There is a large and increasing demand for private security secondary markets and the digital technology that can improve access and liquidity. Dr. James Baty and CEO Jeff Sweeney of US Capital Partners met TFT at a joint event in London on 20 November 2018 to elaborate on the potential of STOs offering investors a new asset class and market reach.
What’s the appeal for digital private securities?
We have established in previous debates that there exists a robust and increasing market in secondary trading of private securities. And there are many commonly known examples, such as Spotify and Uber.
It’s a multi-billion dollar market, but historically limited to very large transactions, because these transactions can be awkward and expensive, and are not subject to widely distributed knowledge.
However, along with increasing demand we now see the advent of blockchain transactions and digital securities reducing secondary market transactions friction, reducing cost, thereby making transactions less awkward and allowing greater access to smaller transactions of value.
This same technology, had it been available earlier could have been used to make transitional large block secondaries less complicated and more affordable.
And there is another reason for great demand in secondaries – the longer maturity time for private companies. Traditionally VC investors would hope to move quickly through B and C round financing, to be recognised as a ‘unicorn’ and launch an IPO, providing a major liquidity event for early investors. But this traditional VC market has slowed, IPOs come later, the market wants more intermediate-term liquidity, so there’s more demand for liquidity than there might have been three to five years ago.
Thus, given the current state of the marketplace, there are trillions of dollars of value that have been locked up in private security holdings, and now we see that tokenisation of securities and transactional market efficiencies offers timely promise to unlock liquidity and provide broader market access.
What is the mind-set needed to focus STOs as an asset class?
Not all private securities are the best candidates for secondary trading, or the adoption of digital security models and blockchain transaction models. So many of the early examples of digital financing are the now infamous ICOs, underlying questionable assets, attempting to skirt securities laws. In other cases, some of these may have been legitimate offerings, but they were still confined to early stage venture round financing, a very small rounding error of the overall large private market, with an intrinsically high failure rate. There may have been a lot of buzz, but this is not really a valuable or very big asset class.
In the end, the SEC (US Securities & Exchange Commission) came out and admonished, corrected and fined many of these early ICO efforts, but it also reiterates a continued goal to want more main-street participation in private securities for qualified investors because they just want that for investment, retirement, and all kinds of things. I.e. investment in successful, later round private placements, that will benefit from improved digital transaction efficiencies.
How can blockchain and digital security technology be used to improve market access to high value assets and a more efficient digital private equity market?
Technology, tokenised securities, digital ledger technology, are important, but what’s equally key are assets of value, and the ecosystem of underwriting broker dealers, transfer agents / custodians, securities lawyers and alternative trading systems
(ATSs). More than just an infrastructure or everybody creating their own marketplace, it’s going to take some of the large trusted brands (because an investment’s made out of trust), to build the marketplace where investors will go, for example the New York Stock Exchange and NASDAQ.
The vast majority of this ecosystem continues to be governed under the applicable regulations and guidance of the SEC, CFTC, and FINRA etc. But some of this functionality may benefit from additional guidance and standards in terms of what kind of high-quality offerings are going to become available and who takes responsibility for filtering and vetting those offerings for integrity? Even though you may not be able to guarantee the financial growth of them, certainly there has to be a guarantee that they’re not fraudulent, that the representations are accurate, where the investors or the analysts can make assertions as to whether they’re a good investment or not, on the platforms where these are represented.
In summary it takes the new digital equity technology, but beyond this technology it takes quality assets, the professional ecosystem, and an emerging evolution of standards and guidelines. In any case there are some significant issues to consider.
What steps to take to begin?
Where you start depends on the ‘readinesses of your existing equity for tokenisation, vs. beginning with a new issue. The elements to consider if you start fresh, is how you would structure your contracts, your offering, your tokens potentially, in a way that would support secondary market activities. On the other hand, if you’ve already issued securities, is there a way that you can tokenise for liquidity opportunity on existing investments? This will likely be more complicated in terms of the terms and the contracts, etc.?
One route is to perhaps amend the existing contracts to allow for and guide secondary sales. That means you have to send it out to shareholders and you’ve got to either go the way of the shareholder vote or might be by negative consent. So an alternative, even when you have existing shares outstanding, is to consider doing another round. Even if an additional raise is not needed, the additional round could be used to provide secondary market liquidity through a stock swap to the new contract terms.
In any case, the basic proposal is to start making all privately issued securities compliant and capable of secondary sales. You must consider the appropriate terms to potentially govern secondary sales, ROFR (right of first refusal) clauses, waiting periods, voting requirements etc., to find the right mix of potential liquidity and desired control.
Who will run the digital secondary markets?
At this early stage there is little standardisation or interoperability for secondary markets and token issues. One may question the relationship between token issuers and secondary markets? Having to incorporate some of the contract terms of the token into the secondary market permissions and approval, etc., there’s probably a handful of types of relationships between issuer and market that can exist.
One model would be: I’ve got a captive secondary market associated with a token-issuing platform. As an issuer I go to company X, they issue my tokens, and they are the secondary market. This assumes that company X, has appropriate licensing and registration for all of the relevant ecosystem components (broker, custodian, ATS, etc.).
Another model is where the issuer issued tokens or not issued tokens, but they go to an independent secondary market and onboard the issuer with their smart contract terms being incorporated into the blockchain. Both the captive and independent secondary market implies that the contract terms would have to be freshly encoded for each secondary market the issuer would allow trades on.
The ultimate goal is secondary markets that support token issuers from many different types of platforms. So, whether I’ve issued my own tokens or I’ve issued tokens with a third party, I can go to this market and plug in because there’s a common infrastructure or a common terminology, contract terms and APIs.
Where do the terms get recorded?
In dealing with blockchain transactions the relevant information may be recorded on-chain (in the blockchain computation) or off-chain (e.g., in a separate indexed database). The blockchain must include the bare minimum of the identity of the security token and the history of the owners. We might conceive that there are natural levels of this allocation of data.
1 – Bare minimum ownership of record – i.e. the normal data that is recorded in a cap chart entry – number of shares (identity of tokens), owner and transaction date, etc.
2 – Ownership augmented with detailed transfer terms – when can this token be exchanged under what conditions, restricted date window, accreditation requirements of investor, etc.
3 – Total and complete contracts terms incorporated in the blockchain. Given the complexities of many contracts this may be limited to particular industries or business niches where the contract terms are already highly standardised. The standardisation and semantic encoding of more generalised smart contracts, is a large and ongoing activity of several industry consortia.
The sweet spot would seem to be category two – where the availability of secondary trading is facilitated by having all of the relevant ownership and transfer terms encoded in the blockchain for ready visibility and compliance.
The Future is Already Here
In summary, digital ledger technology [DLT] using blockchain technology can provide a significant platform for not just the basic issuance of digital securities, but an avenue towards increasing desirable secondary market liquidity for private securities. But just because the algorithms and servers exist, that doesn’t mean there’s not still a lot of work to do to leverage the technology. Issuers need to plan carefully for the contractual terms that anticipate future secondary sales. Ideally digital smart contract standardisation will emerge that enables interoperable secondary markets. In the meantime, multiple competing proprietary platforms and markets will emerge and issuers will have to make careful choices.