Digital Securities — the future of Capital Markets?

Spoiler alert: my answer is an emphatic ‘YES’. In 10–15 years, all securities, private and public, will be digital securities. Why? Simply because it is a dramatically better, more efficient way all around for issuing and managing securities.

This is true for everyone involved, including: issuers, investors, regulators, underwriters, brokers, traders, institutional investors, asset managers, exchanges, and the list goes on. In short, all capital market players benefit in their own way.

Interestingly, the most common reason cited for the rise of digital securities is improved liquidity of illiquid assets. While there is certainly value in that, there are multiple other reasons, some of them are even more compelling. Some of the reasons for moving to digital securities are:

REASON #1: IMPROVED LIQUIDITY OF ILLIQUID ASSETS

Since I mentioned this as the most commonly cited reason for digital securities, we might as well start with this one. It is true of course. A large percentage of financial assets are illiquid, and many of them can benefit greatly from increased liquidity. Here are a few examples:

VC funds: Illiquidity is cited by LPs in VC funds as the number one issue related to VC investments. It is true that some VC funds allow secondary trading of the LPs interests in the fund, but these secondary market transactions typically take long months to consummate and usually involve 25%–30% discount to value. By issuing LP interests as tradable digital securities, very much like SPiCE VC did, LPs can choose the timing of liquidation rather than hold on to their investment for 10–15 years.

Hedge Funds: Hedge funds solve investors’ liquidity problem by buying back investors shares in the fund when investors wish to liquidate their holdings. This shifts the issue from the investor to the hedge fund managers, as it puts unnecessary operational strain and added inefficiency on fund management. This issue will can be solved if fund shares are issued as tradable digital securities.

Real estate: Real estate assets are largely non liquid. Yes, I know, there are publicly traded REITs — which is one of the solutions markets created to the illiquidity of real estate assets. However publicly traded REITs typically do not perform as well as individual assets or private real estate funds.

REASON #2: AN EFFICIENT WAY TO ISSUE, TRACK, AND MANAGE OWNERSHIP OF SECURITIES

Many corporations, large financial institutions, global banks, and institutional investors are discovering this aspect of digital securities.

The latest news about HSBC (HSBC is moving $20 Billion From Paper to Blockchain) is just one example.

HSBC will be shifting $20 billion worth of assets to a new blockchain-based custody platform by March 2020. This will be a vast improvement of the previous system as the HSBC platform will digitize paper-based records of private placements. Private placements are typically held on paper and lack standardization which not only makes accessing them difficult and inefficient but also points towards an archaic and outdated system.

Using blockchain will reduce the time it takes investors to make checks or queries on holdings, and allow real-time access to records of securities bought on private markets.

Another example is the World Bank, which as of last September has issued a total of $108m of Bond-I, blockchain based bonds (World Bank has issued $108 million worth of blockchain bonds)

Societe Generale also issued a EUR 100M covered blockchain based bond, which they claimed is the first tokenized covered bond on public blockchain (Societe Generale issues e100 million covered bond as a security token)

Banco Santander recently dabbled in blockchain bonds as well, issuing $20m of blockchain based, one year maturity bonds (Santander issues first end to end blockchain bond).

The realization that digital securities are the future of securities is also of the reasons driving many large banks and financial institutions to invest in the digital securities ecosystem. As an example, the latest investment round in Securitize the leading platform for issuance and lifetime compliance management of digital securities was led by global banks and financial corporations like Banco Santander, MUFG, Nomura, and SBI (Securitize raises $14m from Santander, MUFG, Nomura Holdings, Japanese Conglomerate SBI Injects 7-Figure Sum Into Securitize ).

There are many other examples of recent major banks and financial institutions investing in the digital securities ecosystem, including Citi, NASDAQ, London Stock Exchange, JPMorgan, and Goldman Sachs.

On the other end of the spectrum, another example is SPiCE VC. The efficiency and greater simplicity of managing digital securities’ lifecycle, is exactly what made it possible for SPiCE VC to increase their number of investors significantly beyond what is customary for VC funds. Typically, VC funds try to have a small number of Limited Partners (LPs) in the fund, usually not more than 20 or so. This keeps VC investment a highly exclusive game, as each investor is expected to invest millions of dollars in a high risk illiquid asset.

To date, SPiCE has over 300 investors, and after the second funding round of the fund, the number is expected to grow further. Beyond SPiCE, as more and more VC funds follow the same route, it will allow expanding the circle of investors in the VC industry to a much wider circle.

REASON #3: AUTOMATED COMPLIANCE FEATURES FOR ISSUANCE AND LIFECYCLE MANAGEMENT

This is a definite win both for regulated players and for regulators. Until today regulators and institutions could only verify compliance in retrospect, mainly through internal and external audits as most related processes were heavily reliant on the human factor. This is particularly true for transactions related to private offering of securities. And then there is the issue of dealing with non compliant transactions and situations after the fact.

In the digital securities era, all relevant regulations are coded into the digital security, and as a result, non compliant transactions simply do not execute. Problem averted and significant expenses spent today on ensuring regulatory compliance saved as well.

REASON #4: FRACTIONAL OWNERSHIP OF ASSETS

A prime example for the value of fractional ownership is real estate. Digital Securities allow fractional ownership in real estate assets, allowing investors to own much smaller portion of the asset than in the traditional world.

A couple of examples for digital securities offering fractional ownership of real estate are:

AspenCoin: The Aspen Digital Security Tokens, the first tokenized real estate offering, offered in October 2018, presented purchasers with the opportunity to hold indirect fractional ownership shares in the iconic St. Regis Aspen resort, in Aspen Colorado (AspenCoin transitions to Securitize after raising $18m in security token offering ).

The German blockchain company, Fundament, is another example. Fundament was approved by the German securities regulator (BaFIN) to issue bonds in the form of security tokens to raise money for real estate development in a $280 million offering. The token is open to any retail investor anywhere with no minimum investment restriction (German regulators approve Fundament’s $280 million token sale )

REASON #5: GLOBAL ACCESS TO INVESTORS

Digital securities offer a significant benefit of global access to investors, which is much harder to facilitate for traditional private offering of securities. For example, SPiCE token holders include investors from the US, UK, Spain, UAE, HK, Switzerland, Germany and Israel.

SO, IF DIGITAL SECURITIES ARE SO GREAT, WHY WILL IT TAKE 10–15 YEARS TO GET TO FULL ADOPTION?

The main reason is that digital securities require a completely different ecosystem (technology, applications, services, regulations) than what currently exists in the industry. Although the industry is already viable and growing rapidly, the domain is still in its early stages - some of the technology is being developed, some is still immature, and some is still yet to come. Regulations are also developing, at differing pace and levels of maturity based on jurisdiction.

This growth will take time, proper investment, and evolution over the years. We are at the front end of this wave, watching it all unfold. One thing is certain — there are exciting years ahead of us in terms of digital securities ecosystem growth.