second market), due to the following key issues: The ecosystem of primary financial market is fragmented, and its infrastructure is not as well established as the second financial market. The main reasons for hindering primary market are high cost on discovery of each other properly, asymmetric information, high cost and complex process of trading stages, and poor financial derivatives in primary market. As the rapidly increasing of information technology in past decades, it plays the most important role in our daily life, in the fields of living, health, communication, entertainment and so on. One of the smartest innovations of information technology is Blockchain, which is proposed by Nakamoto in 2008 [3]. This peer-to-peer electronic cash system enlightened a new methods of data sharing, data security and privacy, incentives for involvers and decentralization, which has potential to addressing the above issues for primary financial market. In this paper, we focus on adopting blockchain technology with financial services, especially for PE exchange in the primary financial market. There are many challenges in the market, according to our survey, that is inefficient asset trading structure, difficulty in matching mechanism, less standardized asset management procedure and so on. Due to the feature of blockchain technology, it is considered as a potential solution for the above challenges. In this survey, we will collect and study the existing efforts to improve the limitations of primary financial market with the help of blockchain [4-10]. For contribution, this paper investigates the application of blockchain in the field of PE exchange as the core content, combining the research literature on this issue, especially the research results in recent years, so that it makes the industry and academia more intuitively understand the current status of the application of blockchain technology to the construction of the new generation of financial market infrastructure. From the perspective of academic research, this article provides a certain support and exploration direction for the deepening research of the innovative application of blockchain in the PE trading field by systematically combining the existing research results. From the perspective of the construction of new financial market infrastructure, the conclusions of this article have certain application value for using the ‘blockchain + securities’ model in actual work, innovating the PE trading model and improving the structure of the primary financial market. The rest of the paper is organized as follows. Section 2 provides a brief introduction to the business process of primary financial market. Section 3 collects and introduces blockchain key technologies and notations as a taxonomy for this survey. Section 4 introduces how the blockchain applied in financial market. A further discussion on combination and primary market will present in Section 5. Section 6 gives conclusion and future work. 2 FINANCIAL MARKET Since the 1970s, the development of information technology has vigorously promoted the popularization and application of the electronic and networked transaction settlement system in financial market, realizing the rapid development of the multi-level securities market and the informatization of market participants and so on. Till now, the biggest feature of securities trading is that there is a centralized third-party credit or information intermediary agency as a guarantee, which realizes value transfer by reducing information asymmetry and relying on authoritative institutions to establish a trust mechanism, no matter in primary or secondary market. 2.1 Workflow of primary market Due to the unique characteristics of the primary market, there is no recognized trading platform for trading in real world [11]. In the industry, when PE transactions are usually conducted, they are based on the following process: Buyers and sellers get to know each other through broker introductions, and sometimes through friends’ introductions, but the majority of the deals are made through brokers, who are often referred to as financial advisors. After the introduction, if the buyer and seller intend to proceed with the deal, they will sign the non-disclosure agreement (NDA). After signing NDA, the seller will send some of its basic information to the buyer for review through the broker or itself. After the buyer reconfirms that this is their interested target, they will continue to follow up, this time they will go to the seller's company for an interview. After the interview, the buyer will start its due diligence (DD), term sheet (TS) will be signed if both interview and DD are satisfied by buyer's requirements, which means that the deal has been completed mostly. TS is a letter of intent for investment and is not binding by law. Finally, the buyer and seller will sign the share purchase agreement and other agreements to determine the investment contract, which is the confirmation of the investment. It is not difficult to see during the transaction process that these characteristics of trust, data sharing, data security and personalization are the main reasons leading to the current status in the primary market [12-27]. 