Hopping on the “digital gold” trend (with possibly two blockchain-based gold exchanges coming on line this year) and the “initial coin offering” (ICO) trend, last week Dubai-based OneGram announced that it was planning to offer a digital coin backed by physical gold.
The aim is to raise $500m in capital through a digital token offering. If achieved, it would be the largest amount raised to date via an initial coin sale.
It has a good chance, and not just for the prevailing winds – ICO sales have been enjoying a surge in investor demand, and the unusual structure and potentially attractive fundamentals of this one could pique interest.
What makes this ICO especially interesting is that it is the first digital token to comply with the rules of Islamic finance. Last November, a clarification of Sharia law qualified digital gold assets as approved investment vehicles as long as they were backed by physical gold.
The potential market is huge: on top of the usual pool of investors, for the first time a digital token will be accessible to Muslims. A recent survey by the Pew Research Institute estimates that there are 1.6 billion Muslims in the world, and total Islamic finance assets reach around $2 trillion.
The plan is to issue 12.44 million tokens, called OneGramCoins. Each will be backed by one gram of gold, and the token price will mirror the gold price. At current market levels, that should bring in over $550 million.
According to founder Ibrahim Mohammed, 50% of the offering has been already been committed. The public sale will start on May 21 and run until September 22 (unless, of course, it sells out sooner, as several other recent token sales have done).
An interesting twist is the objective of creating a payments solution around the token. The company is creating a merchant service program which will make it easy for retailers to accept OneGramCoins (as well as bitcoin and perhaps a couple of other top cryptocurrencies).
Ironically, this seems like a fusion of the old and the new: a modern technology allows customers to return to the ancient tradition of paying for things with gold.
The FT reported yesterday on the intensifying staring match between the EU and the UK over financial services.
London has for some time been in danger of losing its position as the world’s clearing center for euro-denominated derivatives. The city’s clearing houses handle up to three-quarters of the global euro-denominated derivatives market.
The European Central Bank (ECB) has long argued that oversight of euro clearing services would be easier if they were relocated to within the Eurozone, and in 2011 issued a policy reflecting this. The UK took the case to the European Court, which eventually sided with the UK. The reason given was not because geographical restrictions would discriminate against some member states (the UK’s main argument), but because the ECB’s role is to supervise payment systems, not securities settlement. The ECB still alleges that settlement oversight is essential for payment system stability.
Now that Britain will soon no longer be an EU member, the battle lines are shifting. The European Commission (EC) is preparing legislation for June that will impose geographical restrictions on euro-based clearing. An interesting twist is that the EC is not waiting until Brexit becomes a reality.
The policy, due for publication tomorrow, moves to extend the ECB’s role to include supervision of clearing houses if they provide “critical capital market functions” (such as derivatives swaps). If this goes ahead, it will mean that either the activity needs to relocate, or the UK has to allow ECB supervision on British territory (which it’s unlikely to be happy with).
If the activity has to relocate, the fallout will be considerable, and the impact could be felt around the world. Euro-denominated derivatives clearing accounts for about one third of the global interest rate swaps market.
It’s probable that some clearing houses will prefer to wind down than move (CME Group recently decided to pull out of London due to lack of profitability). The larger ones may find that they lose clients. Either would be enough to contract medium-term liquidity in the market.
Short-term, the potential problem is more serious. Clearing houses reduce liquidity risk in financial markets by standing between two traders in a transaction. They also increase transparency by being in a position to publish the price at which a trade executed.
Disrupt those functions, or even temporarily interrupt them, and you increase systemic risk. You also increase the cost of clearing, as economies of scale are reduced.
Some clearing houses are looking into blockchain applications as a way to reduce costs and enhance liquidity. In 2015 a group including settlement giants CME Group, Euroclear and LCH.Clearnet formed a working body to discuss how the technology might be used to settle transactions. The Depository Trust & Clearing Corporation (DTCC) in the US is specifically looking at credit derivatives settlement.
So, there is movement to seek greater efficiencies in settlement, reduce dependence on clearing houses and reinforce transparency. But it’s happening slowly.
Understandably so. Blockchain technology is still new and relatively untested in financial applications. And systemic market infrastructure is not something you play around with.
