Clearhouse
3 Ways Blockchain Will Transform Capital Markets
Publication Date: February 26, 2019

Syed S. Hussain is CEO of Liquidity Digital, a fintech company that is developing an end-to-end platform to facilitate the issuance of digital securities through blockchain technology.

A number of metaphors are being thrown around regarding the innovative potential of blockchain technology, including comparisons to the printing press, steam engine, antibiotics, and the internet. But despite high level talks of societal change, there seems to be no true historical parallel to rival the growing impact and future implications of blockchain technology, especially in how transformative it could be for global capital markets.

So what makes blockchain such a game changer? When focusing on current trends in the space, even the casual observer interested in financial use cases is most often drawn toward the concept of Digital Security Offerings (DSOs).  

At its most basic level, a digital security is a digital representation of an equity or debt security that can be bought and sold online, and is recorded on a blockchain-based distributed ledger. A DSO is the offering of digital securities to usually geographically-disparate investors who then trade them on secondary market platforms, which in turn bring liquidity to their global counterparts.  DSOs will revolutionize the securities markets in a myriad of ways, but for now we’ll focus on three key impacts: accessibility, transparency, and liquidity.

Accessibility

One of the most interesting, impactful, and truly innovative changes that DSOs offer is encapsulated by the term accessibility, sometimes referred to as financial democratization. There are two essential components to this:  time and geography.

At present, traditional stock exchanges are closed more hours a week than open. With digital securities exchanges, this will not be the case as they will be open 24 hours a day, seven days a week, 365 days a year. In fact, securities that sit on these new generation of exchanges will have just one opening bell to signal the start of trading into perpetuity. This will greatly increase market accessibility because access to your investments will not be on a rigid schedule that limits the time and place of trading. Thus, if you thought of a great investment opportunity while watching CNBC on Saturday night, the new structure of securities trading would allow you to execute that transaction at that moment, with minimum time and energy. The rush of orders placed at the opening bell, and the high-frequency trading and high order volume that occurs around that time, will be replaced by a constant stream of 24/7 accessibility.

Second, geographic barriers to capital market access will be eliminated due to the decentralized nature of the blockchain. In a fully matured landscape for digital security offerings, investors worldwide with funds and an internet connection can participate in opportunities throughout the world (assuming they pass KYC and AML checks).  This will be the true democratization of the global financial system, as even small actors can theoretically invest or access capital at rates similar to larger institutions.  Issuers and investors alike should tread carefully, however, because regulators across the globe mandate differing levels of registration with or exemption from securities laws.  And those laws will continue to evolve for the foreseeable future. 

Transparency

True transparency will fundamentally transform capital markets and provide a basis on which to grow new asset classes, as well as to clarify existing ones. 

Often used as a buzzword for blockchain, transparency is already playing a direct role in the growth of the digital securities ecosystem. In a securities transaction, who can you trust to ensure that you receive the fruits of your investment? Where does that baseline, that foundation that makes value transfer possible, come from? Right now, it’s an often highly-paid third party such as a trustee who ensures funds are distributed appropriately and consistent with contractual expectations. But with digital securities, that trust is a basic component built into the architecture of interactions: Who can you trust? The blockchain.

Within this context, transparency is trust’s essential core component. Every trading operation, issuance application, dividend payout and smart contract execution is transparently recorded on the blockchain to improve the overall securities ecosystem experience. This is an immensely powerful tool which seeks to prevent fraud and theft and will be massively important for payment companies such as PayPal as they navigate and adapt to the new blockchain-based monetary landscape.

Liquidity

Another fundamental impact of the DSO is liquidity.  Indeed, this is what has generated the most excitement in the securities space. The introduction of digitized securities into capital markets promises to increase dramatically the pace and quantity of capital transactions.

There are many different factors that interact in this ecosystem to produce heightened liquidity. Here I’ll highlight just two:  fractional ownership and asset fungibility.

Fractional ownership refers to the property of digital securities that allows them to be divided and sold as a part of the whole. For instance, an apartment worth $100,000 in Chicago may be tokenized and issued as 100 security tokens each representing $1,000. But what if I only have $100 to invest? Fractional ownership neutralizes that problem because I can still invest my $100 by purchasing 1/10 of a digital security that will experience the same rates of return as if I owned the whole apartment.