2.2 Primary market exchange and clearing house 2.2.1 Private equity exchange In this paper, the target asset in both primary market and secondary market are corporate shares. The difference is that the primary market invests in the equity of companies that have not yet been listed, and the secondary market invests in the equity of companies that have been listed [28]. The price of equity in the primary market is not transparent and can only be estimated, so there is only valuation for the companies which are unlisted [29]. Since it is valuation, there will be overestimation and underestimation, as well as true and false evaluations. Both overestimation and underestimation can happen in the real practice, but different valuation methods can lead to different valuation results [30]. Many companies do not only focus on valuation when choosing investors, but also depending on investors’ business reputation and so on [31]. Therefore, in terms of equity transactions in the primary market, every case is different, and it is a deal that both buyers and sellers need to recognize, but not the buyers only. False evaluation refers to the fact that provided data are falsified, which leads to untrue estimation. In addition, due to the lack of supervision by regulatory agencies in the primary market, it is easy for buyers and sellers to have mismatched information and be deceived after time and effort [32]. 2.2.2 Over-the-counter Most of the transactions in the primary market are over-the-counter (OTC) transaction [33]. OTC transaction is based on the credit of both parties to the transaction. Both parties to the transaction bear the credit risk themselves. The transaction can only be carried out after establishing a bilateral credit. But the credit risk level is very high, no one would like to bear it with an easy decision. Hence, liquidity for primary market is very low. The OTC market talked above is the generalized OTC transaction without a clearinghouse, not a standard OTC market for commodities, derivatives, bonds and so on. Therefore, the OTC market size for primary market is very limited. If there is a clearinghouse in the primary market, the liquidity problem would cease. In a centralized OTC market, each transaction subject uses a centralized clearing house or exchange trading centre as the counterparty, and the clearinghouse takes the responsibility of bearing the credit risk of market traders [32]. Because the essence of OTC is private transactions between buyers and sellers, and both parties can freely negotiate prices, and the terms are not known to outsiders. Therefore, the intervention of the clearinghouse is to clarify the risks and clear the settlement [34]. Especially after Dodd-frank, the U.S. government hopes that all foreign OTC transactions involving U.S. interests will be settled through a central counterparty clearinghouse (CCC). But currently, plenty of scholars worried about that all the risks like this are concentrated in this CCC, and there will be a systemic risk among the CCC [35-39]. 2.2.3 Clearing house The clearing house is an independent institution responsible for the delivery, hedging and settlement of futures contracts in the futures exchange. The clearing house is a clearing and settlement structure established with the development of futures trading and the emergence of standardized futures contracts [40]. In the development of futures trading, the establishment of the clearing house perfected the futures trading system. It ensures that futures trading can proceed smoothly in the futures exchange, and therefore becomes the core of the futures market operating mechanism. Once the futures transaction is reached, both parties to the transaction will have relations with the clearing house. The clearing house is both the buyer and seller of all futures contracts [41]. Through the clearing house, the transfer, trading and actual delivery of futures contracts can be carried out at any time without notifying the counterparty. It is responsible for the unified settlement, clearing and delivery of goods. This is the special ‘replacement function’ of the clearing house. All these actions of the clearing house can be successfully realized because it has strong financial resources and has implemented a margin system, which is a set of strict debt-free financial operation system [42]. In this article, we mainly explain the issues of equity transferring. Therefore, the target asset of the clearing house should only consider derivatives of equity. 2.3 Challenges in private equity market There are many challenges in the primary market for making a deal, many scholars demonstrated their own research [16, 17, 19–24, 26, 27), which results in a fragmented ecosystem of primary market: (1) high cost of making a deal; (2) low liquidity; (3) lack of trust; and (4) less data security. Under the traditional model, the efficiency of mutual discovery between financing companies and investors is relatively low, and high costs are required. At present, the mainstream method of discovery and matching is through introduction by an intermediary, that is financial agency. However, the financial agency cannot fully understand the needs of both parties, and in order to earn returns or from the perspective of their own interests, increase the cycle of matching between two parties [20–22, 25]. Besides, the liquidity of the primary market needs to be improved. For investors who held assets, objectively, there is also a need to sell assets, especially when they are facing a shortage of funds or the fund needs to exit at maturity. The process in the implementation of asset trading is relatively cumbersome, and there are many links involved in completing the settlement of funds and the transfer and registration of assets. The resulting inconvenience of trading directly restricts the improvement of market liquidity [16, 17, 19]. In terms of transaction procedures, it is difficult for primary market transactions to fully ensure the authenticity and integrity of transactions. In addition to investors, assets transaction participants also involve sellers and third-party intermediaries, such as securities companies, accounting firms, law firms and so on. Under the traditional trading model, there