Crypto, blockchain, and the vision of a new capital market — Bitvo

The value of technology is not just the product or service. Its greatest value is how it changes and shapes the way you see and interact with the world around you.

The iPod was converted into a computer that makes phone calls becoming an iPhone.

A sharing economy platform converted various unused physical assets into revenue streams.

A school directory became a digital social media platform and evolved into an advertising behemoth.

Electricity, computational power, and a modern cipher were assembled into a decentralized payment system with its own digital monetary asset.

But these innovations have a challenge. They all begin by competing with an established order. And changing entrenched views of something that seems to work pretty well takes time, imagination, and execution.

Often, innovation is focused on the beachhead philosophy. Start in one place, establish yourself, and then expand. This approach works well according to Geoffrey Moore’s book Crossing the Chasm, which we’ve explored previously.

But this can also represent a problem when the vision is big.

Crypto has often myopically focused on the money part. This is understandable. But in being heavily invested in this narrative, the reality of money and the potential for a much bigger vision is missed.

Everything comes in baby steps instead of massive leaps. There’s tracking stuff, derivatives, NFTs, and stablecoins with numerous winner take all approaches.

But if we wanted to take a massive leap, what would that look like?

Maybe we could use crypto to reimagine capital markets.

The capital markets are a big area with lots of moving parts. They are an interplay between innovation, economic growth, money, regulations, and human beings.

But first, let’s start our leap with a story about the brain.

Your divided brain and crypto

Your brain has two sides. Each side plays a distinct role in your interpretation of the world. The left and right sides are not political entities but rather complex decoders of signals you interpret from the world around you.

In the book The Master and His Emissary: The Divided Brain and the Making of the Western World, Iain McGilchrist goes on an expansive journey explaining what this means. And the gist is that the left side is focused on the re-presentation of individual elements, abstraction, separating things, and reassembling them. The left side is the dominion of language, the inanimate or nonliving.

The left side of the brain is the world of the abstract. Taking things apart into components and reassembling them, and creating things that do not currently exist.

The right side, by contrast, is the place of the whole picture, the betweenness. It is where art, music, and the living are interpreted and experienced. This is the world of metaphor, nuance, and context.

McGilchrist explores how these two sides work together and how information moves between them. He also describes what happens when the interpretation is dominated by the left brain versus when it operates in a more integrated fashion.

After an exhaustive explanation of the evidence showing how the brain works and how each side operates and why, he dives into history. In part two he demonstrates the evidence of the brain moving back and forth from integrated to left-side dominated through the evolution of music, art, and philosophy across history.

And part of the historical context of this brain duality is money.

Money is a left-brain creation

Money, as we have argued, is a derivative. It is an abstraction representing something on the basis of necessity, culture, and tradition. Money is a creation of the left side of the brain.

But money doesn’t exist in isolation. It is something that fosters interactions between people — a source of information about what different people value and how they interact.

So, it is no surprise that crypto and blockchain operate in a sort of duality. The emphasis in many ways is the token, the money, and this narrative often takes predominance over the innovative decentralized payment system that the coin or token represents.

The narrative is focused on the abstraction. Money reimagined. The dominion of the left side of the brain.

But money doesn’t exist in a vacuum.

Finance is like a living organism, where money is an element of a vast array of people, products, and services. It’s a system involving the interplay between technology, government, human interaction, and a range of expressions of value.

All of which operate in a mostly functional whole.

It isn’t living except in the sense that human beings are interacting with each other through infrastructure and various re-presentations combined into a whole.

As a result, the inanimate capital markets take on the characteristics of a living system.

Bringing the elements of crypto together

Now, I mention this left and right brain paradox because, as McGilchrist notes, when the brain is fully integrated, this is where wondrous things occur. What he means by this is when information is processed by the left and passed back to the right side through the corpus callosum, you get periods like early Greece, The Renaissance, and the Romantic period.

In the current period, we have a mushrooming number of crypto, token, and blockchain experimental abstractions taking place. This is exactly what you want as something is being explored, tested, and built.

But eventually, innovative pieces have to be assembled into something wider that society can use as a cohesive whole.

Now, in the financial arena, there are a variety of niche attempts to explore crypto/blockchain technology. Banks like JP Morgan have explored the development of a bank coin, a throwback to the free banking era of the US in the 19th century.

