A Global decentralized securities market

1. Why ICOs took off

2017 was the year of ICOs. It was in general a time of mania for crypto investors. The inexorable rise of Bitcoin and a number of other small coins in its wake burst into mainstream consciousness. There were several factors that led to this boom:

1.1. Crypto anarchists and individual asset sovereignty advocates

The great crash of 2008 was never really fully resolved. Instead, the credit crunch was ameliorated by central banks resorting to quantitative easing, which is basically printing money. The huge money spigots found its way to capital markets where the increased money supply led to higher asset prices for both stocks as well as real estate. But those in the know were hunkering down in the search of assets that were beyond the reach of the state, such as gold, that could weather the inevitable next storm to come.

Bitcoin, with its bearer characteristics, was a powerful tool for any one who wanted to stake out a position out of the current corrupt financial markets.

1.2. The followers

However, to pin the rise of bitcoin on the world suddenly becoming a libertarian utopia would be to misread the situation. The bulk of those who jumped in were those who saw the opportunity to make a quick buck by riding the trend. The rising price attracted more buyers which in turn fuelled the upward cycle. A vicious (or virtuous, depending on your leanings) cycle ensued.

1.3. Worldwide reach

Because these crypto assets claimed that they were not securities, they could be traded worldwide without the restrictions that are typically placed on a security. Which meant massive distribution, and lower (or zero) cost of compliance.

1.4. Shillers and mania

Because these were not securities, restrictions around promotions of securities did not apply. Shillers, paid influencers like Floyd Mayweather, Paris Hilton and DJ Khaled started promoting cryptocoins. Youtube and other social media celebrities peddled crypto. Every man and his dog seemed to be talking about some or other coin and how they either already had bought a Lambo or were oncourse to. These were heady days and the working philosophy was, Anything goes!

1.5. Liquidity

One of the big reasons why crypto mania took off is that secondary markets emerged where the coins you bought in an exchange could be traded. Whether or not the project for which the ICO was conducted achieved its goals, whether or not the coins/tokens could be used for the purpose what they claimed they were for, you had a mechanism to liquidate it. And given the wide distribution there would always be enough demand from those who’d ultimately be left with worthless tokens.

1.6. Zero regulatory oversight

Zero regulatory oversight also meant that there was widespread fraud, market manipulation of all kinds. This would ordinarily mean that the market participants would lose faith and the market would collapse. And while that did happen eventually and as of late 2018 we are having a front row seat to this exact phenomenon, market manipulation led to superficially rising prices on various crypto exchanges which suckered in ever more participants.

2. Security tokens are hard

There has been a lot of commentary around how ICOs will be replaced by STOs (Security token offerings) and how it will be a far bigger phenomenon than ICOs. While this statement is fundamentally true, the short run adoption of STOs is unlikely to exhibit any of the attributes that led to the phenomenal boom in ICOs.

Below is a list of just some of the reasons that would mean that STOs won’t be the rocket ship that was ICOs.

1. STOs are regulated, they are essentially an IPO in a different form. Which means there is a significant regulatory burden to overcome before launching
2. Advertising of securities has to be factual which means none of the Crypto Mayweather stuff will fly. You would be governed by regulatory restrictions on how securities or security tokens can be promoted.
3. Liquidity would not be as easy, depending on the specific regulatory structures there would be restrictions on secondary market trading. Establishing and running such a secondary market in securities would require onerous market licensing.
4. Jurisdictional restrictions would mean that global distribution would not be a default option.

Security tokens won’t be a free for all, the way utility tokens are. Which means while STOs won’t have the same short term boom, the protections that are inherent to it would eventually prove to be a more sustainable model.

3. Distribution is King

Most Security token pitches start with the premise of making illiquid assets liquid. However this is easier said than done.

To make an illiquid asset like real estate liquid you need to go through several steps.