is often information asymmetry between investors and financiers, which results in long transaction cycles. On the one hand, sellers and intermediaries and other stakeholders have been ‘colluding’ to achieve listing. On the other hand, due to the inability to accurately determine the authenticity and credibility of the underlying assets, coupled with insufficient information disclosure on time, it is difficult for investors and intermediaries to control risks, and results in high transaction risk [23, 24]. At present, primary market transactions have not yet achieved the asymmetric encryption of transaction information with cryptographic technology, and the transmission of information is mainly through email or USB copy. The confidentiality and security of transaction data are still facing challenges [26, 27]. Currently, the global primary market size is considerable, but considering the actual investment and financing needs, the primary market size is supposed to be larger. This situation is mainly caused by the following reasons. (1) It is not easy to achieve rapid matching between investors and companies. Investors cannot quickly find suitable companies when they want to invest. Enterprises, especially small and medium-sized enterprises, cannot quickly find investors when they want to raise funds. (2) Asymmetric investment and financing information can easily lead to unfair business. (3) Since the issuance and registration of private securities mainly rely on third-party institutions and involve multiple parties, the current lack of an efficient integration platform results in high costs and low efficiency in private securities management. (4) Compared with the secondary market, the primary market lacks a variety of options, such as leveraged trading, which limits scale expansion to a certain extent. Recently, the emergence of a relatively novel technology, blockchain, may change the above issues, and securities transactions can be redesigned and optimized through blockchain technology. Blockchain technology can realize the transformation of securities trading from centralized trust to weak centralization and decentralization and is expected to become an important technological innovation to change the securities industry. The characteristics of blockchain have different expressions and differences in different papers. However, the following characteristics have reached a consensus: decentralization, highly transparent, enhanced security and immutability of information. Its technical characteristics overlap with the above-mentioned issues, so let us review it. We summarize the main issues in primary market in the following order: Issue 1: Difficult to discover each other. The buyers and sellers are difficult to match demands and requirements of each other's, the probability of deal is very small, and the cost of a deal is very high. Issue 2: Asymmetry information. Both the buyers and sellers have a strong intention to provide fake information to maximize their own interests. Issue 3: High cost and complex trading process. During the trading process in primary market, there are usually involving third-party intermediary companies to help them conducting target assets. Third-party companies include accounting firms, law firms, appraisal companies and so on. The third-party intermediary companies have a strong intention of fraud. Since the cost of fraud is low and difficult to be discovered, they will fraud for some bribery and benefits. The bribery and benefits are usually conveyed by the sellers, but sometimes also by the buyers as well. Issue 4: Poor financial derivatives in primary market. The financial derivatives market is very developed in the secondary market, but it is very poor in the primary market. However, many excellent companies are capable of doing derivatives before they go public, which can greatly improve the liquidity of the primary market. 3 BLOCKCHAIN Blockchain technology is another disruptive technology after cloud computing, Internet of Things (IoT) and big data. Blockchain is not simply to increase the efficiency of digital collaboration in the original business format, but through a new technology-economic paradigm to provide an infrastructure based on value interconnection for the securities industry and securities trading models. Relying on its unique characteristics of ‘decentralization’ and ‘trust’, applying blockchain technology appropriately might ensure the establishment of trust between multiple parties while protecting data privacy and is expected to become an important part of the financial market infrastructure [43]. 3.1 Blockchain One important purpose of the innovation of blockchain technology is to serve financial transactions. It is an append-only distributed ledger of transactions. First presented with Bitcoin [3], the blockchain started as a decentralized electronic instalment framework, which eliminated the requirement for any outsider association for instalment moves. The first Bitcoin blockchain composed information as a chain of squares coordinated by using the square hash esteems, henceforth the name ‘blockchain’. As indicated by Ref. [3], the Bitcoin was the first to present blockchain as the totally framework on a distributed system. 3.2 Core technologies of blockchain 3.2.1 Cryptographic algorithm The blockchain uses a large number of cryptographic technologies, such as Hash algorithms (such as SHA3-256), asymmetric encryption and elliptic curve digital signatures, as well as multi-party secure calculations, zero-knowledge proofs and so on. Use cryptographic technology to realize functions, such as transaction verification and transaction privacy. In layman's terms, through cryptographic algorithms, the identities of both parties to the transaction will not be impersonated by a third party, nor will the information be stolen by a third party, and the functions of ensuring the integrity and non-repudiation of the information can be realized. 