However, the clock is ticking. And heavy investment in new systems that perpetuate current inefficiencies and are not future-proof will end up adding even more pressure to financial services firms’ already squeezed margins.
Yesterday’s Lex column in the FT (paywall) commented on the mountain of cash sitting in VC funds. According to analysts at Goldman Sachs, approximately $121bn is waiting to be invested. This reveals two things:
Investors are hungry for VC returns.
VCs are having a tough time finding viable investments.
The first point is understandable, given the paltry returns elsewhere.
The second is interesting. It’s not for a lack of startups vying for cash. And not just startups, there are plenty of ongoing businesses that could use an infusion, which they might not be able to get from ever-more-conservative banks.
Could it be that investment firms are understaffed? Or could it be that the opportunities don’t meet the requirements?
The pressure is on, as cash holdings weigh down the overall returns, which further down the line will affect the amount of cash coming in.
This could explain the interest of some VC firms in alternative investments. A few weeks ago Harvard Business Review looked at the surge of interest on the part of VCs in ICOs, or “initial coin offerings” – tokens issued on a blockchain that confer value or utility.
In spite of their tenuous legal situation (are they securities? are they currencies? For now they are largely unregulated), institutional investors are attracted by the potentially high returns and the liquidity. And institutional interest could explain why several recent issuances were sold out within minutes.
The danger is the paucity of supply relative to the funds available. VCs could end up competing for stakes in blockchain projects, which would push valuations to ridiculous levels.
There is no way that crypto investments could make even a small dent in the piles of unused cash. CoinDesk Research revealed that 2016 saw a total of $236m of investment in ICOs. Even if 2017’s offering were to triple, it would still be miniscule in comparison.
This creates a potentially dangerous situation. Even if only 1% of the surplus cash wanted to try out an ICO opportunity, the imbalance in demand and supply would distort market fundamentals.
A bubble in the ecosystem would do damage – when it pops, investment and development are likely to be set back for years.
Snap’s recent IPO created a stir not only because of the impressive valuation and the post-launch price pop. It also generated controversy due to the voting rights of the listed shares. As in, they don’t exist.
As a result, FTSE Russell (market leader in the creation of global market indices) has decided to exclude Snap from its global indices when they are revised in June, pending revision. This is a blow to the company, since inclusion in an index implies a significant boost in liquidity, especially given the recent surge in demand for index-based funds.
Bloomberg’s Matt Levine points out that the increasing role of index funds in the market confers an increasing amount of power to the index creators. That FTSE Russell can make such a key decision about the market prospects of a company is disconcerting, especially since the criteria are not clear.
Here we start to scratch the surface of a fundamental shift in market models.
Although FTSE Russell has said that it will collect opinions from investors before making a firm decision, the fact that this is even up for review implies a judgement call.
The concerns are apparently centered on the governance model. Fund managers and even the SEC have also expressed concerns, citing uneven representation and its potential impact on disclosure requirements.
But the deeper issue at play is this: centralized vs decentralized control.
Giving all shareholders a say in how the company is run – who’s on the board, capital increases, corporate policy, etc. – is a more “democratic” approach to governance. Spreading responsibility for major decisions across the ownership structure is a gesture of faith that the owners will have the company’s best interests at heart, and that a collective decision carries more weight than one taken in isolation.
However, giving up control is understandably difficult for most founders (even with a fortune on the table in exchange). Hence the creation of a separate class of shares for outside investors (ie. not the founders and not the initial backers) with no voting rights. In fact, the founders have created a separate share class for themselves, with 10x the voting rights of the “normal” shares owned by the original backers (1 share, 1 vote). So, Snap’s founders effectively can do whatever they want with the company.
While that may sound fair on the surface, when you admit external investors, you relinquish control. At least, that’s how economics has worked up until now.
It’s not obvious why public companies bundle ownership and voting rights, other than the belief that it makes the shares more attractive. Snap has gone the other way, alleging that the market wants the founders to retain control.
In theory, their argument should be easy to prove: if investors don’t want that, they won’t buy the stock. Since the share price has remained well above its launch at $17, we can deduce that investors are not too unhappy.
