Blockchain technology, markets and the retail investor
This blog explores how centralized entities can use blockchain technology to deliver improved outcomes to retail investors (prior blogs covered consumer financial services and payments).
Blockchain based capital markets products are delivered in three configurations today:
This analysis is premised on serving retail investors via Configuration C, and evaluates impact on the four milestones of the investment process, assuming no regulatory arbitrage:
Investment decision
The adoption of blockchain technologies will expand the investible asset class for retail investors. Traditionally, retail investors were restricted to Quadrant 1 (see below):
Over time, the share of the markets inaccessible to retail investors increased (Quadrants 3 and 4) because of regulatory burdens associated with public markets. This, in turn, triggered retail investor friendly innovations.
In traditional securities, such innovations improved access by either targeting the what (e.g., alternative investing platforms) or the how (e.g., commission fees trading).
In the crypto world, the primary innovation was the expansion of Quadrant 2. Most crypto tokens were designated as utility tokens and hence, bypassed securities’ regulations. While that wild west era is over, blockchain technology can expand the investible asset class for retail investors via two mechanisms:
New forms of tradeable assets
Blockchain technology converts the intrinsic economic value of an object to a tradeable asset by applying four levers to it:
i. Tokenization, which refers to the digital representation of value, is neither new to the blockchain nor by itself transformative.
ii. However, when combined with a private key based Digital Custody system, tokenization allows the holder to digitally prove token ownership to a potential buyer, making it easily tradeable.
iii. The technology allows a high degree of Atomization, both in terms of the what (e.g., a specific building on a specified street corner) and how much (e.g., one hundredth of an apartment).
iv. Finally, Programmability of the token means that the representation of value (e.g., tokenized equity of a private company) can be digitally integrated with its privileges (e.g., dividends) and restrictions (e.g., only sold to accredited investors).
The above levers work, whether the underlying source of intrinsic value exists in atoms (e.g., real estate) or bits (e.g., a virtual gift card).
The chart below depicts how these levers create an illustrative non-fungible token (NFT), a new asset class innovated by the crypto ecosystem:
Another example of a new asset form is Ethereum staking, which converts computer processing power into an income earning asset! Stakers donate their computer’s processing power to run validation software on the Ethereum network in return for Ether tokens. Staking is conceptually similar to mortgage-backed securities, with the revenue stream derived from payments made by the Ethereum network, instead of mortgage repayments. The underlying innovation is the ability to programmatically calculate and distribute financial rewards to a large pool of investors.
Increased participation from retail investors
Apart from enabling new asset forms, blockchain technology can increase participation from retail investors, even for legacy assets:
On the supply side, issuers can better target retail investors without running afoul of securities’ regulations. For instance, when offering securities in private markets, issuers can programmatically ensure that trading is restricted to accredited investors.
On the demand side, retail investors can manage their risks better because of three reasons:
A. They can choose assets in a fine-grained manner. For instance, an investor may invest in tokenized shares of office buildings in cities where remote work is not popular.
B. Investors can invest in very small amounts, though admittedly, even traditional securities are fractionalized today.
C. In the current securities marketplace, the data associated with a security is not easily accessible to retail investors. But in the blockchain ecosystem, a token can be programmatically integrated with its associated data (see below) and facilitate custom indexing by investors:
Investment decision: concluding thoughts
An open question is whether crypto assets are securities. An instructive comparison is between the fractional shares of paintings, issued by Masterworks and non-fungible tokens. While fractional shares of the same painting resemble securities, it is hard to argue the same for an NFT, which maps to a distinct work of art.
If the Walt Disney Company allowed the Magic Key Pass to become a tradeable instrument, the latter would be classified as utility tokens in crypto-speak instead of securities. It is unlikely that regulators will let this fly. In the short-term, regulators are like Humpty Dumpty, who famously said “when I use a word, it means just what I choose it to mean”. However, eventually, which crypto assets are securities will be adjudicated by the courts.
Trade Execution
At the point of hitting buy/sell on their brokerage app, retail investors seek the best price at a low transaction cost. For traditional securities, this occurs via the below workflow:
Brokers have a regulatory obligation to obtain best execution for their clients. In recent years, there is controversy on whether payments for order flow violates that obligation. However, retail investors don’t mind as the practice funds commission free trading.
The workflow for blockchain issued assets would not be radically different from above. Historically, one major difference has been that crypto exchanges like Coinbase are effectively broker-dealers and exchanges rolled into one. Over time, as the industry matures, these roles are likely to be decoupled.
Decentralized exchanges
It is worthwhile to do a sidebar on the innovation of decentralized crypto exchanges, the biggest of which is Uniswap. The latter deploys a peer-to-peer model, as visualized below:
i. Liquidity providers (LPs) are asset owners who deposit their assets with the exchange, making them available for sale. They are also willing to buy more of the assets they deposit. Hence, they are equivalent to market makers in centralized exchanges.
ii. Traders buy assets from the pool and are thus equivalent to investors in centralized exchanges.
The way prices are determined in Uniswap is different when compared with centralized exchanges:
Centralized exchanges (like NASDAQ and Coinbase) use a simple order book system. Buyers and sellers submit their orders and the exchange matches them based on their order quantities and price expectations. To ensure there is always a counterparty, centralized exchanges deploy market makers who continuously quote bid and ask prices. The market makers capture the bid-ask spread as compensation for the risk they assume.
