Regulated Digital Securities on Blockchain Ledger Technology Infrastructure are here to stay and growing. The real story is the Trillions of dollars in illiquid private Alternative assets that will be using this technology to raise money and trade (see The rise and rise of private markets, McKinsey Global Private Market Review 2018).
Interview with Jeffrey Sweeney, CEO of US Capital Global
Why will Digital Securities make life better?
This is an exciting way to hold and trade valuable assets electronically. Regulated equity securities, using blockchain digital ledger technology (DLT), will provide opportunities for capital market efficiency and liquidity for issuers and investors. As the digital private securities marketplaces develop, there will be increasing opportunities for valuable private assets and securities to be bought and sold by qualified investors.
Are ICOs Dead?
Last year saw an ICO, or Initial Coin Offering, bubble where ‘coin’ = cryptocurrency, tradeable ‘utility’ token, or unfortunately some mechanism to raise equity or revenue sharing financial instruments. More recently, the news wires have been full of stories of many ICO issuers being subpoenaed, ordered to repay funds raised, and the promoters being fined and prosecuted. The attempt to use Blockchain Ledger Technology via the ICO to avoid securities regulations is over. In the United States, the majority of ICOs have been unequivocally determined to be a regulated security. Other key ICO venues, such as Singapore and Switzerland, have seen similar tighter regulation of those ICOs deemed as securities. The regulators have come forward and ruled ‘it is a security’ and subject to all rules and regulations around securities distribution. That ICO marketplace and its use of Blockchain Ledger Technology was predominated by speculative early/angel stage ventures, but now we are seeing Digital Ledger Technology, and the offering of Digital Securities, expanded to a radically larger set of asset classes.
What’s a Digital Security?
Generally, there are three top level definitions for ‘digital tokens’…
• Cryptocurrencies a general purpose token to represent the digital function of a currency.
• Utility tokens represent access to a good or service, essentially like a digital ‘coupon’, e.g., for membership or discounts.
• Digital securities represent the ‘tokenisation’ or digitisation of underlying securities. Digital securities are securities. They are regulated, unlike ‘Utility Tokens’ or ‘Coins’ that may bypass regulatory securities scrutiny. Technically, Securities include shares of ownership, income streams (fractionalised loans or derivatives), etc. and include private and public market offerings, encompassing the full range of Alternatives.
Why ‘digital’ and what’s a DLT anyway?
Digital Ledger Technology is a technological infrastructure innovation in this sector at a promising inflection point in the history of private capital market innovation. It is one of the most promising technologies for use in keeping track of and facilitating transactions for Alternative Investments to come along. It just must be done properly.
Using it with a wider and better class of assets, instead of risky early stage venture equity investments, makes obvious sense.
What other assets can be used by Blockchain Ledgers?
There are billions and trillions of dollars of other assets that can be kept track of by Blockchain.
Bitcoin is a particular digital financial asset that was instrumental in making Blockchain Ledger Technology popularly understood. It was one of the first assets to come on scene using DLT. Bitcoin and other financial transaction coins have been mostly determined to be essentially commodities and not securities. Commodities have a different regulatory framework than securities.
But we are concerned here with alternative assets. This is a multi-Trillion-dollar asset class with very narrow public distribution. Few are able to participate in this asset class – even though the population of qualified investors has quadrupled over the last 20 years, participation in this asset class has barely increased. As the early interest in DLT technology has shown improved transactional integrity, security, and ease of secondary sales of electronically registered assets. DLT can unlock the access to this massive asset class and provide a way to hold and trade these assets in an efficient, secure, and compliant manner. The real insider secret is the conversation about trillions of dollars of private investments in Alternative assets (Alts), and that has almost no internet sizzle at all. Not yet at least.
Types of Alternative Assets
The Angel Round: The discredited ICO was a cousin to the failed Crowdfunding hype and a hopeful means of investing in a particular Alternative asset class. That particular asset class was an attempted substitute to the Angel Investment Round, or Venture Stage investing. One of the smallest and riskiest stages of alternative asset classes, but essential to the growth and development of our economy. Big money can be made investing in early stages that become successful. The likes of Google, Uber, and Airbnb were at one-time venture stage companies. Successes are rare, and some say failure rates are over 90%, but rewards are huge for backing the winners. These venture investments are regulated as securities and generally reserved for ‘Friends and Family’ or ‘Institutional Investor’ rounds lead by the issuer and open to almost anyone and private placements, or general investment rounds restricted to so-called sophisticated investors. The ‘startup’ equity round is an alternative asset class, but only one of thousands, and does not define Blockchain Ledger Technology any more than Bitcoin does.