What’s more, the market’s widely accepted definition of “ownership” implies responsibility, but there apparently is no legal basis for that interpretation.
The market has also always assumed that owning a “share” means owning part of the company. That definition seems to be changing, with the advent of new types of representation such as token-based dividend rights and blockchain-based funding models.
Snap’s decision highlights not only a shift in sentiment, but also a widening gap between the two schools of thought: those that think ownership should be decentralized, and those that don’t.
The debate looks set to intensify over the coming months, and not just because of the tie-in with political trends of anti-globalization and concentration of power. Underlying disquiet over the decentralizing influence of blockchain technology is likely to encourage attempts to regulate or channel applications. A heated discussion of the meaning of ownership is likely to surface, and the emergence of alternative investment vehicles could call into question established power structures.
If you’re thinking that this sounds like a full-blown attack on the capitalist model, you could be right.
Only this time, the resulting schism is unlikely to be as ephemeral as Snapchat’s messages.
Now that the market excitement over the possibility of a bitcoin ETF seems to have been put to bed with the SEC rejecting both the Winklevoss and the SolidX proposals, it’s worth thinking about what needs to change for an official bitcoin investment vehicle to happen.
Forbes published today an interesting article by Moe Adham that unpacks the SEC decision. He pins the causes on two things:
1) The lack of “surveillance-sharing agreements with significant markets”, in this case between the listing exchange (BATS) and a commodity exchange operator (Gemini, which does not have a significant market position). The concern is that the market insignificance of the exchange on which the underlying asset will be traded could leave it vulnerable to manipulation.2) The Gemini Exchange is not regulated enough (it is, though, one of only two regulated bitcoin exchanges in New York – but apparently that’s not enough).
Moe then goes on to hypothesize on what would need to happen before a US-listed bitcoin ETF is approved:
1) The majority of bitcoin trading needs to happen on US-based exchanges.2) US-based bitcoin exchanges need to be regulated.
I agree with Moe that both of the above are unlikely to happen in the near future, but I don’t believe that those are the necessary conditions.
In its ruling, the SEC specified that the main reason for the rejection was:
“because the Commission believes that the significant markets for bitcoin are unregulated.”
While this may be true today, it’s unlikely to remain the case for long. As we have seen, several other majormarkets have made moves to regulate their cryptocurrency exchanges, and we will most likely see this trend pick up steam.
Even if the SEC were to insist on most exchanges being US-based (which I think even they would agree is an unreasonable condition), it’s not totally out of the question. Almost 40% bitcoin trading now happens in US$, making it the largest market, according to Cryptocompare.
Although only two of the top five US$-BTC exchanges are based in the US (Poloniex and Coinbase), one of them (Coinbase) already has a New York BitLicense. Poloniex, on the other hand, pulled out of New York rather than have to apply for a BitLicense. But that might change, either because Poloniex shifts priorities or because the requirements become less costly and cumbersome.
In the bitcoin sector, regulation is a trend that can only move forward.
With increasing exchange oversight and greater liquidity in the major trading markets, bitcoin prices will become more reliable and transparent, solving another of the SEC’s concerns.
So, I’m more optimistic than Moe that we will see a listed bitcoin ETF in the near future.
I don’t, however, think it will happen in the US first. Another country is far ahead in terms of regulation and acceptance by the financial system, and its regulators are more likely to approve a liquid, listed bitcoin investment vehicle in the short term.
The Wall Street Journal reported this morning that the NYSE’s Arca exchange, which hosts the trading of more than half of the exchange-traded funds (ETFs) listed in the US, suffered a “glitch” at the end of trading yesterday. All live orders were cancelled, and a “backup method” was used to determine settlement prices.
Why is this interesting? In part because of the lack of information. The NYSE is not disclosing details about why the system failed. Either this is because they don’t know (disconcerting in this day of electronic information) or because they’re trying to figure out how to spin it (which could mean that it’s more complicated than just a simple “glitch”).
It’s also interesting given recent progress made in blockchain applications for trading and settlement of securities.