In Uniswap, there is no human entity quoting prices. Rather, once the LPs deposit their assets to the exchange, price is determined by a mathematical formula called the Automated Market Maker function, which simulates a downward sloping price-quantity demand curve. The market makers thus cede control of pricing to an algorithm! They are compensated for the risk they are assuming via trading fees paid by investors who trade on the exchange.
The above sounds complicated and it is! Hence, most retail investors use centralized exchanges like Coinbase.
Trade execution: concluding thoughts
A blockchain enabled securities system is likely to follow the template of legacy centralized exchanges for trade execution. The benefit of decentralized exchanges for retail investors is as yet unclear but practitioners should follow this space closely as it evolves.
Trade Settlement
Trade settlement for retail investors, is usually a simple matter of two flows:
Compared to real estate transactions where settlement can take weeks, most equities settle within two days of the trade. However, two major operational risks exist in that time lag:
i. The first risk exists anywhere delivery and payment are asynchronous, for example, in e-commerce. The risk is that one side delivers the security but the other side does not pay (or vice versa).
ii. In real estate, it will be illegal for a seller to enter into a deal without owning the property. However, the buyer, often, hasn’t arranged financing on the offer date. Hence, only the payment side can fail on settlement. In securities, on the other hand, either delivery or payment side can fail because of market practices (short selling, margin trading etc.).
The underlying reason for the above risks is that securities transfer via the custodian system while cash moves through the banking system. Except where the central bank manages both (e.g., government bonds), the two systems are not integrated:
In the current system, such operational risks are managed via intermediaries and regulations, freeing investors to focus exclusively on market risk. Much of this is invisible, except in rare circumstances, like when Robinhood was forced to halt trading of meme stocks because these operational risks became unmanageable.
In a crypto enabled trading system, both securities and money (a stablecoin) are on the same blockchain network. A smart contract (fancy term for software code on the blockchain) can enforce simultaneous delivery and payment:
Of course, not everyone wants T+ instant settlement. Practices like short-selling, securities lending, netting and margin trading evolved on a paradigm of latency between trade and settlement. Fortunately, the flexibility of smart contracts means that all such practices can be coded.
Trade settlement: concluding thoughts
The adoption of stablecoin based settlements will reduce trading friction for retail investors. Further, the use of smart contracts can embolden providers to offer more complex trading strategies to retail investors, by programmatically mitigating risks.
However, the bigger impact will be that the reduction of operational risks will reduce entry barriers (regulatory and capital burdens) for startups and unleash innovations that benefit retail investors.
Position management
The attributes of blockchain technology with significant potential impact on position management are:
Self-custody
For traditional securities, we trust that our broker will not fraudulently transfer the ownership of our assets to another party. Crypto assets, on the other hand, were designed for self-custody. The person who knows the private key of a blockchain address controls all assets owned by that address. You cannot easily transfer your Apple shares to a friend but transferring crypto assets is as easy as a Zelle payment.
Since management of private keys is difficult, most retail investors delegate custody of crypto assets to centralized entities like Coinbase. In reality, a range of custody models are feasible:
Direct holding
Most countries follow an indirect holding method of recording securities ownership:
In practical terms, this means that our brokerage firm is listed as the owner in the official book of records. Crypto assets can be directly held without any efficiency loss.
Why does it matter
Most retail investors who use centralized crypto exchanges are not using self-custody or direct holding, even though they have the capability to do so. Regardless, these capabilities themselves can impact three areas:
Security
The FTX debacle of 2022 illustrates what happens if the custodian of the private key is a nefarious entity. However, in a centralized ecosystem (premise of this blog), most retail investors would continue to rely on regulators to do their job.
Transactional efficiency
A second set of benefits relate to transactional efficiency. For instance, dividends can pass directly from the issuer to securities holder, even when the securities are held within a fund. Another example of a transactional benefit would be the ability of shareholders to vote on issues instead fund managers voting on their behalf.
Product innovation
The most compelling benefits, however, will arise via product innovation. One example of this is the ability of crypto asset holders to lend their assets. While this practice of yield farming has gained notoriety, in reality, it is only a flamboyant counterpart of securities lending, whereby buy to hold investors like pension funds enhance their returns.
Yield farming, though, is only a low hanging fruit innovation. The possibilities are endless. For instance, issuers may combine features of securities with utility tokens (e.g., Disney shares that allow park privileges) to encourage retail participation.
Position management: concluding thoughts
The reason crypto asset holders do not exercise direct holding over their assets via self-custody is that management of private keys is onerous. Over time, two things need to happen:
i. On the supply side, UX level solutions need to evolve that strike a balance between security and customer experience.
ii. On the demand side, product innovations must make the benefit greater than the inconvenience for retail investors.
Summing up
When the Bitcoin white paper was published in 2008, no one predicted the use of NFTs for intellectual property commercialization. Similarly, the crypto ecosystem will yield innovations in capital markets that we cannot visualize today. However, we can identify some of the technology attributes that will lie underneath those innovations:
The innovations that will gain traction are those which use the above lego blocks to offer value propositions beyond speed and cost. These include
a. new forms of tradeable assets
b. greater alignment of portfolios with investors’ risk preferences
c. increased investor empowerment around both investment selection and corporate governance
d. integration between an individual’s role as a shareholder and as a consumer of the same company
