What securities markets can learn from crypto markets
A regulated blockchain financial market is coming together from two sides. From one side come the unregulated blockchain tokens. Regulators want to bring their exchanges into a regulatory framework. This is a special concern of the SEC in the US. From the other side, traditional securities will be moving into a blockchain format in order to get access to global distribution, liquidity, and programmable features. That’s what Aboveboard is working on.
Both of these efforts will be more successful if regulators allow the securities market to learn some things from the unregulated token market.
Regulators are starting with an assumption that crypto markets will adapt to US securities regulation, once participants figure out they that need to comply. According to this story, issuers will reformat public offers into Reg CF or Reg A+ offerings. They will find their way onto SEC regulated exchanges that have better custody of assets and cash (this is a big problem now) and follow a stack of rules about how quotes can be distributed, matched, and settled and who can do it. The results of this experiment will show that investors appreciate the protections of US securities regulations.
The other possibility is that regulation in the US drives more and more activity outside of the US.
We are already seeing the results of this experiment. The unregulated crypto markets are running at much higher volume than the JOBS act markets, and are preferred by investors as well as by issuers. Why is this? Even with a heavy mixture of fraud and abuse and bubbles, the unregulated crypto markets are attracting better talent and delivering higher returns. The Ethereum ICO alone provides about a 4X return to all ICO investment, even if all of the other investments go to zero.
I think that we have learned some things.
- Markets are global. Markets with a global customer base will do well.
- Investing is a sport of active participation. The JOBS act imagines investors as passively looking at a prospectus and then buying and holding. That’s not what is happening. Investors are active supporters, customers, and also traders.
- Investors are willing to buy instruments with no security rights if they can get participation and liquidity.
- Utility tokens have a role in the cloud economy. The good utility tokens are designed to pay for API calls between computers. These computers are quite different from the human investors that buy securities and pass KYC/AML checks.
We can see the importance of global compatibility if we look at three US venues.
- The US private market rules are approximately similar to foreign rules for offerings to “sophisticated” investors, except for extra the lockup applied in the US. This private “exempt” market for accredited investors works. It does $2.4T/year in issuance, it is growing, and it crosses borders. That’s the market I am betting on in the US.
- The JOBS act market (Reg CF and Reg A+) allows investing and trading by the general public, but only under a bunch of rules and restrictions that are specific to the US. Three years after launch, this market is running at very low volume. It’s possible that it can be repositioned as a US-specific channel for global securities. It’s possible that those securities will have some utility and participation value. We’re going to try that.
- The US enforces a mass of rules about securities exchanges which were designed to fit the old-style DTC ledgers, stock exchanges, brokers, and settlement process. If we interpret these rules literally, then US investors will not be able to trade with foreign investors. There are currently no exchanges for blockchain tokens that satisfy US rules. The current generation of exchanges has significant problems with custody and transparency, and US-specific regulations might make fixing those problems even more difficult. It will be a sad and lonely exchange that traps securities with a US transfer agent under layers of rules that are only inflicted upon US persons. I believe that exchanges will need to be decentralized enough to accept securities that are held by outside traders and custodians. Securities will move around the world.
Securities exchanges will show whether US regulation can accommodate the new world of global securities. We’re trying to fix a basic problem with the first generation of crypto exchanges. They hold the cash and the assets for customers, and often lose one or the other. Securities exchanges have a much better custody architecture. All securities exchanges do is match trades. Then they send the matched trade out for settlement to someone else, a custodian that is selected by the investors to hold assets. Securities exchanges have a much worse settlement architecture. Through a complex series of messages, money and securities move between custody banks and/or brokers. Brokers who are members of the exchange have a responsibility to manage this process and guarantee delivery. In theory, a crypto exchange could have a much better settlement architecture involving an “atomic swap”. The principals to the trade could swap directly, if they have proven that they have the cash and the assets. Or, they could assign a custodian to handle the assets. The custodian could even sign an attestation guaranteeing delivery at the time a trader posts a bid or an offer. This would give us the best of the securities exchange trading architecture, combined with the best of the blockchain settlement/swap architecture. However, it’s not currently a legal approach under US law. Under US law, the process has to be managed by a US broker.
We will know that we have learned something will be if we can design a security token exchange that meets US rules, while allowing people from around the world to have their own remote custody.
The big opportunities exposed by crypto are in globalization, active participation by investors, and exchange innovation. It’s going to take some creative work to combine them with US security rights, and US security exchanges.