1. Setup the required retail legal structures to acquire the asset
2. Have the necessary funds at hand to underwrite the purchase. Real estate in particular does not work with crowdfunding if you cannot provide certainty. Transactions have contractual obligations with firm settlement dates and if you do not hit your funding goals then there are legal and financial ramifications
3. Have the technology to sell the units in the fund to a large number of small investors
4. Sell the offer to potential investors who buy units or shares in the entity that holds the asset
5. Get the required legal structures to make a market in the units or shares of the entity
6. Get the required technology to facilitate the secondary market trading of these units
7. Get a large number of investors interested in buying the units on the secondary market, and entice those holding to sell to get a secondary market going

All of these steps are hard and this is something that today’s financial markets have evolved to do over centuries.

New players, platforms, even if they have strong amounts of funding simply cannot match the depth and width of existing stock markets which have decades if not centuries of distribution and entrenched acceptance with brokers and the necessary checks and balances to control scamsters.

Case in point is that the market capitalization of Amazon alone is several times bigger than the entire crypto market combined.

All of the above also explains why groups like t0, Harbor, Polymath have not been able to demonstrate substantial traction despite several hundred million of funds backing them.

4. The 2 Paths to build distribution

Security token offering platforms are fundamentally a bit like equity crowdfunding platforms with a better underlying technology.

However a platform always faces the risk of being lumped along with its offers. Early on in particular, investors see the offers on the platform as linked to the credibility of the platform. Which means any failure of offers is likely to impact the success of the platform. This is whether or not the platform is legally distinct to its underlying offers.

The platform can take a hands off policy and make it clear to the investors on the platform that the offers are not linked to them and they are just a platform. It can also choose not to do any active promotions on behalf of the issuer and ask them to do their own promotions. But the reality is early on issuers lack distribution, they need access to investors as much as they need the technology and compliance structures.

A platform that adopts a hands off, free for all will find it hard to get going in a retail securities environment.

However if the platform decides to do the promotions to build out the distribution, it risks getting lumped with the offer itself and its success or failure as an investment. Plus if it is an illiquid investment such as real estate or even an early stage startup, then there is no short term exit for investors (apart from a potential secondary market which again is meaningful only if you have a large number of investors).

This means such a platform would struggle to get enough investors interested in the first offer and if it does succeed, then every subsequent offer would be progressively harder. You would be fishing in an ever shrinking pool of investors.

Investors will not reinvest or refer other investors till they see returns which given the nature of the investments would take a long time to materialize, which if often longer than the runway of these startups.

There are 2 ways to resolve this.

4.1. Own offer

The simplest to understand (but hard to execute) way is to control the investment offering. You build an investment product which you control so that you can ensure investors get the outcomes they expect.

Such an investment product should be high return and also generate ideally regular monthly (or some other short term) income. This would mean investors see money flowing back to their pockets and are likely to recommend their friends.

However you also want to have the necessary balance sheet to underwrite several transactions, so that the platform is able to demonstrate large volume and is able to achieve take off transaction velocity. To achieve this you want something whose transaction size is smaller.

Real estate related loans run into millions of dollars, business loans run into tens of thousands of dollars and personal loans can run into a few thousand dollars. Personal loans in emerging markets can be as small as a few hundred dollars per transaction. Which incidentally explains why we as a business are looking at this segment as an application.

However while running your own offer is a viable path, it is a long path and can often distract or take you away from the key goal of building a platform or market place. While the intention is always to open the platform after you have built up the distribution of investors, the process can take long to materialize.

4.2. If you can’t beat them join them

Distribution is important as it is the basis of liquidity. Without distribution you cannot achieve consistent success in fundraising for the initial raise. However as noted earlier, in a market place achieve initial distribution can be very hard which leads to the classic chicken and egg conundrum.

However if we can address the underlying assumptions then there are a few potential pathways to achieve the outcomes without having to go through the long circuitous path of building distribution via your own investment offering.

In a well functioning existing stock market, liquidity is generally not a problem. Anyone looking to sell generally can find a willing buyer. Price is a function of supply and demand, however the question of distribution is already addressed. All or most of the interested parties are already on the stock market. You get to reach them all in one place and transactions are more likely to be possible as the odds of someone being interested in trading with you are higher if everyone is in the same place.