The NYSE is not as deeply invested in blockchain exploration as other exchanges (notably the Australian Stock Exchange, Nasdaq and Deutsche Börse). It is an investor in cryptocurrency exchange Coinbase, although the exchange’s interest in bitcoin seems to be limited to the index it launched in 2015. Nor is it one of the more technologically advanced exchanges. Bats, for example, has a better reputation on that front.
Maybe what happened yesterday will underline the need for a more robust, transparent solution. Maybe this will affect the scope of the resources thrown at the problem. Maybe the end result will be a blockchain platform, or maybe not – either way, we will likely end up with answers to questions we haven’t even asked yet.
Now that the Winklevoss Bitcoin ETF is off the table, it’s worth looking at the alternatives, present and future. What can you invest in if you want exposure to bitcoin without holding bitcoin?
In chronological order of listing, we start with a couple of Scandinavian funds.
The first publicly traded vehicle was an Exchange Traded Note (ETN), not an Exchange Traded Fund (ETF). An ETN is a debt note designed to provide investors with a return linked to a certain benchmark. On maturity, the investor will get the initial cash back, plus or minus the change in value of the underlying asset. An ETN can be liquidated before maturity by trading it on an exchange, or by handing in the relevant amount of the underlying asset to the issuing bank.
ETNs and ETFs are similar in that both track an underlying asset, both have lower expenses than actively managed mutual funds, and both trade on major exchanges. The main difference between them is that with an ETF, you’re investing in a fund that holds the underlying asset. With an ETN, you’re not – the return is tracked and calculated. Since an ETF is not backed by an asset, its credit worthiness is tied to the reliability of the underwriting institution.
In May 2015, Stockholm-based XBT Provider launched the first bitcoin-based ETN, on the Stockholm Stock Exchange (part of Nasdaq Nordic). It was called Bitcoin Tracker One and was denominated in kronor. Bitcoin Tracker EUR, denominated in euros, followed a few months later.
Trading of the two was briefly suspended a year later when XBT Provider’s parent company – KnC Group (which also owned bitcoin miner KnC Miner) – declared bankruptcy ahead of the bitcoin halving. XBT Provider was swiftly bought by Global Advisors (Jersey) Limited, a Jersey-based investment manager (of which more down below).
Both notes are now available in 179 countries (if investors have an account on Nasdaq Nordic), and both prospectuses have been approved by the Swedish financial supervisory authority.
In December 2016, Global Advisors (Jersey) Limited listed the Global Advisors Bitcoin Investment Fund on the Jersey Stock Exchange. While the vehicle had been created in 2014 and had received regulatory approval from the Jersey Financial Services Commission, this listing made it the first regulated bitcoin fund to trade on a recognized, regulated exchange. Rather than just hold bitcoin, it actively manages holdings in order to outperform the underlying asset.
The custodians for the fund are Gemini and itBit, both regulated bitcoin exchanges. Although the fund is pitched as a pure bitcoin play, its charter allows it to hold up to 25% of its wealth in non-bitcon assets.
The Bitcoin Investment Trust (BIT) was the first US-based private investment vehicle to invest exclusively in bitcoin. While technically it is a fund that can be traded and is available to certain segments of the public, holders can only sell one year after purchase.
BIT began raising capital on SecondMarket, an alternative exchange for private stock owned by Digital Currency Group CEO Barry Silbert, in September 2014. SecondMarket made a $2m seed investment in the fund. BIT is aimed exclusively at institutional and accredited individual investors, with a minimum investment of $25,000.
In 2015 it launched a new sponsor, Grayscale Investments. It also moved its trading to the OTCQX, the leading over-the-counter exchange in the US, where it resides today. The fund usually trades at a significant premium to the underlying asset, largely due to the low liquidity.
The merger represents a major shift in the exchange landscape in the US. CBOE Holdings Inc. is the owner of the Chicago Board Options Exchange, the largest options exchange in the US. Bats is the second largest stock exchange operator in the US, and the largest in Europe.
Could this affect the probability of the SEC approving the Winklevoss’ fund?
Let’s look at why they chose Bats for the listing. They were originally going to go with Nasdaq, but in mid-2016, they filed an amendment changing the exchange to Bats. Press comment at the time stressed the advanced technology of the trading platform, hinting that the Winklevoss brothers were choosing the more forward-thinking option.
No doubt the technology is part of it, but it’s likely that a larger role was played by Bats’ experience with ETFs: it is the largest ETF exchange in the US.
Nasdaq is no slouch in the technology department. Of all the US exchanges, it has invested the most in blockchain exploration. Its Linq platform enables private company shares to trade on the blockchain, and it recently released the results of a blockchain-based voting trial it conducted with Chain in Estonia last year.
But Nasdaq has fallen behind Bats in market share, and does not have its clout in ETFs.
Also, Bats technology is by many accounts the best in the business (all of CBOE Holding’s operations will migrate to Bats’ platform, a strong vote of confidence). However, at its first attempt at an IPO in 2012, the technology failed and the IPO had to be withdrawn at the last minute. The systems have been considerably strengthened since then, but the SEC could see the dependence on technology as a vulnerability.
That is unlikely, though, since the trend for exchanges is to move to electronic trading. Bats was founded in Kansas in 2005 out of frustration at the duopoly of trading markets, shared between Nasdaq and the NYSE. Unlike other, older exchanges that have incorporated technology bit by bit into their operations, Bats was technology-first.
The merger with the CBOE could be interpreted as enhancing Bats’ stability and reputation. The new entity is expected to have a market capitalization of approximately $10bn, close to that of Nasdaq. While Bats is a relative newcomer, the CBOE is over 40 years old. While Bats is known for its technology, the CBOE still operates physical trading pits. And CBOE Holdings is poised to join the S&P 500.
Furthermore, the CBOE is strong in options, and already talk is circulating of the new enterprise developing an exchange for options on ETFs. This could enhance the revenue prospects in a sector suffering from declining volatility, tougher competition and lower fees.
Even if the SEC denies approval for the Winklevoss ETF fund, it is only a matter of time before a proposal is presented that it will approve. When that day happens, the exchange of choice will probably be Bats.
The merger with CBOE is likely to work in favour of the ruling: if the SEC harboured any doubts about Bats’ durability and reliability, the additional clout and growth potential should put those to rest. Furthermore, the expertise in ETFs should facilitate sensible governance and compliance. And the combined entity’s reach across financial products and geographical jurisdictions underscore the potential that innovation in ETFs could bring to a diversifying segment of the economy.
That does not mean that approval is probable – there are a host of other complications to consider. It does mean that the choice of exchange unlikely to be a negative factor.
The looming decision by the US Securities Exchange Commission (SEC) is, according to market analysts, putting wind under the bitcoin price sails. Market attention and media headlines seem to be focusing on the short-term impact. A pity… they’re missing out on a more interesting story.
A brief summary of the situation so far: in June 2013, Cameron and Tyler Winklevoss – the owners of the New York-based Gemini bitcoin exchange – submitted a proposal to the SEC for a bitcoin exchange traded fund (ETF) to list on Nasdaq. Since then, the Winklevoss Bitcoin Trust proposal has gone through several amendments, including switching to the BATS exchange (newer, and allegedly more technologically advanced) and establishing pricing mechanisms and custodianship procedures. After seeking public comment and using up all the deadline extensions available, the SEC is due to make a decision on approval by March 11th.
Many doubt that it will be approved. In fact, BitMex is running a book on the outcome, which places the probability at less than 40%.
Why would the SEC say no? The decision is a complicated one, but can be broken down into three sections: the intrinsic (issues pertaining to the fund itself), the extrinsic (issues pertaining to the market) and the bigger picture.
Amongst the intrinsic considerations are the suppliers of the various services that the fund will need. The Winklevosses propose that price determination and custodianship be carried out by their Gemini exchange. In the ETF world, it is unusual for one entity to fulfil both of those functions and at the same time be the sponsor.
The SEC also has concerns about bitcoin and its market. Its recent request for information included questions about forks, immutability and hacking, which reveals uncertainty over the strength of the technology. Furthermore, most of bitcoin’s trading volume is in China and Japan, which raises the spectre of manipulation of a US asset by foreign entities.
While structure and market concerns are fundamental, the SEC is no doubt also considering abstract issues such as its own reputation, and the possible effect on financial instruments. Here’s where the more interesting long game shows itself.
The SEC’s main purpose is that of protecting investors. Supporting innovation is not on its list of priorities. Given the relative youth of bitcoin and the potential vulnerabilities of the technology (mining decentralization, accidental forks, quantum technology), the risks are high. And if the SEC approves and something negative happens, that’s their reputation shot.
So, will the SEC embrace evolution and innovation, and acknowledge that bitcoin is here to stay? If so, that would mark a precedent that could shape expectations for years to come.
Or, will the SEC play it safe and defer difficult decisions until a later date? In which case, think about the message sent to change-makers. While it’s impossible to suppress creativity, a “no” decision could send innovators scurrying to find alternative (and less-regulated) outlets.
It’s also important to think about the bitcoin market beyond the immediate impact.
The Winklevoss proposal was recently amended to increase the initial amount from $65m to $100m, which signals strong initial demand. Analysts Needham & Company estimate that $300m could pour into the fund if approved, which given the limited daily volume (US$ trading is usually under $50m/day) would push up the price. How much of that is already priced in, we don’t know. And it’s worth remembering that the estimated inflow is just that, an estimate based on the performance of other similar funds (which is tricky, given that this is a first).
If the SEC decides “no”, it’s probable that the price will fall sharply. But bitcoin has many other fundamentals in its favour, and the price is likely to find support at lower levels (how much lower, I don’t know).
So, the immediate impact, even if the ETF is approved, is uncertain. The longer-term impact, however, is clearer.
There’s the liquidity aspect. If approved, the increase in bitcoin demand will boost trading volumes overall, which will reduce volatility, making bitcoin even more attractive to investors. Most of the increase will be in the US, since the fund will be doing its trading on the Gemini exchange. This will even out the current geographical imbalance in trading volumes, and calm the unease of regulators. It’s worth noting that Gemini is one of two bitcoin exchanges to have a BitLicense, which makes it one of the most highly regulated exchanges in the world.
Beyond price and liquidity improvements, there’s the reputation. Bitcoin will go from being “something criminals use” to “something approved by the SEC”, which would add a lasting veneer of respectability. Institutions and investors, not just in the US, would start to see it as an asset class rather than a libertarian speculation.
This could rattle economists and policy makers, since bitcoin represents an alternative to the established system. But it is in line with increased interest in blockchain technology from institutions. Central banks around the world are studying cryptocurrencies, some with a view to launching their own. And the recent appointment of bitcoiner Mick Mulvaney as Trump’s Director of Office of Management and Budget could herald a shift in the official attitude.
Finally, it’s important to bear in mind that an approved bitcoin ETF would be the first “mainstream” fund to be based entirely on a digital concept, with no tangible underlying asset. This could unleash a stream of creative financial engineering which could usher in a new era of opportunity. Or, it could end up increasing market instability, especially when combined with a federal policy of more relaxed regulation of financial institutions.
So, the ramifications go well beyond a “yes” or “no” and the resulting impact on the price. The initial swings will be exhilarating or horrifying, depending on your position. But the bigger picture, which affects us all, is much more compelling.
I used to work, many years ago, as a broker of Canadian equities in London (don’t judge, it was the ‘80s). It was so long ago that I confess that I don’t remember much about the process, other than that we would write down our clients’ orders on bits of paper, and hand them in at the end of the day to the head of the desk. From there they would get passed on to the settlements department, which had its own floor, it was so large. Several days of stock price and currency movements later, the settlement would go through. I never thought to question the efficiency, I just assumed that that’s what it took to get ownership transferred.
When I started studying the blockchain, I assumed that aha!, here was a way to save billions in tied up money, simply by reducing the settlement time to seconds rather than days. I assumed that the blockchain’s transparency and immutability would make the cumbersome checking of ownership and payments unnecessary. Matching, verifying and netting would be reduced to code. So it needn’t take several days, right?
As with most financial concepts, it’s not that simple.
To see why, let’s start with a simple example. You and I are together in a café. I have a share certificate in my hand, and you want to buy it. You hand me the cash, I hand you the certificate, and we have instant settlement.
But wait a minute: how do you know that that share certificate is not fake? How do I know that the cash is not fake? My doubts are easier to resolve than yours (I just happen to have a fake bill detector in my pocket). How are you going to check that the certificate was not forged or copied? That’s going to take you a while. We no longer have instant settlement.
