Crypto Market Commentary
15 May 2019
Doc's Daily Commentary
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Mind Of Mav
Security Tokens And The Future Of Capital Markets — A Post Consensus Recap
Tokenization was the hottest thing at Consensus this year. A vast majority of booths representing asset management dealt with STOs, tokens, securities, or had plans to expand in that direction.
So, let’s cover some of the emerging trends regarding the future of capital markets and how security tokens fit into that.
Future capital markets
Activities and roles will look different in the future capital markets.
Transition is happening, not just because of blockchain but also because of consumer behaviour and regulatory changes. We have observed a similar evolution in the past for eCommerce, retail banking and mobile internet services. Securities markets are opening up around the world. More capital flows across borders and investment opportunities are more readily available for a wider global audience. Interaction does not happen by visiting a bank desk, but mostly online, through browsers, forums, and apps.
Capital markets have resisted the change of going online longer than other industries. For the most part, these capital markets have been slower to evolve, as there are more checks and balances in place to reduce risk introduced by changes.
We can see how this transaction shifts roles in the markets and as new roles are created, the importance of some old roles declines.
The most notable change is that having a distributed ledger acts as the backbone of the clearing for settling transactions. This will change the nature of custody and central depository business, as open access and self custody makes direct peer-to-peer transactions possible while still maintaining ownership information real time.
Above is the summary chart of some of the changes we see happening. We discuss some of the major changes between current and future capital markets below.
How security tokens benefit the investor
Tokenising an investment opportunity does not make the investment itself more attractive as tokenization does not directly change the fundamentals of a prospective return on investment (ROI).
What changes, however, is how effectively the capital markets themselves will operate. This does not only mean improving cost but also time. For example, it is cost-effective to create exchanges where they could not exist before, e.g. small-cap minerals. Security tokens will also make it easier to invest and manage early stage equity investments across borders. These efficiencies will indirectly make investments more attractive.
Blurring the line between private and public securities
It is just a matter of time before all assets, both private and public securities, are tokenized.
Managing shareholder records on distributed ledgers have a low transactional cost and no barriers to entry. This is unlike the current custody infrastructure which has evolved to serve the public securities market. Distributed ledgers are so practical in the record keeping process that it makes sense to use them even for managing for small business cap tables.
When private securities can be transferred as easily as public securities, the line between what is private and what is public starts to blur.
Investment platforms and market-based opportunity evaluation
Traditionally the investment industry has been exceedingly relationship-centric. Family offices and boutique investment banks serve their high net-worth clients and venture funds look for founders in Silicon Valley.
Investment platforms will consolidate the capital raising business in a similar manner to what has happened in eCommerce. Customers will go to portals to see more opportunities (products) that they can compare side-by-side and investing in them is an effortless paper free transaction. The access to information and opportunities is democratized, meaning that retail investors across the globe get access to the same opportunities as the seasoned private equity investors
With the rise of the Internet, all commercial transactions are moving from long term, relationship-centric, to more short term, transactional centric. As there is no cost in opening an online account, it is easy to shop around for the products across different services and even nations.
From post-trade services to a blockchain settlement
Cryptocurrency exchanges have demonstrated global real-time 24/7 markets. The ability to have open and free access to the same distributed ledger has made this possible. In the case of cryptocurrency exchange, the ledger can be Bitcoin blockchain, Ethereum, Ripple or similar.
Some of these exchanges are centralized or operate in a closed-loop system with only withdrawals and deposits exposed to the world. Some of the exchanges are decentralized, or “DEXes”, where trades themselves are settled publicly on a blockchain.
Cryptocurrency exchanges still need custody functions or services for cryptographic key management, but they do not need it for storing of assets or outside settlements. It is impossible to “cheat” a blockchain, so exchanges can rely on transactions coming in and out.
As seen from the diagram above, the securities industry has a lot of organizational complexity around clearance and settlement. All this can be done more streamlined with a distributed ledger. This will change not only the cost of operating markets, but the structure of the markets: Trading 24/7 is different, but globally more fair, than trading during London business hours.
Currently, securities exchanges operate on a two-tier principle: retail investors cannot directly trade on an exchange themselves, but they need to go through a broker who has bought a membership to the exchange. Then, the broker will trade on the exchange on behalf of their client. Cryptocurrency exchanges are the opposite and everybody has direct access to the order book as well as the ability to trade instantly.
Legacy exchanges did not want to deal with retail investors directly as the scalable online systems handling the management of a large number of investors had not yet been invented. Also, on legacy exchanges, members often traded on credit and there was a need to ensure the creditworthiness of members. Limiting dealing with members only is also a way to exercise power, protect the business interests and maintain the status quo.
In cryptocurrency exchanges, the investors deposits tokenised hard money and hard assets on the exchange. There is no settlement or counterparty risk, as described above, and thus it is easy to allow anyone to participate directly.
Scalable shareholder management
In private equity, professional investors may prefer a “clean cap table”: only having a few big names in the shareholder registry. Retail investors, employee-owners and other small ticket investors are lumped together behind a proxy entity. This kind of structure is often called a special purpose vehicle (SPV) or nominee structure. The proxy structure prevents small ticket investors exercising their investor rights directly, but also makes the company management more lightweight.
The nominee structures are historically preferred because there are no efficient ways of managing a large number of small shareholders. Corporate governance actions such as inviting shareholders to the meetings and paying dividends happened through unscalable methods like paper mail. Financial market regulators, however, dislike proxy structures as they add middlemen and put a certain class of investors at a disadvantage.
When ownership is tokenized and shareholder accounts are on a blockchain, corporate governance actions scale well regardless if there is one shareholder or a thousand shareholders. Paying dividends or handing out voting ballots to a large number of people can be done in a single distributed ledger transaction. Thus, there is less need for proxy structures.
So as you can see, there’s a lot that is emerging and a lot that still needs to be built.
But, it’s clear to me the future is tokenized, and tokenization is the future.
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An Update Regarding Our Portfolio
We are pleased to share with you our Community Portfolio V3!
Add your own voice to our portfolio by clicking here.
We intend on this portfolio being balanced between the Three Pillars of the Token Economy & Interchain:
Crypto, STOs, and DeFi projects
We will also make a concerted effort to draw from community involvement and make this portfolio community driven.
Here’s our past portfolios for reference:
RSC Managed Portfolio (V2)
RSC Unmanaged Altcoin Portfolio (V2)
RSC Managed Portfolio (V1)