Why Blockchain does not have an obvious use case in securities
Lets start with the biggest elephant in the room. The key innovation in Bitcoin, which set off the Blockchain revolution is the ability for parties that do not know each other to trust each other and collaborate. You can be anonymous and do not need a trusted central 3rd party and you could still be able to transact with other anonymous parties in an immutable fashion.
Securities almost all over the world require KYC as a legal requirement. The entire securities regulatory framework is based on centralized regulators who police and enforce the law of the land.
Transactions happen between known actors who trust each other (or atleast the law) and operate within set frameworks. Existence of trust is a precondition for securities, which means that there is precious little for Blockchain to do that meets the eye.
In addition Blockchain is slower, less user friendly and costlier to operate than a centralized system typically used by exchanges. Which means existing listed securities exchanges have little to gain by moving to Blockchain. Arguments have been made about how settlements can be made faster from T2 or T3 to T0. However those gains can be made without blockchain in a much cheaper manner and do not necessarily require a Blockchain implementation. The inefficiencies in current exchanges have more to do with arcane regulatory requirements than technology itself. The technology to achieve T0 has been with us for decades.
Problems faced in Estate Baron
Konkrete as many of you know is an evolution of our existing real estate crowdfunding platform called EstateBaron.com. We help property developers raise equity funding for their development projects by doing unlisted IPOs. We structure each offer as a full retail offering giving developers access to a new investor pool and small investors access to opportunities that they never had before.
Conflict between curated controlled market place vs open for all
However there is an inherent conflict in all market places. Do you let it be a free for all or have some amount of curation and control built into it? One of the big challenges which we faced was that the issuers after raising money decided to forget about providing investors regular updates on the progress of their investments.
In other cases the updates were not factual, the intention was not to scam the investors (atleast so far) but to hide negative developments and save face.
On the ASX this is something that would be policed actively. Non compliance of disclosure obligations would lead to a trading halt or even suspension from the exchange. However in our case we did not have a secondary market, money was raised and given one shot to the developer. There was limited leverage which we could exercise on the issuers.
And given that we were an early stage company our resources to police were also limited.
While an argument can be made in favour of laissez-faire, in practice if you do not regulate it leads to a stunted market place as participants do not end up trusting that they would get the results they expect.
The solution: Smart securities and Decentralized governance
Governance can imbue the platform with trust. And this governance can be achieved in a decentralized manner through the use of blockchain. You can use the community to police and regulate (especially if you do not have the resources yourself). This in turn makes the platform more scalable and productive to all parties involved.
The first step to achieve decentralized governance is to develop smart securities. Smart securities are securities operating using smart contracts. The funds are deployed and actions taken based on the terms of the offer which is encoded into the smart contract. It eliminates the need to trust the issuer that they are doing what they said they will do and also ensures that investors get real time insight into money spend as well as automatic updates on actions taken.
At its very core, every business can be thought of as a simple machine.
Input -> Process -> Output
The process highlighted above involves some sort of value creation, so that the expected value of the output is greater than the input + cost of the process.
Input can be raw material that includes physical goods or resources, physical effort, intellectual property and capital.
Capital itself can take the form of debt or equity.
The output is cashed out on the market to generate revenues, which then get distributed in the following order.
- Repayment of creditors (debt)
- Payment of any outstanding expenses that were not already covered as part of the process costs
- Reinvestment to improve process
- Profit distribution to equity holders
Note that each business may either have all or only some of the above.
Let’s assume that for now the smart security contract involves only the capital side as input and other resources such as physical effort and IP are brought in by the business principal. We will not concern ourselves with physical labour barter or similar activities and keep the smart security contracts simple for now.
A smart security contract will comprise of 2 main parts.
Capital Input: Where capital in the form of debt and equity is collected and distributed to the process based on the requirement of capital at that point in time and milestones achieved.
Milestones and other triggers for funds release can be achieved in a decentralized manner using 3rd party claims via the ERC 725/735 mechanism.
Revenue input: Where the revenue proceeds are collected and distributed to the capital providers based on the terms of the offer.
Note that in the above process, except for the value creation step, all processes are on-chain. Measurement of off-chain progress is handled using ERC 725/735 claims. Where possible the objective of the smart security contracts should be to bring all processes on chain so that they can be measured without loss of data between the on-chain and off-chain worlds.
The whole process becomes more plausible especially if you have a fiat pegged stable coin that is used as currency. If you have to interface with bank accounts it becomes extremely hard to achieve the efficiencies that can be achieved using smart contracts and ERC20 stable coins.
Also note that programmable securities are only possible in predictable and highly structured business models. For instance it would work great for an index fund, and even debt to property developments where the processes are well understood and predictable. It does not however lend itself automatically to early stage high ventures where the business model and product market fit is yet to be achieved. It is not completely impossible to apply the concepts of smart securities and decentralized governance in such cases but it does require additional thought, and our own offer at Konkrete falls under this category.
An investor owned and controlled securities platform
We envision the following life-cycle for the investment process
- Deal Sourcing
We intend to use decentralization for each step, so it becomes
- Crowd sourcing
- Crowd diligence
- Crowd funding
- Governance using smart securities
- Returns paid back via smart contracts in the form of stable coins in a programmatic manner
We are conducting our own IPO and selling shares in the foundation public company which will own and operate the platform. Investors who end up using the platform thus have the opportunity to participate in the ownership of the Konkrete platform itself. Our shares will be represented in the form of security tokens and we will progressively decentralize all our operations to move towards a fully decentralized organization in the long run.
As part of our efforts to decentralize, we will allow any shareholder to submit a project for consideration. All shareholders would then vote on whether or not the project can be listed on the platform. These votes can be conducted in a fast and efficient way on the blockchain.
The next step is raising the funds, any capital raising fee (or a part of it) would automatically be paid to all the shareholders once the fundraising is complete via smart contracts. This (and a few other things we are working on to incentivize promoters) will help fundraising happen faster which is the raison-d’etre of the platform from the issuers perspective.
The next step is to structure the offerings in the form of smart securities as described earlier and provide investors real time insight into the progress of the venture. And finally any payouts to investors happen automatically via the smart contracts. For eg: In our own case as described above investors get paid the portion of the revenue as soon as it is received.
Using Blockchain it would be hard and eventually impossible to fudge on the revenues and expenses. The public visibility of all transactions makes continuous disclosures automatic and also reduces audit costs. This will also ensure that investors get their dues as promised in an automated and immutable manner.
Decentralization too early in a platform that has so many moving parts and complexity from a regulatory stand point will mean that the platform never takes off. It will require a critical mass of a community to develop before DAOs organically emerge from it and leverage the solutions we are building. In the short to medium run we as founders will have to act as benign dictators who act on behalf of shareholders to shepherd the platform towards the eventual goal of complete decentralization.