Distributed Ledger Technology (part V)
WELCOME TO THE TOKEN WORLD
In 2016, a major report had been published on the changes that blockchain technology would bring to financial markets, reducing the need for reconciliations and bringing many billions of annual savings1 to the financial industry.
the time, my opinion was that the Distributed Ledger Technology
introduced by the Bitcoin could be a fit for a public decentralised
ungoverned currency and that it would require several technological
evolutions to become fit for the financial markets.
Firstly, the scalability issue to process the volume, secondly the confidentiality issue to keep transactions private, and thirdly the regulation and governance issue to offer the same level of protection as current markets.
SO MANY ICOS, SO LITTLE ECONOMIC IMPACT
The past three years have seen the launch of thousands of cryptocurrencies, often through an Initial Coin Offering (ICO) process.
Andy Wharol said:
“in the future, everyone will be world-famous for fifteen minutes”
It is now possible to create a cryptocurrency in fifteen minutes2 and possibly become famous. However, cryptocurrency issues have generated little interest from regulators because of their relative small size compared to the global economy. The global value of cryptocurrencies is les than two hundred billion euros3. Just taking the euro currency alone, its fiduciary4 value is five times larger5 and the euro supply is about fifty times larger, and other large legal tenders like USD, GBP, CHF, and JPY and cryptocurrencies do not currently represent a systemic risk.
FROM COIN TO TOKEN
Inceptors of cryptocurrencies have tried to improve the technology to overcome the three main issues just mentioned.
In financial services, most initiatives have, in various ways, reduced their scope to private, permissioned and partially recentralised technology in order to progress in the digital representation of assets.
Financial regulators are showing themselves to be pragmatic, authorising issues on a case-by-case basis or on a sandbox basis.
The interest has now shifted from coin to token.
Focusing on securities, security tokens have a clear issuer, which is not the case for the Bitcoin. This is why regulators want these issuers to apply to tokens the existing regulations covering their underlying assets.
In Europe, they are making a clear distinction between securities and financial instruments, because they are subject to different regulatory frameworks.
The buzzword is Security Token Offering (STO). There are solutions available today to issue and maintain a registry of holders for bonds, equities or funds. The next challenges will be the ability to manage corporate events and to organise efficient secondary markets.
INTO THE TOKEN WORLD
In the mind of operators, a digital representation of assets allows a better circulation of assets, what they call a greater velocity, the capacity to exchange assets almost immediately.
Taking a real estate example, buying a property takes weeks. Buying tokens representing shares of a company holding a property would take only minutes.
Furthermore, if the token is properly designed, it could take little time to bundle this property with another one or, on the contrary, to split it into parts, bare ownership and usufruct, or into fractions. In other words, securisation and stripping made easy.
In these transactions, the trading, the settlement and subsequently the safekeeping of the representation of the asset could be done at once. Such immediate processing would require the use of a standard unit of account linked to one of the main existing currencies, and this is the reason why there is such enthusiasm for stable coins9 and whether to use them in Exchanges or for Registries.
This is probably the reason why JP Morgan announced in february 2019 it will issue its stable coin in June 2019. My understanding is the holder will face a JP Morgan risk. There are ways to launch stable coins with a better credit risk. For instance, share or unit of a Money Market Fund in the EU would have a better credit risk than any commercial bank, even if they loose a bit of value because of the current negative creditor interest at the European Central Bank10.
BACK TO THE REAL WORLD
Issuers and investors need to know and apply the requirements of all applicable laws, regulations and tax systems. This includes identifying counterparties (KYC), checking the origin of funds (AML), making declarations of threshold crossings, checking foreign ownership restriction, as well as reporting capital gains, or even withholding tax. This applies to security tokens too.
Considering the number of initiatives, these digital markets will stay fragmented for several years before a cross-chain of integration is built or before a leading platform emerges. In the meantime, it seems necessary to rely on trusted intermediaries to provide a single interface for all these chains, convert cash to and from these chains, to safeguard the keys to access them or even hold the tokens themselves.
Imagining this world of digitisation is quite easy. Guaranteeing the reality of the assets represented by the tokens, and possibly their condition of these assets, understanding the rules or assessing the fairness of a joint ownership agreement, or applying taxeswould be additional services required by counterparties.
ONE STEP AT A TIME
Just like Artificial Intelligence, Distributed Ledger Technology is already having an impact on the Financial industry.
The current EU infrastructures with RM, MTF, OTF, CCP, T2S, CSD and Target211 have a proven reliability record for issuing and exchanging safely securities leveraging regulated intermediaries. They may be capable to reduce their turn around time and list more assets than just securities.
On the token side, providing that law, regulation and tax requirements are met, granting direct access to retail that are holding 30% of securities will first be an education issue but it might bring an incredible efficiency for other types of assets like non-listed securities or real estate.
They always say time changes things,
but you actually have to change them yourself12
1. Profiles in Innovation Blockchain by Goldman Sachs in May 2016, p. 5.
4. In this context, fiduciary money means banknotes and coins.
5. Banknotes and coins represent €1,034 billion, and total euros in circulation account for €11,618 billion
6. A token that is as a store value and as a medium of exchange, not issued by a central Bank.
7. A token linked to a network or to an issuer to fund a project and later gives right to goods or services.
8. A token behaving like a security with holders regarded as owners.
9There are different definitions for stable coin. Here it means a unit pegged to a legal tender on which the credit risk is as almost as good as the corresponding Central Bank risk and better than commercial bank risk.
10ECB deposit facility currently bears a 0,40% negative interest rate.
11 RM: Regulated Market, MTF: multi Trading Facility, OTF: Other Trading Facility, CCP: central clearing counterparty, T2S: Target 2-Securities, CSD: Central Securities Depositary, T2: Target 2
12 Andy Warhol’s quote