Back in the day when share certificates were bearer items (pieces of paper that belonged to whoever held them, much like the €20 in your pocket), checking authenticity could have been enough for the transaction. But now you need to know for sure that I have the right to sell that certificate, because if not, once I’ve disappeared with the cash, you could find that the rightful owner appears and wants the sale declared null and void. How do you do that?
And while you’re doing all your checking, I could decide to change the price. Markets move, after all. How do you prevent that from happening?
The settlement is getting more complicated, right? Now let’s throw in the delicacies of electronic payment, and electronic transfer. To the same doubts about authenticity, we can now add doubts about settlement. Even if we’re satisfied that we are who we say we are, and that we have the right to send the digital certificate/payment, I’m not going to transfer ownership until you send the money, and you’re not going to send the money until I transfer ownership. Who can help us with that?
And, since it’s unlikely that I hold my digital certificates, I have to route all instructions through my certificate custodian. And, how did you and I find each other in the first place? Suddenly a lot of other parties are getting involved, and each is going to want to verify and check that everyone is who they say they are.
So, a lot of verification is going on. And it’s that verification that takes the time.
In theory, the blockchain can help us with verification, in that if something is stored on the blockchain, it’s fact. But is it? Let’s presume that I, personally, don’t have the power to publish my share ownership on the blockchain. My custodian would have to do that. (Why he would do that is an interesting dilemma, since once he has published all his clients’ shares to the blockchain, he is out of a job.)
And how do we know that my custodian will publish the correct information? That my share holdings are 100% intact (nothing has been siphoned off), verifiable, and in a universally accepted format? Who decides what that format is? Would that not be a very, gasp, centralized decision? For a technology that rests on decentralization?
Let’s assume that we figure out a way for my custodian to blockchain all of my holdings and manage to keep his job. So, he transfers the digital ownership of the shares I want to sell to my broker, who is in contact with your broker. Why is my broker going to trust your broker to make the payment on your behalf? It’s easy enough if they know each other or have done business before. But what if you are in Azerbaijan and I am in Iceland? (And let’s not even go into how long it would take a payment to get from Azerbaijan to Iceland…). Right now regulation makes this all work relatively smoothly. And regulation insists on verification and re-verification of the facts and identities. It’s very unlikely that just putting it on the blockchain would be “good enough” for the regulators.
And we shouldn’t want it to be. Efficiency is great, yes. But when it comes to large sums of money, reliability is more important. And when you think of all of the verification that needs to happen for a trade to take place, settlement of two or three days doesn’t sound like that much, after all.
It is possible that the financial sector could come up with a way to encode verification, identity and transactions. But to do it going back far enough for it to be useful would entail a colossal cost. And to do it in a uniform manner in a fiercely fragmented business would require almost magical management skills.
But that’s not to say that blockchain settlement is not a good idea. Some asset classes take longer to settle than others. So, it’s quite possible that we’ll end up seeing separate settlement practices for separate types of deals, and some of those may well use the blockchain. I can especially see blockchain-style settlement being used for future asset classes that haven’t even been invented yet. Building a new settlement system from scratch would be an excellent opportunity for the blockchain to show its power. Converting current systems? Not so much.
And while decentralized trading sounds efficient and, well, democratic, we need to take a look at the steadying role a centralized control can play. Imagine what could have happened in September 2001, and again in the 2008 crash, withoutSEC interference. And the need to reverse a trade, either because of error or because of contractual conditions, is a relatively common occurrence, and something that the blockchain is not set up to allow.
The “blockchain as a new settlement system” dream is appealing. But as with much of the information and talk surrounding this powerful technology, it is largely hype. An improvement on the current system would benefit liquidity and profits, and make the sector more resilient to shocks. And the blockchain does have a role to play in making payments and data transfer more efficient. But it would be a mistake to assume that technology alone is the barrier to an instant settlement system. There is much to explore, though, and much to learn, and things can always be improved, indeed should be if the solution is practical. The sector and the blockchain will find ways of working together if we can move away from sweeping proclamations and towards practical applications that can help today.