Japan Exchange Group research explores Bitcoin in capital market infrastructure

The Japan Exchange Group (JPX) recently released a working paper to further technological advancements and the ongoing global efforts for applying blockchain technology to capital market infrastructure.

Formed by the merger of the Tokyo Stock Exchange and Osaka Securities Exchange in 2013, JPX is a financial services corporation that operates multiple securities exchanges. The corporation and its subsidiaries make up the world’s third largest, and Asia’s largest, market for investments. The corporation generated operating revenue of ‎¥114.7 billion (US$1.11b) in 2016.

The working paper describes the findings of an internal research group established by the corporation late last year. “Virtual currencies such as Bitcoin have become a popular topic of conversation all over the world,” the author asserts. “People were initially interested in virtual currency itself, but its underlying technology, blockchain or distributed ledger technology (DLT), has attracted a lot of attention recently from various industries exploring applications other than virtual currency.”

“There is no reason to limit the application of DLT to virtual currency, and the existing centralized consensus process can be replaced by DLT in theory. Due to DLT’s innovative concept and wide range of applications, it is said that it will bring a ‘paradigm shift to the fifth generation’ of IT evolution.”
— – Applicability of Distributed Ledger Technology to Capital Market Infrastructure

The research group conducted two private blockchain proof of concepts (PoC) this year, to gain further insight beyond current research or studies from publicly available information. “Unlike Bitcoin, which has been operating since 2009, DLT application in capital market infrastructures has rarely been investigated and needs further experiment and enhancement,” states the paper.

The first proof of concept started in February, and was conducted with IBM Japan. The second commenced in April, and was conducted with Nomura Research Institute and CurrencyPort. Japan Securities Depository Center, Inc., Mizuho Securities Co., Ltd., Monex, Inc., Nomura Securities Co., Ltd., SBI Securities Co., Ltd., and the Bank of Tokyo-Mitsubishi UFJ, Ltd., all participated in the testing.

Protection against node occupation, or attack from outside, was secured by adopting a permissioned network where only trusted entities are allowed to participate. The first proof used Hyperledger, the second Ethereum.

“Although the anonymity of participants is secured, it is unlikely that infrastructure users would accept sharing material information, such as a large transaction or bilateral OTC trading conditions including prices, in real time,” the paper states.

Bitcoin wasn’t used as its throughput capability was deemed insufficient to process current daily securities settlement volumes. “Virtual currencies and securities have different product specifications and trading/settlement procedures, so the functional requirements of DLTs are accordingly different,” the paper explains.

In order to increase Bitcoin’s throughput capacity, the authors argue that it’s necessary to either increase the maximum number of transactions per block or adopt a faster consensus algorithm. “The former could be achieved by raising the block size, but this will lead to consuming a larger network bandwidth during the consensus process. The latter also has some concerns.”

“The time to generate a new block mostly consists of the duration of PoW, and setting a shorter duration for this process will weaken security and might cause inflation as a result of the higher pace of the virtual currency supply.”
— – Applicability of Distributed Ledger Technology to Capital Market Infrastructure

Private blockchains built on a permissioned network do not necessarily need a consensus by proof of concept and can use a faster consensus algorithm. “If the consensus algorithm is fast enough, network latency becomes a non-negligible factor,” the paper explains. “This indicates that geographical node concentration will improve the throughput, but it will sacrifice the high availability of the infrastructure. The infrastructure operator needs to strike a balance between throughput and availability.”

Each proof of concept environment was built on a public cloud service where the number of nodes was close to the minimum required for a different consensus process, Practical Byzantine Fault Tolerance (PBFT).

In the original PBFT algorithm, proposed by M Castro in 1999, consensus is reached with the approval of roughly 2/3 of nodes, which ensures robust consensus as well as the capability to endure node failures. “Since computationally intensive calculation is not necessary, consensus can be achieved faster than with PoW,” the paper explains.

The group tested blockchain implementations in securities issuance, corporate actions such as dividend and stock split, ownership registry, trading, settlement and clearing, cash payment, and data privacy control.

“Through our research and PoCs, we have concluded that DLT has the potential to transform capital market structure by encouraging new business development, improving operation efficiency, and contributing to cost reduction.”
— – Applicability of Distributed Ledger Technology to Capital Market Infrastructure

Several technical issues were found during the proofs. The paper lists non-determinism in executing smart contracts and data privacy control as the most important when considering blockchain utilization in financial markets.

Non-deterministic factors such as time-trigger events, listening to an outside data feed, or random number generation might prevent consensus, as it’s a challenge for smart contracts running each node to reach exactly the same result. “This is not negligible since those processes are very common and frequent in capital markets,” the paper explains.

Data privacy control is a more critical factor. “Considering existing business practice in capital markets, an infrastructure disclosing all transaction data in a publicly available manner would not be accepted by existing players,” the author argues. “Data privacy control is a very important and necessary requirement, but DLTs fulfilling this requirement are currently limited.”

Longer term issues with blockchains being a core technology of capital market infrastructure again focused on throughput. The throughput capacity achieved in the proofs limits the applicable field of businesses, and did not reach a level sufficient to handle a high traffic volume market stably.

“There might be a few DLTs announcing high throughput figures in demonstration, but measurement conditions such as the use case or geographical node distributions are not clear enough.”
— – Applicability of Distributed Ledger Technology to Capital Market Infrastructure

In spite of the technical issues, the paper concludes that blockchain technology is “extremely attractive as an infrastructure technology with high availability, immutability, and high resiliency from system failure at a relatively low cost.”

“DLT consists of several inter-related technical features and the best balance of those features will vary depending upon what type of business the user company designs on DLT,” the paper states. “Bitcoin has already found well-balanced technical parameters for the use case in virtual currency. We need to explore the new balance for capital market infrastructures considering business requirements raised in this paper.”