Others have tried cross-border trades in bonds and payments. Central banks are focused on CBDCs. There are various companies attempting to create security tokens similar to stock shares and markets to trade these.

Crypto itself has a variety of products and services that borrow heavily from traditional finance. Futures, options, exchanges, and trading platforms are some.

DeFi has a nascent lending market, synthetic assets, automated trading, staking, and stablecoins.

What if we take all these left-brain components and send them over to the right side of the brain to imagine them as a cohesive whole?

Defining capital markets

The first step might be to define what the capital markets are.

The capital markets represent access to public financing through equity and debt and access to capital through other instruments.The equity (stock) and or debt (bonds) represent the capital structure of the company. There are a variety of other financial products and instruments that cover a wide range of assets, including futures, options, ETFs, and various kinds of funds.

Capital markets are often described as primary, or the realm of new issues like IPOs, where secondary markets are represented by various exchanges and liquidity pools.

Money raised from the capital markets, sometimes called public money, is typically considered the most expensive kind of capital. This is because the requirements to access this money includes extensive regulatory requirements and documentation.

The capital markets system involves an interplay between exchanges, brokerage firms, lawyers, regulators, institutions, and OPM (other people’s money). Regulation and registered individuals act as gatekeepers in an effort to maintain confidence in the system.

Capital Markets are, in essence, a vetting, legitimizing, and amplifying system for capital formation and movement. These elements combine to create confidence in the marketplace.

As we’ve seen in the 2023 banking debacle, (and in crypto’s 2022 financial gymnastics) confidence is a significant element in the pricing and performance of equity and debt. The entire capital markets system exists on the basis of this confidence.

All of these things work together to create a place for capital formation, growth, and distribution.

Crypto has borrowed individual concepts extensively from the financial system and combined it with cutting-edge technology. This development took place in a regulatory gray area. The result has been some amazing innovations and ideas and many beneficial developments that might otherwise not exist in a more restrictive environment.

And predictably, some blowups, scams, and problems have occurred. Which, if one explores the historical context, is an unfortunate but normal part of the innovation development process.

The current system works pretty good, but…

Well, let’s address one likely objection here. Some will say that the system works pretty well as it is. It’s not perfect, but something that has been in development and refinement for a long time.

Our current system, the LLC, the first stock, derivatives on stock, are 400 years in the making. Money, banking, trading, annuities, government debt, and futures markets have been around even longer than that.

These are valid points.

But we could look at this another way.

Was there a demand for the telegraph before it was shown to Congress in 1838?

Or an all-electronic exchange in 1971 when the NASDAQ was founded?

What about the creation of ATSs (Alternative Trading Systems) when the SOES (Small Order Execution System) became ARCA?

Or the move from the centralized exchange model to hub and spoke to the all electronic liquidity pool model we have today?

What about the creation of the all-electronic ICE (Intercontinental Exchange) futures exchange?

ETFs?

Or algorithmic trading? Or any other elements that have been created and integrated into the financial system.

The beauty of finance is both a willingness and a need to innovate and improve.

And the last 100-plus years have seen a massive increase in innovations across the financial space. Just think, currency trading as we know it only really began in 1971.

One of the reasons this sort of discussion is lagging is that few in crypto want to deal with the regulatory struggles and implications of a security token.

And yet, this might end up being the most lucrative area for exploration.

There is also another objection. This would be that crypto is a separate system designed to give people the option to exit the current system. The idea of crypto becoming THE system for some is a non-starter. This, too, is a valid point.

But what if a cohesive crypto and blockchain system can help with the problems in the current system?

The difference between a stock and a company

One thing you learn when you trade equities is that there is a difference between a stock and the company it represents. That isn’t to say they aren’t related or that one doesn’t impact the other.

They do.

But a stock is merely a representation of a portion of a company or, more in some cases a portion of the residual cash flows of a company. The company exists in capital markets through its capital structure. The representation of that structure in secondary markets will typically be more fluid and dynamic than the business itself.

This is why speculative companies can have great trading stocks whether they have a currently viable business or not. The idea is that they have potential, and that potential translates into a valuation.

Then, there are great companies that have lousy trading stocks. Liquidity is part of this story.

If we look at the capital markets, we can, therefore, think about it in a layered format. The company is built on top of a capital structure that interacts with it through a series of financial intermediaries. These are a network of financial institutions, regulatory and SROs (Self-regulating organizations) like exchanges, brokerage firms, and institutions.

