In this post, we discuss how tokenisation, security tokens and blockchain technology will change the nature of the capital markets. This article is a good read for business or technical people involved in finance, blockchain and the tokenisation space. In this short introduction we cover how capital markets are defined for the context of discussion. Then we dive into how tokenisation will change the structure and roles of the market, where we will find the benefits and how all this aligns with other macro trends.
What are capital markets
The term capital markets covers activities of raising money for long term investments using financial instruments and how these financial instruments get traded.
Based on the trading counterparty, capital markets can be divided into primary markets (raising debt or equity capital) and secondary markets (trading those instruments forward to next investor). The difference: when you buy a share in a primary issuance you are typically giving money to the issuer. When you are buying that share in secondary markets, you are giving money to your trade counterparty.
The financial instruments, or securities, which get moved around, can be equity or debt based. Equity is company’s shares, representing ownership in the company’s revenues and assets. Debt is a loan agreement, which represents a right to receive interest payments as well as a return of principal invested.
Structure and history of capital markets
Besides trading counterparty, capital markets can be roughly divided based on the offer type. This is a division between public markets and alternative investments.
In the public markets, also known as main markets, the issuer goes through more scrutiny and has stricter regular reporting duty. In contrast, alternative investments fund raising happens often in private, offers are less scrutinised, but the cost of fundraising is lower. The term alternative investment terms is broad, and not well defined, and may capture also non-securities investments like real estate.
How securities are held?
The current capital markets developed from paper-based securities to dematerialised securities. Paper certificates have become outdated and are no longer used. The ownership of public securities is only a book entry in a computer system for brokers.
Private securities have a less systematic proof of ownership. For a sufficiently large deals a company appoints a registrar to maintain the records of security owners. Depending on the jurisdiction, the ownership of private securities can be a line in an Excel file or an official record in the Companies House database.
To hold securities, you need to open an account with a broker. The broker then holds their own account on a bigger broker. At the top of this hierarchy, the top level balances are kept in the database of a central securities depository (CDS). The most well-known CDS is the Depository Trust Company (DTC) in the United States which maintains top-level ownership records of $53 trillion USD in assets.
CDS were originally created to handle settlements, as it was difficult to interconnect the old computer systems. Securities transfers were slow, often manual, settled by the end of day or even in the worse case by carrying around paper certificates in bags.
What are security tokens
Security tokens, or more correctly tokenised securities, take the above idea of the dematerialisation of ownership records further and move the record keeping activities from a custodian/broker managed records to a distributed ledger. If you are new to securities and security tokens you might want to read in-depth introduction about these here.
The most well-known form of distributed ledger technology is a blockchain (people use these terms interchangeably). A distributed ledger operates on tokens to transfer value between accounts.
In tokenised securities, one token represents one share. The issuer defines that they are using tokens to present legally binding shares the Articles of Association or similar issuance document.
Current capital markets
A good overview of how services for capital markets currently operate comes from a European Central Bank paper titled Securities Custody Industry. Below we see typical producers and consumers of services in the public market ecosystem.
Securities originate from issuers which are typically companies, financial institutions or public sector institutions who are looking to raise funds. Investors are then buying and trading these securities.
Investors are typically divided into two classes. Retail investors, or everyday investors, are not experts in financial markets. They can be people saving in stock markets or normal businesses managing their treasury. Institutional investors, e.g. Blackrock, make investments for everyday, have the training and have the supporting staff to make well-researched high-value transactions.
Intermediaries are supporting this ecosystem. Investment banks like Goldman Sachs help their clients and issuers to raise money by underwriting the offer. Brokers, like Fidelity, have an existing audience of retail and professional investors. They then market the investment opportunities and broker the trades for them, taking a fee in the process. Custodians like BNY Mellon account the assets on behalf of their clients and provide trade processing and reconciliation services.
Activities can generally be divided into originating the securities and then investing into them, either in primary or secondary markets.
On the origination side, we have an issuer who issues out the new securities with the help of an investment bank or such. In the case of small and medium enterprises, they often directly sell their equity to venture capital funds.
Investors do research in the available investment opportunities, by analysing market conditions, expected risks and return of investments. When an investor decides to proceed with the investment, the trade enters the execution phase. Execution may be signing the subscription agreement of new shares, or filling the online shares buy/sell form on a broker platform.
After the execution begins the post-trade phase, the different service providers exchange information and money to ensure that the new owner of the shares receive them. This action is correctly recorded in the master ownership records or shareholders registry. Because the traditional markets and banking systems do not work in real time, there may be settlement failure, e.g. when the subscriber of the new shares did not make the wire transfer to pay for them.
Future capital markets
Activities and roles will look different in the future capital markets.
Transition is happening, not just because of blockchain but also because of consumer behaviour and regulatory changes. We have observed a similar evolution in the past for eCommerce, retail banking and mobile internet services. Securities markets are opening up around the world. More capital flows across borders and investment opportunities are more readily available for a wider global audience. Interaction does not happen by visiting a bank desk, but mostly online, through browsers, forums and apps.
Capital markets have resisted the change of going online longer than other industries. For the most part, thesehe capital markets have been slower to evolve, as there are more checks and balances in place to reduce risk introduced by changes.
We can see how this transaction shifts roles in the markets and as new roles are created, the importance of some old roles declines.
The most notable change is that having a distributed ledger acts as the backbone of the clearing for settling transactions. This will change the nature of custody and central depository business, as open access and self custody makes direct peer-to-peer transactions possible while still maintaining ownership information real time.
Above is the summary chart of some of the changes we see happening. We discuss some of the major changes between current and future capital markets below.