3.2.2 Consensus mechanisms Consensus mechanisms, such as the proof of work, proof of stake, delegated proof of stake, Byzantine fault tolerance, algorithm and so on, are mainly to solve the strategies and methods of how multiple consensus nodes achieve data consistency and correctness. Different application scenarios will use different consensus mechanisms to balance the efficiency, security and data consistency of the system. 3.2.3 Smart contract The term ‘smart contract’ was proposed by Szabo, Doctor of Law, long before the popularization of blockchain in 2003 [44]. He believes that a smart contract is a set of commitments defined in digital form, including agreements on which contract participants can execute these commitments. Generally speaking, it is a contract that can be automatically executed when certain conditions are met on a computer system. Running smart contracts on the blockchain can ensure that the entire process is open and transparent and cannot be tampered with. At the same time, it can also avoid the influence of centralized institutions, so that smart contracts have to operate efficiently. Nick's work theory on smart contracts has not been realized until the innovation of blockchain, an important reason is the lack of digital systems and technologies that can support programmable contracts. The emergence of blockchain technology solves this problem. It not only supports programmable contracts, but also has the advantages of decentralization, non-tampering, transparent and traceable processes, and is naturally suitable for smart contracts. Therefore, it can also be said that smart contracts are one of the characteristics of blockchain technology. Blockchain-based smart contracts include transaction processing and storage mechanisms, as well as a complete state machine for accepting and processing various smart contracts; and transaction storage and state processing are completed on the blockchain [45]. The transaction mainly contains the data that need to be sent; and the event is the description of the data. After the transaction and event information is passed into the smart contract, the resource status in the contract resource collection will be updated, which in turn triggers the smart contract to make state machine judgements. If the trigger condition of one or several actions in the automatic state machine is met, the state machine selects the contract action to execute automatically according to the pre-set information. According to the trigger condition contained in the event description information, the smart contract system automatically sends out pre-set data resources and events, including the trigger condition from the smart contract when the trigger condition is met. The core of the entire smart contract system lies in the smart contract with the transaction and the event are processed by the smart contract module, it is still a group of transactions and events. The smart contract is just a system composed of a transaction processing module and a state machine. It does not generate a smart contract, nor does it modify the smart contract. It exists only to enable a complex set of digital commitments with trigger conditions to be executed correctly according to the will of the participants. 3.2.4 Incentives Incentive mechanism is one of the important cores of blockchain. In the blockchain, the more data nodes are involved, then the blockchain will be more secure and stable, the incentive mechanism can not only attract more people willing to become data nodes, but also attract everyone to rush into the ‘mining circle’ frantically [46]. To put it simply, the incentive mechanism under the blockchain is to encourage nodes to participate in maintaining the safe operation of the blockchain system by means of economic balance, and to prevent tampering with the general ledger, which is the driving force for the long-term maintenance of the blockchain network [3]. Incentive mechanisms are not available in all blockchains. Some alliance chains and private chains do not have incentive mechanisms. The nodes in alliances and private chains are designated or composed of communities of interests, so there is no need for incentives. Incentives mainly exist in the form of a public chain. The nodes in the public chain are distributed all over the world, everyone on the chain does not know each other, and there is no central organization to endorse, which requires all nodes to work together to maintain the security and stability of the system. In order to achieve this goal, the blockchain system encourages participants to work actively, so that there are enough nodes in the system to ensure the normal operation of the system. In the blockchain, digital currency is used as an incentive method, such as Bitcoin (BTC) and Ethereum (ETH), which are the result of incentives. We taking BTC as an example to see how the incentives are obtained. Bitcoin is issued in the form of mining. In fact, the first transaction recorded in each block is defined as a coin base transaction, that is a certain amount of Bitcoin is used as a reward for miners who mine the block. This special transaction was made out of nothing. It was just a digital number at the beginning, and as the number of miners supporting the network gradually increased, this digital number was given the attributes of value and liquidity, and it became a digital currency [47, 48]. 3.2.5 Multi-signature (privacy) Multi-signature technology provides more security than traditional single-sig