Digital Securitisation of the World’s Assets

Collaboration across domains will support major growth as the financial world (and beyond) climb towards digital securitisation.

The task is not a small one. As financial, technical, regulatory and commercial domains across the world climb towards the summit of a vertical glacier (or gather in their communities to discuss securitising assets using the blockchain), there is one factor that gives hope to this monumental task — people are collaborating. It seems everyone understands that collaboration across domains is vital, and that this isn’t just a technical challenge, or a regulatory one, but one that requires everyone in the space to work together. A big party is planned and everyone is invited.

However, working in the same room isn’t all that is required. If parties are working at different speeds, in different directions with different long term objectives without a sufficient flow of information between each other then our financial utopia won’t be realised. Are the worlds of regulation and technology too opposed? Perhaps traditional capital allocation is too philosophically misaligned to the purist vision of decentralisation? We’re about to find out.

So what is a digital security? Take an expensive asset such as a large property development. By representing its value digitally, and breaking this value down into thousands of smaller parts, you open up investment from the ‘long tail’. This means anyone can invest in traditionally out of reach assets using the immutable record keeping of the blockchain and its low friction of trading value. This, in theory, would increase liquidity in that asset, whether it property, or a painting, a diamond, a sports team…you name it.

So back to Collaboration

The open source community is naturally very collaborative, all providing a subset of tools that allow others to build scalable, robust solutions quickly. The need to replicate software is avoided so teams can focus on creating something new for the community, instead of competing on a small scale with those working towards the same goals. A question could be, can open source methodology be adopted by the law firms? Or by the regulators?

Whether you see digital securitisation on the blockchain as a new dawn of the internet, or as merely a mildly interesting technical exercise, the regulators, law firms, institutions, venture capital firms and entrepreneurs alike are all lining up to figure out how to act, and who to act with. A barrier that lies in the way as we move towards such utopia is fragmentation.

So what is fragmentation and why is it happening?

Fragmentation is a result of an attitude that opposes open source mentality, and it doesn’t just happen within closed-source software development. It happens within regulation, law and the spread of knowledge too. Here is a run-through:

Regulatory fragmentation

• Collaboration is required across a large number of regulatory bodies. Due to the differences in attitude towards cryptoassets across jurisdictions we don’t always see a central line of thought as to where regulation is going in this field. This leaves uncertainty across other verticals that aren’t necessarily able to progress efficiently in line with uncertain future regulatory decisions.
• Having said this, the FCA recently published their guidelines on cryptoassets with 3 more papers on the subject to follow. This sends positive shockwaves throughout projects within the crypto-community, and sends a message that the regulators are serious about this emerging field, despite having approved zero security offerings to date (this won’t be the case for much longer).
• For example, we expect to see many strongly regulated marketplaces in 2019, the result of great technical, regulatory and commercial collaboration.
• Finally, the ability to keep records in real-time that report directly into institutional or even retail portfolios will further provide key opportunities for the regulatory compliance of these systems.

Technological fragmentation

• As mentioned, open source technology has created an attitude of natural collaboration within tech communities. The introduction of blockchain and the rise of crypto-projects has only accelerated this.
• However the utility-token phase of late 2017/early 2018 saw projects striving to avoid regulatory hurdles. This brought the advantage of really testing a new crowdfunding system, but was to the detriment of investors who weren’t informed and ended up with tokens backed by empty promises.
• The move towards securities is already taking a different approach. Companies instead are wanting to promote their regulatory integration. This is partly to attract more institutional capital which so far has been timid, understandably, in entering the industry.

Commercial fragmentation

• Token offerings have done a great job in showcasing new models of fundraising to the wider community, aligning incentives for all participants, regardless of ticket size. This has ensured the inclusion of the so called ‘long tail’ of investors.
• However the attitude towards such investing is varied, with ‘all-weather’ funds such as a16z carrying on through the ‘crypto-winter’ whilst many crypto based VCs seemed to crumble along with the price of many ICO tokens.
• Now security tokens seem to be showing signs of aligning investor mentality again. Some traditional venture capital firms are increasingly keeping an eye on the space as securities pose lower regulatory and economic risks in comparison to utility tokens.
• The expectation of institutional capital to invest heavily in the crypto-sphere has been around for some time now, but as more participants work on security token design this is showing no signs of flagging.
• Andrew Keys of Consensys points out that “traditional participants like Fidelity Digital Assets, Nomura, Northern Trust and others will set an infrastructure for funds, investing in many asset classes and instruments”. He also predicts more insurance capacity and ILS products by the end of 2019, bringing in more collaborative stakeholders to this growing ecosystem, further encouraging institutional investment.

Knowledge fragmentation

• The distribution of knowledge is vital. All stakeholders must continue to engage the wider community.
• User journeys must incorporate this education piece as well so that people understand not just what they’re investing in from a compliance perspective but what risks are associated with the investment.
• If decentralisation is meant to be disintermediating value chains then the attitude towards the spread of knowledge has to follow the same mentality. Financial inclusion isn’t just about lowering barriers to capital, it’s about distributing knowledge so that consumers aren’t just enabled, they’re empowered.

Collaboration built in…

One phenomenon is bringing a lot of hope to the table: Smart contracts allowing “Built-in collaboration”. Instead of forcing collaboration on human groups with varying objectives, we are instead seeing compliance, legal terms and commercial collaboration being written into the technology. Slowly but surely, these are then becoming industry standards, enabling multi-sector interoperability.

An exciting example of this is with a newly proposed Security Token standard, ERC1400. Here, Polymath (commercial), Ethereum developers (technology) and a whole host of legal, regulatory and economics representation are working on the standard together. See https://thesecuritytokenstandard.org/ for a summary of this. Instead of just Know Your Customer (KYC), there is potential to enable Know Your Asset (KYA). Now technology is being used not to get around regulation, but to grow alongside it without slowing down the rate of technological progress.

The regulators such as the SEC in the US and the FCA in the UK, amongst others, have done a great job at this point in being open to cryptoassets and have gone to significant lengths to make sure that such assets are as well defined as possible so the industry can progress, with The Markets in Financial Instruments Directive (MiFID) driving trading and settlement of security tokens. A summit held in London this month, Security Token Realised, were optimistic about the next wave of adoption as security tokens would largely exist under current security regulation. The blockchain element acting as an enabler of better regulation, not as a complicator of it.

In Summary

Not only does all this collaboration bring great potential in formalising the digitisation of assets but in the grander sense gives the world an opportunity to take the power of capitalism and apply decentralised processes to improve some of the downsides. This is through the alignment of incentives, increased participation and inclusion, better defined objectives and equality of input/reward. Without effective collaboration across all stakeholders in this growing ecosystem, our climb upwards together will become a slippery slope to the bottom. It is proving to be a big group effort to reach the top, but the industry already knows that the view once we get there is worth it.