The Capital Markets Inefficiencies and How Security Tokens and Blockchain Could Transform Them

Author: Ben York

The topic of Security Tokens is increasingly prevalent in the cryptocurrency space. With the decline in popularity of Initial Coin Offerings (ICOs) and the massive drop in the price of Bitcoin, the cryptocurrency and blockchain space needs a new topic of conversation. Enter Security Tokens, hailed by some as the future of capital markets and vilified by others as a new wave of ICOs and pyramid schemes. It can be difficult with all of this back and forth to discern whether security tokens are indeed the real thing.

Although it is digitized now, the current capital market ecosystem was built around a paper-based system. The main issue is in the process of buying and selling assets, all parties (including intermediaries) need to know who owns what. This is done through a chain of brokers, exchanges, central security depositories, clearing houses, and custodian banks, which is where we begin to see the inefficiencies within the system as all parties need to keep their own ledger for each side of every transaction. This duplication results in high costs and slow transaction times for market participants.

The main issue at hand is keeping track of ownership, which can be made simple through the implementation of blockchain technology. However, there are numerous other benefits to blockchain technology that could transform the way capital markets operate. Blockchain’s main benefits include:

• Encryption — transactions would retain security and anonymity of highly sensitive data within a shared environment
• Mutual consensus verification — allowing a network to agree to updates in the database with certainty that the dataset remains correct without needing the oversight of a central governing authority
• Smart contracts — programs and code can be uploaded into the actual securities to generate instructions downstream
• Distributed records — all records are stored locally by participants as the golden source of information

In this article, we look to give an overview on the current capital markets landscape, what inefficiencies lie within this system, and how Security Tokens and blockchain technology as a whole could transform investing as we know it. We’ll follow the flow of securities transactions starting with their introduction to capital markets through trading and ultimately custody.

Initial Offering

When companies want to issue an Initial Public Offering (IPO), they first need to find an investment bank to underwrite their offering. This process in itself could take weeks, months, or years depending on how attractive the offering is to the underwriting bank. Once the company finds a bank to work with, they then spend weeks on a roadshow to showcase their offering to investors in the hopes that the investors will want an allocation in their offering. (I’ll take a pause here to note that there are numerous inefficiencies within this system where “hot” companies will have oversubscribed offerings, investors get cut back, and both sides are upset. On the contrary, companies that can’t drum up enough support for their offering are already off to a poor start in their capital markets foray.)

After all the investors have their allocation, the security opens for trading on exchanges. Let’s say the offering goes exactly as planned and there is a perfectly matched allocation for the offering. When the equity actually begins trading it’s entirely possible that the stock pops, which to an outside observer seems like a positive but actually means the bankers did a poor job in underwriting the company and potentially left millions of dollars on the table.

With the use of Security Tokens, a number of these inefficiencies disappear, but the overall system remains the same. The ideal way a Security Token improves the IPO process would be through new offerings issued in the form of a compliant digital token. The Security Tokens would allow for transparency and verification of holdings, which in turn would reduce credit risk associated with certain investments, simplify the Know Your Customer (KYC) process, and decrease the number of middlemen involved. New financial derivatives could even be created as the securities being issued could be unbundled so that the cash flows of the company and the rights could be transferred separately each with their own intrinsic value.

Secondary Trading

In secondary trading, the same questions around ownership still remain. Secondary market participants include brokers, exchanges, central security depositories, clearing houses, and custodian banks. All of these individual parties need to keep track of who owns what on individual ledgers, which is what makes transferring ownership slow and costly. Transactions take between 1–3 days to settle (unless it’s a cash settlement) because the records of all parties need to be updated and reconciled at the end of the day. Most of this verification is done manually, which adds to the settlement time and greatly increases the chance of errors.

Security Tokens and the implementation of blockchain into secondary markets would give transparent real-time information, which could reconcile disputes between counterparties and allow selective revealing of trusted data to counterparties ahead of trades, improving overall transparency in secondary market trading. Additionally, Security Tokens would decrease the amount of duplication, and therefore the risk and costs associated with it, since each party can view the ledger and no longer needs to keep their own individual records.

As discussed briefly earlier in this article, derivative transactions are particularly interesting with the implementation of Security Tokens. New unbundled securities could create bespoke financial instruments consisting of individual cash flows that exactly match the needs of the client in terms of risk and timing. Derivatives could be programmed as smart contracts to capture specific margin agreements and swap conditions, greatly reducing the operation burden on brokers and clients.

Settlements and Clearing

Typically management of the actual assets being held and traded is outsourced to custodian banks. Balances at these custodian banks have to be reconciled across a complex global financial network, each with their own ledger. Transactions take days to settle because of all the back and forth confirming trades and reconciling everyone’s ledgers.

Security Tokens and blockchain technology have the potential to cut out middlemen in these transactions altogether. Trades executed with blockchain technology embedded within the assets removes the need for post-trade confirmation with central clearing due to the increased transparency. There would be no need for a central clearing authority and transactions would take place near real-time. Additionally, smart contracts could pay out dividends and conduct stock buybacks through a code, reducing the operational burden associated with holding securities.

Conclusion

One of the main concerns with shifting from traditional capital markets to a Security Tokens market is that some traditional roles within these ecosystems will no longer be needed. We saw this take place with the shift towards electronic trading and it is a valid concern. However, with the shift to Security Tokens, all market participants will still have a role to play albeit a slightly different than their current function.

• Dealers will still have a viable role in sourcing liquidity and taking principal risk
• Trading venues will still remain as they are today since facilitating price discovery and matching counterparties are still necessary functions (their value actually increases with cryptographic signature data. When a transaction is executed, they are required for settlement)
• Custodian’s role will change as distributed asset ledgers with flat accounting remove a fair portion of their current function, but managing holding information and ensuring all transactions function correctly will still be necessary

It is worth noting that it is possible to achieve some of the benefits of blockchain technology without actually implementing it, but blockchain makes these benefits easier to achieve.

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8 DECIMAL CAPITAL is a multi-strategy investment firm focusing on token and equity investments. 8 Decimal currently has more than 40 portfolio companies with an AUM of 60M USD. The investment team consists of more than 10 venture capital veterans, researchers, and trading professionals. The advisory board comprises Fan Zhang (Former Founding Partner of Sequoia Capital China), Karen Chen (Former CEO of UBS China) and Ben Bartlett (Vice Mayor of Berkeley). Based on the professional fund index ranking agency Token Metrics, 8 Decimal was ranked second out of the 51 active crypto funds. 8 Decimal is also well-received in China, named one of the top 10 funds in the blockchain industry by both 36氪（36Kr.com）, Chain Capture , and Odaily, as well as named one of the top 20 funds by Tsinghua X-Lab and Youth Education Chain League.