How security tokens benefit the investor
Tokenising an investment opportunity does not make the investment itself more attractive as tokenisation does not directly change the fundamentals of a prospective return on investment (ROI).
What changes, however, is how effectively the capital markets themselves will operate. This does not only mean improving cost but also time. For example, it is cost-effective to create exchanges where they could not exist before, e.g. small-cap minerals. Security tokens, will also make it easier to invest and manage early stage equity investments across borders. These efficiencies will indirectly make investments more attractive.
Blurring the line between private and public securities
It is just a matter of time before all assets, both private and public securities, are tokenised.
Managing shareholder records on distributed ledgers has a low transactional cost and no barriers to entry. This is unlike the current custody infrastructure which has evolved to serve the public securities market. Distributed ledgers are so practical in the record keeping process that it makes sense to use them even for managing for small business cap tables.
When private securities can be transferred as easily as public securities, the line between what is private and what is public starts to blur.
Investment platforms and market-based opportunity evaluation
Traditionally the investment industry has been exceedingly relationship-centric. Family offices and boutique investment banks serve their high networth clients and venture funds look for founders in Silicon Valley.
Investment platforms will consolidate the capital raising business in a similar manner to what has happened in eCommerce. Customers will go to portals to see more opportunities (products) that they can compare side-by-side and investing in them is an effortless paper free transaction. The access to information and opportunities is democratised, meaning that retail investors across the globe get access to the same opportunities as the seasoned private equity investors
With the rise of the Internet, all commercial transactions are moving from long term, relationship-centric, to more short term, transactional centric. As there is no cost in opening an online account, it is easy to shop around for the products across different services and even nations.
From post-trade services to a blockchain settlement
Cryptocurrency exchanges have demonstrated global real-time 24/7 markets. The ability to have open and free access to the same distributed ledger has made this possible. In the case of cryptocurrency exchange, the ledger can be Bitcoin blockchain, Ethereum, Ripple or similar.
Some of these exchanges are centralised, or operate in a closed loop system with only withdrawals and deposits exposed to the world. Some of the exchanges are decentralised, or “DEXes”, where trades themselves are settled publicly on a blockchain.
Cryptocurrency exchanges still need custody functions or services for cryptographic key management, but they do not need it for storing of assets or outside settlements. It is impossible to “cheat” a blockchain, so exchanges can rely on transactions coming in and out.
As seen from the diagram above, securities industry has a lot of organisational complexity around clearance and settlement. All this can be done more streamlined with a distributed ledger. This will change not only the cost of operating markets, but the structure of the markets: Trading 24/7 is different, but globally more fair, than trading during London business hours.
Currently, securities exchanges operate on a two-tier principle: retail investors cannot directly trade on an exchange themselves, but they need to go through a broker who has bought a membership to the exchange. Then, the broker will trade on the exchange on behalf of their client. Cryptocurrency exchanges are the opposite and everybody has direct access to the order book as well as the ability to trade instantly.
Legacy exchanges did not want to deal with retail investors directly as the scalable online systems handling the management of a large number of investors had not yet been invented. Also, on legacy exchanges, members often traded on credit and there was a need to ensure the creditworthiness of members. Limiting dealing with members only is also a way to exercise power, protect the business interests and maintain the status quo.
In cryptocurrency exchanges, the investors deposits tokenised hard money and hard assets on the exchange. There is no settlement or counterparty risk, as described above, and thus it is easy to allow anyone to participate directly.
Scalable shareholder management
In private equity, professional investors may prefer a “clean cap table”: only having a few big names in the shareholder registry. Retail investors, employee-owners and other small ticket investors are lumped together behind a proxy entity. This kind of structure is often called a special purpose vehicle (SPV) or nominee structure. The proxy structure prevents small ticket investors exercising their investor rights directly, but also makes the company management more lightweight.
The nominee structures are historically preferred because there are no efficient ways of managing a large number of small shareholders. Corporate governance actions such as inviting shareholders to the meetings and paying dividends happened through unscalable methods like paper mail. Financial market regulators, however, dislike proxy structures as they add middlemen and put a certain class of investors at a disadvantage.
When ownership is tokenised and shareholder accounts are on a blockchain, corporate governance actions scale well regardless if there is one shareholder or a thousand shareholders. Paying dividends or handing out voting ballots to a large number of people can be done in a single distributed ledger transaction. Thus, there is less need for proxy structures.
Decentralised finance, funding and collateral management
Popular first generation decentralised finance services by DeFi Pulse
Decentralised finance (DeFi) is a term used to cover capital market activities happening solely on a distributed ledger, usually in the form of smart contracts. Today, the most well-known examples are automated loan services where one gets a loan against tokenised collaterals. There is no human interaction involved, everything happens automatically through the preset risk rules. Typical users for this kind of service are traders who are leveraging their positions.
The efficiencies of decentralised finance raise from the explicit risk, rules and transparency. All pricing and risk management happens automatically, real time and public. A borrower cannot get an unfair deal. A lender cannot be exposed to fabricated collaterals. There is no way to build a credit position that would be outside the system rules. Pricing smart contract based financial instruments is straightforward as there is perfect transparency to the underlying assets and their performance.
We can see smart contracts becoming a more efficient and automated way to provide financial instruments like futures, securities lending and credit default swaps.
How TokenMarket is building the future capital markets
TokenMarket is building an investment platform where retail and professional investors can come to invest in the same high tech ventures. We are tokenising issuance and building a regulated security token exchange. We believe we are creating the future capital markets in our bottom-up approach by setting up early-stage companies in a blockchain native manner. Investors get the benefits of scalable blockchain governance with the investor protection of regulated securities.