Now, what if we took a company’s capital structure and used a unique blockchain to create, manage, and run it?

Security token chains

The blockchain could be forked from an established chain template approved by regulators.

The chain would likely have to be Proof-of-Stake for throughput volume and efficiency. PoS characteristics could be an additional incentive for holding and using approved or valid security tokens for staking.

The chain might have single, dual, or multi-token capability. This would help with multiple classes of shares, like voting and non-voting, preferred or common equity, or different countries and regions.

The chain could have a limited DeFi capability to add issuance of debt, derivatives, or options. You might also have the ability to support other new innovative securities created by innovators working with the technology.

By using a blockchain architecture the clearing element would be taken care of by the chain, secured by validators, and the chain assembled by miners. This would mean clearing could go to T+0 on-chain for plain vanilla trades. For more complex settlements, these could be managed by outside firms acting on behalf of the investor or trader.

The chains could be public and easy for regulatory and forensic work for compliance and investigation.

The registered professionals in the current system are considered gatekeepers. In the crypto scenario, the gatekeepers are still professionals, but you also have other tools to accommodate various regulations.

Turning the digital wallet into a gateway

One problem in equities markets is keeping track of things like ownership or concentration restrictions. Another area of concern would be insider trading. Or those who are banned from trading securities for various infractions.

A good place to control this would be at the digital wallet level. Here, regulators could have approved wallets. And since we’re talking about programmable assets, you could restrict access to that security or asset based on a variety of factors according to regulatory requirements.

For example, a company doing business in a sanctioned country might mean that the citizens of some countries can’t own or hold shares. Or some companies can only have a certain level of foreign ownership. The wallet could restrict that.

Company insiders might have a unique wallet classification allowing for the identification of their trades through a public address. There are whole services now that track insider trades through public filings and other big changes in public addresses for various coins. With T+0 (trade date plus zero days), everyone would know in real time when insiders are buying or selling, which might eliminate insider trading.

The wallet could have automatic alerts for concentration thresholds for institutions when ownership reaches 5%, 10% or other predetermined levels.

Regulated wallets could be held or distributed through licensed institutions acting as gatekeepers that will provide a variety of services like brokerage firms do today. Services might include advisory, custody, trading, margin, and prime brokerage services.

These wallets would give you access to the securities that are approved by regulators for trading on an exchange or trading platform. The secondary market ecosystem can be the pool system that exists today in crypto. But, with the wallet, people would also be able to buy and sell any regulated security peer-to-peer as well. Provided, of course, their wallet had no specific restrictions.

So the entire system could be decentralized. But with a public ledger and control of the wallets, the regulators would have adequate scope to execute their responsibilities.

Moving crypto from money to mainstream

Now, I admit this is both ambitious and incomplete. But the idea here is to think about crypto from less of a left-brain abstraction to a more systemic whole for the benefit of humanity.

As the world is evolving, there is a big debate about where things are going and how they might change. If money is in the process of changing, it will mean that almost everything that interacts with money will change with it.

Cash, while anonymous at one level, is still a person-to-person exchange. But for broader markets, cross-border trading, and large transactions, cash in paper is impractical. That means digital has a role to play.

Admittedly, digital has some drawbacks. One might be a Carrington-like event when digital records could be completely compromised. But an immutable distributed ledger and good key/wallet management might be enough to counter that.

Another might be hacking and phishing attempts or Princes from certain nations that need your help to “release a fortune” they are due for “a small fee” or your keys. Don’t fall for it.

Energy is another one. And one would have to calculate all of the energy use in the financial industry as it is now and compare that with an alternative scenario. There may or may not be a difference. And this doesn’t take into consideration other energy innovations that are sitting out there waiting to come public or will be developed.

But if we want to continue to encourage and support innovation, we have to make use of the innovations we have at our disposal that can make things better.

These innovations open other avenues for improvements and efficiencies. They create demand for key skills and put the human being at the center of innovation and exchange.

Right where they belong.

But it all starts by taking all of these niches and modules of innovation and creating a magnificent whole with them.

__________________

Bitvo is a crypto trading platform regulated with FINTRAC as a Money Services Business and as a restricted dealer with the Canadian Securities Administrators.

Originally published at https://bitvo.com on October 16, 2023.