This drives liquidity by enabling smaller investors to participate, lowering the barriers to entry and increasing transaction turnover. Increased liquidity in capital markets also creates an associated liquidity premium, which essentially increases the asset value as a percentage of the whole.

The second major factor is the fungibility of asset classes. Simply put, if distinct asset classes when digitized and securitized are able to be traded interchangeably, the probability of liquidity events increases dramatically. Consider the example above of a digitized apartment. What’s stopping you from trading that 1/10 of a digital security for $100 worth of U.S. Treasury Bond securities? Absolutely nothing!

Many view fungibility to be the essential revolutionary element in the development of digital securities. No longer will investors need to partially divest from the stock exchange in order to diversify into other asset classes such as bonds and real estate. Access to digitized investments of all shapes and sizes, from more dependable long-term funds and bonds to quick day-trading equities, will be available to a much larger percentage of the world, thereby driving a veritable explosion of liquidity events.

The digitization and securitization of assets will in turn bring enhancements to blockchain technologies, particularly in the areas of security and compliance.

A fundamental concept underpinning the development of blockchain technology and the resultant DSO field is the security of digital assets. Similar to legacy banking, confidence in the system is based on the assumption that assets or their monetary equivalents are reasonably safe and cannot easily be stolen (and if they are, the assets are backed by insurance). Even though there are weaknesses inherent in any new technology, the current improvement rate of cryptographic security protocols is very high, and many companies are developing institutional-grade custody solutions.  When stored online with best-in-class custody providers or offline in cold storage, the risk that those funds will be stolen or lost is minimized.

Additionally, companies such as Microsoft and Amazon are highly involved in the back-end of this paradigm shift towards blockchain-based securities trading. They are eager to provide secure storage and processing solutions for as many start-up or institutional players as they possibly can.  This in turn brings much-needed stability to the arena. Therefore, especially in the nascent DSO industry where the security of digital assets is paramount, established partners and a custodial product strategy that remains far nimbler than the threats made against it are absolutely necessary, and thankfully, are becoming easier to find.

In terms of compliance, the Securities and Exchange Commission (SEC) has now made it clear that it has yet to come across an initial coin offering (ICO) that was not also an issuance of unregistered securities. At the end of 2018, SEC Chairman Jay Clayton commented: “If you finance a venture with a token offering, you should start with the assumption that it is a security.”

The prevailing wisdom has thus adapted, and come to dictate, that projects be proactive about approaching regulatory bodies with a plan to register their offering or issue it through an exemption, and that entities enabling the trading of DSOs register as a securities exchange or an alternative trading system. Some issuance platforms have developed their own compliant digital securities models, underwriters are preparing appropriate due diligence, and exchanges are suspending and banning fraudulent actors.

Here is where things get interesting for national securities exchanges and the companies listed on them:  The regulation and standardization of digital securities allows the industry to finally progress through the initial stages of trepidation and uncertainty to solidify processes like ensuring compliant tokenomics design and offering structure. Just as it did to the nascent institutions of the American West during the late 19th century, the imposition of regulatory order on the ‘wild west’ of blockchain-based currencies will enable new and exciting possibilities to take root and grow into stable, well-functioning pillars of the new digital economy.

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Syed S. Hussain is CEO of Liquidity Digital, a fintech company that is developing an end-to-end platform to facilitate the issuance of digital securities through blockchain technology.  Liquidity Digital is backed by Soramitsu, a blockchain technology company which is part of the Linux consortium and developer of the Hyperledger Iroha protocol.

The views and opinions expressed herein are the views and opinions of the contributor at the time of publication and may not be updated. They do not necessarily reflect those of Nasdaq, Inc. The content is for informational purposes only and does not attempt to examine all the facts and circumstances which may be relevant to any particular company, industry or security mentioned herein and nothing contained herein should be construed as legal, tax, investment, financial, or other advice. Nothing contained herein constitutes a solicitation, recommendation, endorsement, or offer by anyone to buy or sell any securities or other financial instruments in this or in in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction.