In theory, decentralised ledgers could help revolutionise the global capital-raising process, disrupting the share and bond markets in the same way that bitcoin promises an alternative to central bank-issued money.
Blockchain technology provides a censorship-resistant, transparent record of ownership, allowing companies to democratise their fundraising campaigns and avoid the expensive, investment bank-dominated market for securities issuance.
As well as recording ownership and transaction data, blockchains can support programmable ‘smart contracts’: in the context of share and bond markets, these contracts could include automated instructions for important post-trade processes such as dividend and interest payments or the movement of collateral.
But initial excitement about the possibilities of blockchain-based fundraising has been tarnished by the fraud-ridden boom in initial coin offerings (‘ICOs’), a market which has now attracted heavy-handed intervention from securities regulators.
A third wave in the cryptocurrency boom
However, some blockchain optimists believe that a new wave of security token offerings (‘STOs’) could help build on the promise of decentralised ledger technology while staying on the right side of regulators.
“Bitcoin was the first wave of the cryptocurrency movement—it’s disruptive for gold and existing forms of money,” said Daniel Masters, chairman of CoinShares, speaking at a breakfast briefing organised by Financial News in London on November 8.
“The launch of ethereum in 2015 allowed blockchains to be used to form capital. This ushered in the second, ICO wave of the cryptocurrency boom,” said Masters.
However, said Masters, this leg of the boom ran into trouble.
“Many ICOs were able to raise large amounts of money in very short space of time using this novel fundraising mechanism. But the model was soon abused and, understandably, the SEC and other regulators have since come down hard on ICOs.”
“Now we are seeing the emergence of a third wave—the security token movement,” said Masters.
“This allows us to take the existing regulatory framework for securities issuance—for example Reg D, Reg S, Reg A, Reg A plus or Reg CF in the US—and use those regulatory safe harbours, which usually involve some kind of prospectus and an exemption from the 1934 Securities Exchange Act, to issue blockchain-based smart securities.”
Bridging the gap between public and private share markets
But why should security tokens take off and what are they likely to achieve? They can help bridge a large gap between the valuation of publicly listed and private company shares, according to CoinShares.
“Security tokens will make shares in private companies liquid, transferable and transparent,” said Masters.
“Once you have added these three features to private company shares, they effectively resemble public securities,” he added.
“But public securities trade at a much higher valuation than private securities. A dollar of EBITDA in the private share market may be worth $5-10 of share price. But in the public markets the same dollar of earnings may be worth $20-25 in share price terms. That’s an arbitrageable window between the two markets—public and private.”
According to Masters, the third leg of the cryptocurrency boom will involve the securitisation of a broad range of assets, forcing traditional financial institutions, many of whom have so far remained sceptical about this new technology, into the fray.
“If wave three involves the widespread tokenisation of hard assets, real estate and private shares, then legacy financial institutions—investment banks and insurance companies—will not be able to avoid it,” said Masters.
“This is going to be the next powerful movement in the crypto space.”
And, says the CoinShares chairman, the emerging security token market will prove a friendlier place for regulators to operate.
“Bitcoin and ethereum have been a nightmare for regulators to cope with,” said Masters.
“But a security token framework is a win for them. I believe this is going to be the next powerful movement in the crypto space.”
A blockchain-based equity fundraising
Speaking at the same event, Myles Milston, founder and chief executive of Globacap, a digital platform that aims to tokenise illiquid assets, such as private equity, property and loans, recounted his own company’s experience in raising equity capital using a blockchain.
“We created our own capital structure on a blockchain using the Financial Conduct Authority’s sandbox,” said Milston.
“We took investments from a number of jurisdictions, created our equity shareholder register in blockchain form, and issued securities on the blockchain,” he said. “We then tested share transactions between buyers and sellers and documented the efficiency gains we made as a result.”
According to Milston, there’s rapidly increasing interest in applying blockchain to securities issuance, clearing and settlement.
“The FCA’s sandbox applications are a very good indication of where things are heading in the crypto space,” said Milston,
“The participants in the first three FCA sandbox Cohorts were largely focused on the uses of blockchain in payments remittance. But in Cohort 4, there are three firms, including ourselves, focusing on securities-related blockchain tests. Over the next eighteen months we expect to see real propagation of these ideas.”
Three steps to launching a security token
Some nifty footwork is needed to comply with the existing regulatory framework while issuing shares on a blockchain, says CoinShares’ chairman. The Holy Grail is to end up with a token that can be traded globally.
“In the US, there are three steps to launching a security token,” said Daniel Masters.
“The first is to carve out the regulatory safe harbour in which you can issue the token. Phase two is to make the tokens operable. This means addressing questions like identity, verification and the audit trail. The third step is how to make the tokens interoperable—how to meet the regulatory requirements in country A, country B and so on.”
A company named Securitize says it has managed to find regulatory safe harbour, issue a token and deploy it for trading on a decentralised exchange, said Masters, although he hasn’t verified these claims.
“Over the last six months the first step—achieving regulatory safe harbour—has been addressed in certain subsets and areas,” said Masters. “There’s a lot of work going on regarding the second step. Not so much has yet been done on interoperability.”
Which settlement currency for STOs?
According to CoinShares’ chairman, the expanding market for security tokens will also provide a boost for the most widely traded cryptocurrency, bitcoin. Bitcoins have a collective market value in excess of $110bn.
“Bitcoin becomes both the native settlement currency and the backbone of the settlement system”
“As we move towards the greater interoperability of the global exchanges on which security tokens are traded, bitcoin is almost certainly going to be the settlement currency in which token purchases and sales are recorded,” said Masters.
“The bitcoin network itself forms the basis of the IT security for the settlement system as well. If you’re running databases off to the side, perhaps containing details of your company’s transactions, customers and constitutional documents, at some point you will want to attest the state of your database in a non-revealing way, so as not to breach regulations like Europe’s GPDR.”
This can be done by hashing such records and entering the cryptographic link into bitcoin’s transaction history, says Masters.
“You can embed the information in bitcoin’s blockchain. Bitcoin then becomes both the native settlement currency and the backbone of the settlement system,” said Masters.
However, Globacap’s CEO points to digital representations of national currencies as a more likely unit of account for security tokens.
“I do believe that a crypto-based mechanism will become the universally accepted settlement currency,” said Milston.
“But I’m not sure it will be bitcoin,” he added. “There are entities working on a crypto-pound, crypto-dollar and crypto-euro. When we see those, we’ll see immediate uptake from institutions.”
A lower hype cycle
Perhaps inevitably after the 2017 hype surrounding ICOs, proponents of security tokens are more modest in their predictions regarding the uptake of these new instruments.
“In 2019 I expect to see up to $2 to $3 billion of securities in various forms that tokenise quickly or promise to do so when operability standards arrive,” said CoinShares’ Daniel Masters.
“Capital-raising in the form of security tokens is already happening,” said Globacap’s Myles Milston.
“But when will the secondary market arrive? In the next 6-12 months I think we’ll start to see it take off.”