The document discusses how blockchain technology could disrupt stock exchanges and Wall Street. It notes that active management has underperformed, fees are decreasing, and liquidity provided by high-frequency trading may shift away from exchanges. Blockchain eliminates third parties like exchanges by allowing direct trading between parties on distributed ledgers with no fees and immediate settlement. This could lead to new global blockchain-based exchanges handling multiple asset classes within 10 years that circumvent the traditional exchange model.

1. Electronic copy available at: https://ssrn.com/abstract=2866962
How Blockchain Could Disrupt Wall Street!
Mukul Pal
Founder, Orpheus Risk Management Indices
email: mukul.pal@orpheusindices.com
Abstract
The financial markets are not only changing internally but also externally as blockchain starts to change
the infrastructure landscape. The falling fees 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 third party. Stock Exchanges are third parties. The idea of long term stock exchange, raised by
Eric Ries in “The Lean Startup” were 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 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.

2. Electronic copy available at: https://ssrn.com/abstract=2866962
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 though mergers give it 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

3. will abandon geographical biases or asset preference for alpha. There could be larger shifts away from
Equity as an asset class. It will be 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 200 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 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 creats 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.

4. Bibliography
[1] The Dying Business of Picking Stocks, Wall Street Journal, Oct 17, 2016
[2] Why hasn’t Active investing outperformed Passive investing in recent years?, CFA Institute, 2015
[3] Finding Peter Lynch, Blog Tralio, Feb 8, 2009
[4] PWC – Asset Management 2020 a brave new world
[5] Fees on Mutual Funds and ETFs Tumble Toward Zero, Wall Street Journal, Jan 26, 2016
[6] What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing, Wall Street Journal, Oct 19,
2016
[7] The Rise of the Buy Side, Bloomberg, Aug 16, 2016
[8] Virtu Never Loses (Well, Almost Never). Bloomberg, Aug 11, 2016
[9] The Lean Startup, Eric Ries, 2008
[10] Business Process Reengineering, Hammer and Champy, 1993
[11] M&A Needn’t Be a Loser’s Game, HBR, June 2003
[12], [13] Stocks exchanged, Economist, Fen 27, 2016.
[14] A Rogues’ Gallery of Traders, Bloomberg.
[15] Sex Shops, Bingo and Sewage Define New Era of Pension Portfolios, Bloomberg, Nov 4, 2016
[16] Pal, M. “How Did Physics Solve Your Wealth Problem!”, SSRN, 2016
[17] Germany’s Neuer Markt to close, BBC, Sep 2002
[18] Pal, M. “The Fruit Basket Paradox”, SSRN, 2016
[19] Banking Is Only The Start: 20 Big Industries Where Blockchain Could Be Used, CB Insights, July
15, 2016.
[20] Will Blockchain Kill Clearing, CAPCO, Jul 19, 2015.
[21] ‘Blockchain could be totally transformative for fund industry’, Financial Times, May 22, 2016.
[22] trade is the settlement, t0.com
[23] Clash of the Titans: Blockchain meets Quantum Computing, David Shrier, 2016
[24] Pal, M. “Architecture of Data”, SSRN, 2016
[25] Simon, H. “Architecture of Complexity”, Proceedings of the American Philosophical Society, Vol.
106, No. 6. (Dec. 12, 1962), pp. 467-482.