The second issue of achieving the minimum fund raise for the offer is also not a problem as listed companies or entities have already achieved their minimum funding goals. They list only after they do so (in most cases) and then people are only trading. Unlike a crowdfunding platform or an STO, people are not dealing with the uncertainty whether or not funding goals will be met.

5. Why STO?

However if a company is already listed, why would investors want to use an STO to participate in it? Would they not go directly on the exchange and buy and sell as they deem fit directly?

The answer is we are not aiming to target investors who already have access to these exchanges. We want to make these high quality liquid investments accessible to investors who did not have access to them before.

For instance, the US stock markets are very liquidy and one of the most advanced in the world. You can buy world renowned companies like Amazon, Google, Facebook etc. On the other hand stock markets in emerging markets like India have some of the best opportunities for arbitrage. Day traders can make a fortune trading the volatility.

However stock markets are often national silos. Most markets wittingly or unwittingly limit access to international investors. Even where the local government policy makes it easier for international investors to participate, the paperwork involved and the administrative process to setup an international investor in a different countries broker account can get tedious. Some markets make it harder than others.

This effectively is a form of financial apartheid where only certain investors have access to certain investments.

We propose that we use blockchain to make it possible for any one in the world to invest in any listed security in the world. And we propose to use Blockchain to achieve that.

6. How to make a global decentralized securities market possible

In the explanation here we are going to gloss over some legal structuring issues. This is done with the intention of keeping the explanation simple as well as more focused on the technical implementation. Legal structuring often is specific to a certain jurisdiction and to go through every single permutation and combination of pairs of countries where the issuer is in one country and the investors is in another country is beyond the scope of this article.

We use the principle used in a Depository receipt. When a company that is listed on one exchange in Country A wants to trade on another exchange in another country B, what is done is an entity is setup in country B that buys a certain number of shares of the company. The shares of the company are held in deposit and units of this entity are then traded on the market in country B.

But we will also add decentralization to the mix and not require yet another exchange.

We will have to do the following steps

1. Lock out certain number of shares for the company
2. Represent those locked shares on the blockchain
3. Once they are on the blockchain they may be freely traded from one investor to another

6.1. Lock out the shares

The simplest way to lock out shares is to use the mechanism of pledging. Pledging is a form of security lenders take on a borrower’s listed shares and give him some money in return. Both parties fill up a form and notify the broker that certain shares held by the borrower are now pledged.

The broker holds these shares in escrow and does not allow them to be traded till the pledge is removed by the lender.

Typically there are no additional fees charged by the broker to record the fact that certain shares are now pledged. Nor do brokers care about who the lender is and what terms exist between the lender and the borrower. They simply act as a non partisan escrow service.

When there is a buy order for a particular share, someone who is in that particular market where the stock is listed will buy the shares or use his existing shares if he already owns them and pledge them with another party on the chain. This party will then tokenize the pledged shares and represent them on the blockchain in the form of security tokens (ST).

Once the shares are represented on the blockchain then these STs may be traded freely on-chain.

In the event that someone wants to liquidate their STs and they do not have a buyer on-chain then they will instruct the pledging party to unlock the underlying shares and liquidate them on the market on their behalf.

This means especially early on when it may be the case that there are only a certain number of buyers with no guaranteed buyer for anyone who is looking to sell, in such an event the seller takes advantage of the liquidity provided by the exchange through its widespread distribution.

We would have several master nodes that act as the counterparty for pledging. When an investor wants to sell and cant find a buyer on chain the above process would kick in reverse and the master node would liquidate the underlying pledged asset to release the funds to the party that held the security token.

Both the master node and the original buyer who facilitated the purchase receive recurring fees from transactions rather than a lump sum payment so as to keep them vested in the success of the network.

The more master nodes we have and the more local buyers we have the more decentralization we can achieve. The more decentralized the system the harder it is for local authorities to shut it down citing international transactions.

The incentive for the local buyer is the price premium security tokens are likely to attract as well as the passive income they can generate through transaction fees.

7. Conclusion

Once you have enough distribution then you can open up your platform for other alternative investments. The path would still be to focus on your internal offerings first so that you can control the outcomes and then open source/decentralize the whole thing once sufficient distribution is achieved.