Monday, March 5, 2018
More than 1,200 dealmakers brought their ardor and business plans to sold-out Polycon18, a giant-sized version of television’s Shark Tank which convened at the Bahamas’ Bal Mar Grand Hyatt Hotel from February 28th to March 3rd, 2018. Attending investors were shown project offerings, as well as conference materials that cited U.S. Senate testimony by SEC chair, Jay Clayton, to the effect that initial coin offerings (ICOs) of securities tokens would indeed be considered securities:
“When investors are offered and sold securities – which to date ICOs have largely been – they are entitled to the benefits of state and federal securities laws and sellers and other market participants must follow these laws.”
Regulation is a dark cloud moving over the fintech marketplace. Space-squatting “sooners” fear being misquoted and having their ventures disemboweled by federal enforcement officials. For instance, at Polycon18, the keynote speech by Patrick Byrne, CEO of Overstock.com was placed off-limits to the media. Then, and perhaps it was no surprise, Mr. Byrne also cut short his panel discussion following news reports that the SEC had just asked for documents about tZero, the Utah-based Overstock subsidiary with plans to be an early-stage distributed ledger, i.e., token facilitator.
That investigative action brought a chill to the conference goers, notwithstanding the warm Caribbean breezes. Yet, the fact that that tokens might be securities could not have been a surprise to the capital market professionals in the audience. Nor could the intense scrutiny of the SEC to any announcement that a potential post-Madoff pyramid scheme might be in the works. Still, without any overt criticism by the SEC, Overstock’s market cap dropped almost 10% after the news reports.
Title Encryption and Blockchain Verification are Novelties
For all the jargon of the presenters, the presentations at Polycon18 made it clear that while securities tokens will have important new features, it’s also clear that the token market will also share elements of conventional financial products and services. For instance, pre-set execution scripts, i.e, “smart contracts,” will self-execute after fulfillment of defined conditions. Most investors would find that very similar to existing agency service contracts with well-defined terms and conditions. However, the scripting of well-defined terms should not be taken as a given in today’s litigious markets. It will be very difficult to craft the benchmark contract, as present trade groups will testify as to the ongoing changes needed to refine their industry standard contracts in response to regulatory changes.
The Bahamas conference was organized by a firm that hopes to lead the tokenization of the securities market: Polymath. The Polymath token system, which is said to be regulatory-compliant, is being built on a blockchain consortium of database start-ups and tech entrepreneurs. That’s not a new structure: bitcoin is also a consortium. However, for its primary market, Polymath, which says it is not an exchange or broker-dealer, but rather a “protocol”, plans to deploy its tokens using templates on the more advanced blockchain network of the Ethereum cryptographic currency.
Early Regulation by North American Authorities
The Toronto venture exchange (TMX) has listed many of the presenting sponsors. At the same time, the New York State Department of Financial Services now oversees a few of the service providers. For example, the Gemini Trust Company, which is owned by the Winklevoss twins of Bitcoin and Facebook fame, has registered as a trust company specializing in digital asset exchange and custody.
Given the evanescent nature of digital assets, many Polycon18 presenters talked about strategies to engender trust in the token consortium. However, the basis of modern financial markets is really quite simple and needs no tricks. Unless each claim for redemption of the digital asset against real-world assets is honored, no one will buy the tokens or trust the consortium. Any blockchain network will collapse if a trade is not honored. That will negate the implied ‘full faith and credit’ of the network. Of course, it’s the grey areas and perimeter players that will create the problems. (No doubt, encrypted time-stamps will also create some interesting legal issues in a future SEC enforcement action.)
The token itself, when linked with its underlying stock as collateral, will be viewed by many investors as either an exotic securitization, a depositary receipt, or even as a single-stock OTC fund. Without collateral, the token is just an unsecured claim against the blockchain.
The key to the securities token – forgive the pun – is that the ownership is encrypted. Only the holder of the private key to a particular token’s encryption block can unlock the rights to sell, loan, pledge or assign the linked security. In a sense, that will make the token into a quasi-bearer instrument. Still, the holder at time of execution may not be the original owner, given the possibility of network hacks.
To regulators, encrypted tokenization of securities will no doubt look like just that much more opaque leverage, especially if the blockchain system is to be built on top of the existing securities markets. That will create a lot of questions. On the other hand, if, as some speakers projected, the token network will supersede the securities markets, then there will be just as many questions to be answered – none of which were openly discussed at the conference:
How much leverage, if any, will be allowed in financing the purchase of tokens? Will federal margin rules apply? How about hypothecation by dealers? Will tokens be subject to lending agreements by encrypted owners? How will dividends and corporate actions be handled if there are no registrars or transfer agents? Who acts as custodian in holding the underlying securities? How will regulations against undue concentration of ownership be enforced? Will the tokens be used as collateral against derivative contracts? How would one hedge a tokenized position, anyway?
The list of questions goes on and on, but so does the initiative to tokenize the capital markets. Investors and their agents will be well-served to monitor any developments that can alleviate the concerns of regulators, given that a central ambition of the securities token community is to minimize the manipulation of asset prices by government authorities and their central banks.