By Jeffrey Sweeney
Digital securities, STO’s, blockchain equities, are all securities, plain and simple. They fall under the same rules and regulation as all other securities. But we also all know that not all securities and markets are the same.
For the retail market, there are the more highly regulated public securities, the home of large public corporations. Private securities are the home of a significant other element of the economy; smaller business, early stage entrepreneurial firms, alternative assets, real estate etc. The impact of digitization applied to these distinct markets will be significantly very different. Public markets trade at high volumes, at wireline speeds, and they are already highly standardized. Private securities are low volume, trade at analog speed, and very customized. Private securities are ripe for distinct efficiencies provided by digitization.
Private securities are offered to a limited number of accredited investors and they trade very infrequently, if ever. The advantages of digitization here are quite dynamic. In private markets digitization can bring increased standardization, improved visibility, and development of secondary trading where little or none existed before. These advantages can be achieved in digital private markets by adopting standardized derivative contracts, combined, with the key functions of counterparties like regulated asset managers, broker dealers and custodians. This article elaborates on this model.
Derivatives as a Path to Standardization
The suggested strategy for digitization of private placements is to make them available as a derivative product. A derivative contract, or product, is an economic interest or contract in the underlying asset or security, while that security is held by a custodian. This will simplify the complex underlying subscription agreements, and make them easier to sell in a primary or secondary marketplace.
In private markets digitization can bring increased standardization, improved visibility, and development of secondary trading where little or none existed before.
This approach addresses two key friction points for alternatives; excessive customization of transactions or securities, and regulatory risk. This form of digitization of the economic interest in the underlying security is also compatible with using forward thinking commercial custodians to secure transactions and ownership. All of this is based on achieving increased standardization and ease of trade. Think commodity trading, the pioneer of derivative contracts.
Derivatives themselves are nothing new and already represent a 500 trillion-dollar market. But this protocol should also be used in the rollout of the digital private security marketplace. If you use a derivative model with a simplified subscription, and if you custody the asset of the derivative with a regulated asset manager, then you can compartmentalize the risk and streamline the overall subscription and trading process. This specific modality creates a more standardized derivative product, minimizes counterparty risk, eases reporting, and facilitates higher volume price discovery and transactions.
The Challenge in Standardizing Private Placements
There are many current efforts to elaborate smart contract standards for financial transactions and securities, but current business practices are complex and voluminous, and the encoding of these terms is a significant undertaking. The Hyperledger project and Ethereum Alliance are working on digital smart contract specifications. The current ERC catalogue includes ~58 final and ~150 draft, EIP specifications these include basic execution functionality, smart contracting terms, vendor interface specifications. But this is just a small portion of what needs to be achieved to address the overall challenge of standardizing the issuance of digital securities.
The suggested strategy for digitization of private placements is to make them available as a derivative product.
And so, when issuers today seek to offer native digital securities, this typically involves significant and costly custom specification of terms for their STOs. This creates a major barrier to issuance. In the long term this will become more standardized and interoperable, but in the short term this complexity can result in issuance documents that may be difficult for the investor to confidently assess, and thus inhibits the adoption of digitization benefits. Derivatives are inherently shorter contracts and they refer to the more complex underlying asset or security in an annex or appendix. Thus, providing a simpler and shorter contract to digitize.
Key Issues in Risk Control
Key elements of risk in private securities include fraud, misrepresentation, transaction security, visibility and reporting. For fraud and misrepresentation, regulated broker dealers are responsible for the due diligence associated with bad actors, valuations, etc. These licensed professionals evaluate and attest to the specifics of the offering.
For traditional transactional security, issuers and investors rely on custodians and related transfer agents to ensure that securities are safe and not lost or transferred in fraud or error. In traditional ‘electronic’ markets (which may be managed by computerized ledgers), if there is an error, or some sort of transactional fraud, the rightful owner can inspect the records and unwind an erroneous transfer.
While digitization through cryptographically secure transactions may provide some additional security to the description and identity records of securities ownership and transfer, it also raises some new risks because of the difficulty of recovering lost assets (think Mt Gox). We need to implement custody practices for unwinding erroneous or fraudulent digital security transactions. These traditional regulated roles of broker dealer and custodians, provide key asset and transactional security to the ‘fintech’ of digital securities. But the use of derivatives greatly enhances the ability to facilitate these controls.
Key elements of risk in private securities include fraud, misrepresentation, transaction security, visibility and reporting.
Counterparty Roles in Derivatives
There are three regulated counterparties to consider in risk containment of the underlying security; the financial advisor, the asset manager, and the custodian.. First registered investment advisors are often the proxy for direct investor interest in private placements. Their role is to conduct investment analysis and make recommendations to investors about risk, rate of return and suitability. Is the asset fundamentally a good fit for the investor, his portfolio, and strategy? In the case of derivatives, they will rely on the role of the asset manager to conduct due diligence for fraud, sound financials, and clear risk disclosures as well accurate potential rates of return.
The regulated asset manager is responsible for a correct representation of the risk and potential rate of return underlying the asset. The asset managers of the underlying assets thus assume and contain this risk, so that investment advisors and investors can rely on the professional representations and focus their attention on portfolio strategy.
Finally, there is transactional risk. Everyone has heard stories of someone losing all their crypto coins because they lost the key to their e-wallet. This transactional risk can be addressed in digital securities by using regulated custodians to custody the rights to the derivative. The investor is thus secured against fraudulent or erroneous transactions.
Additional Reporting With Derivatives
For even the least widely held public securities there are significant reporting requirements, ongoing news and price visibility. But what about private placements? The structure of a derivative can create specific additional investor rights around financial reporting requirements on a quarterly basis, notice of cap chart changes, press release announcements etc.. These rights may not have originally existed to the owner of the underlying asset, but are contractually agreed to by the asset manager in the terms of a ‘side letter’ enhancing the rights of the investor in the underlying security. So while the ‘fintech’ of security digitization addresses some concerns of investors in private placements, the ‘regtech’ of packaging these securities into derivative offerings with specific investor rights, addresses significant other issues of risk and visibility.
In Summary – Digital Securities in Private Placements
Any significant technology advance comes with some initial ambiguity. Cloud computing, artificial intelligence, digital securities, each of these revolutions comes in many different flavours and affects different use cases. The advantages (and challenges) of digitization of securities are very different for investors in private placements vs. public securities. Using a derivative model in the digitization of securities, can bring higher levels of standardization in subscription agreements and investor rights to private securities and increase their acceptance, distribution, and secondary trading.