Alternative assets are not just made up of early stage venture investments. Sophisticated investors and institutions allocate the bulk of their billions and trillions in valuable assets like real-estate, growth stage companies, private equity and pre-IPO companies. These sophisticated investors continue to increase the allocation into private alternative assets with the motive of potential alpha and outperform the public markets. With the use of DLT, it becomes easier to hold these assets digitally, as well as transfer them to other investors. With an electronic asset and regulated electronic platforms for the exchange of these assets, the marketplace for private alternative investment assets will approach the accessibility of the Public market. The financial regulators are preparing for this eventuality with the expansion of the Alternative Trading Systems ‘ATS’ to facilitate these assets to be exchanged. The precursors to these exchanges are the Cryptocurrency exchanges, but they are virtually unregulated and have the reliability, fraud, and theft problems one would expect in an unregulated environment.
Who moved the goal post? Many venture stage investors were hoping for a huge win when the early stage company they invested in went public. But, increasingly, those IPOs have been delayed, and the early investors or Venture Funds were left with tremendous book value and little to no liquidity. Private companies, their owners and investors, have all the same desires as public companies – to raise new capital more easily or provide liquidity to employees or investors, but with far fewer options.
Venture Secondaries are sales of a private security by the original purchaser of the equity to another party. This resale is called a venture secondary or secondary sale of private securities. The delay in private companies going public has spawned a very large market in the sales of these venture secondaries in primarily large, near Billion dollar or greater, private companies. The venture secondary sale of private, very largely capitalised companies, is a complicated and expensive process. Current venture secondary sales require specialised lawyers and complex financial instruments, because the shares were never anticipated to be sold to a second investor. Transaction volumes for private placements are usually low, with high minimum investment, and restricted to sophisticated investor classes. So the recording of shareholdings is a simple paper document / spreadsheet task. Plus, historically, secondary trading was discouraged or restricted. But since today’s firms stay private longer and may want more secondary trading, so having a better company ledger that improves efficiency, visibility, and supports secondary shareholder transactions – ‘digital ledger technology’ (DLT) – is now very desirable.
Blockchain DLT is Evolving to Alts
The concept of Blockchain Digital Ledger Technology is now almost completely divorced from Bitcoin and other cryptocurrencies. It turns out what looked like a sideshow for Bitcoin, Blockchain Digital Ledger Technology, has become the main act in a revolutionary technology for so many sectors, financial and otherwise. We are focused here on Blockchain Digital Ledger Technology use in the financial sector and, even more narrowly, its use in keeping track of and, to a lesser extend, facilitating transactions in Alternative Asset Securities. Digital Ledger Technology can unlock the access to this massive asset class and provide a way to hold and trade these assets in a secure and compliant manner. That Ledger service is huge, but it is the Alternative asset class itself that is massive.
Alternative assets… Not just Angel Round
Alternative assets are virtually any asset that is not a public security or a ‘rated, i.e. rated by a rating agency, like Moody’s or S&P. Public Stocks and bonds, derivatives, most sizeable financial instruments that have a formal equity coverage or rating like BBB or AAA, are considered not alternative but ‘conventional’ investments. Liquidity is a major factor in an investment to be considered conventional. On the other hand, prominent Alternative investments, like Angel Rounds in start-up companies or pre-IPO companies, lack the essential coverage of equity research, credit rating, and readily liquidity, which make them an ‘alternative’. Both early stage companies and later stage companies valued in the billions are in the same ALT category. Spotify was in the ALT status before it went public and became a conventional investment because of its equity coverage. Non-rated Real Estate partnerships are also Alts, as are mid to small size growth private companies, to name just a few. Bringing the advantages of DLT to the full range of alternative assets opens up a huge range of opportunities.
Alternative Investment Uses for DLT
What DLT offers is a way to keep track of who owns these companies, when they bought them and for how much, and if they were even qualified to purchase them, from a regulatory perspective. Holding the asset as an electronic record makes it vastly easier to change ownership and display a ledger of other owners of a particular asset, also known as a capitalisation chart. DLT also allows for the listing of assets for sales on exchanges. The use of DLT can have a dramatic effect on the Alternative asset class, but certain building blocks of best practice must be in place. They are the same building blocks and principles which have allowed other markets to thrive and become the massive pillars of our financial communities. When Alternative assets adopt both the principles and standards of the bigger, liquid markets, and with the DLT to facilitate holding and transfer of custodianship, Alternatives and their technology platform DLT will become a massive, widely distributed market. They will rival the public markets in size and ability to create wealth. The private Alternative market already approaches the public market in size, but lacks the broad participation from the general population the public market has. DLT can change and will change that. Even US SEC is coming out with statements they want to encourage and broaden the participation in private, alternative securities.
In Summary – Alternative Investments have always needed and been waiting for Blockchain DLT
The Alternative Investment marketplace has been waiting for something like Blockchain Ledger Technology to come along and help make this happen in a cost effective, compliant, and efficient manner. The solution is traditional markets and market functions augmented with digital technology to provide more efficiency, broader access, and increase liquidity. We are convinced the current professional and regulated financial network should be engaged in the digital marketplace. Regulated Custodians, Broker Dealers, and Securities counsel are essential ingredients to a stable and trusted marketplace. Trust and integrity are absolutely required for the alternative investment digital marketplace to thrive and be the wealth creating engine it has the potential to be. •