When WorldCom was on top of the world as the second largest long-distance telecommunications company, valued at a market cap of $175 billion during the dot-com boom, it was a larger-than-life story of Wall Street’s potential to line the pockets of those who invest wisely. When it was discovered that WorldCom CEO Bernie Ebbers was defrauding investors by reporting false profits of over $3 billion through shady accounting practices, countless investors were left without savings and retirements they were banking on.
WorldCom’s story is far from unique — the notorious Bernie Madoff defrauded investors out of at least $17 billion, Italian dairy giant Parmalat was found to have forged countless documents and covered up $14 billion in expenses, and everyone knows the name Enron for all the wrong reasons. Human nature is to skirt the rules, especially when one’s job and income are set to be secured by a bit of loophole-finding, but these schemes ultimately come crashing down on those who least deserve it. This is not to condemn all of Wall Street, only to say the patently obvious: the more consumer protections and transparency in speculative markets, the better.
This is what blockchain proponents seek to provide. The use cases start simple, with automation in stock trading reducing the need for brokers and intermediaries, with connected fees ultimately withering away for those who prefer trading on their own, à la the Robinhood app. In the bigger picture of Wall Street, logging trade histories and other mandatory financial and regulatory reporting data is considered a quicker, more affordable way to maintain regulatory checks on the markets. Blockchain may also provide entire new asset categories and classes to be traded.
When it comes to trading stocks, several intermediaries reside between buyer and seller, including but not limited to stock brokers, depositories, banks, clearing corporations, and other financial institutions, depending on the nature of the trade. These intermediaries often help the markets function more efficiently, but some are worth more than others. There’s a few issues with brokers, as just one example of how legacy trading systems are limited. Typically, an online broker requires a minimum to open an account, typically around $500 or $1,000, but sometimes as high as $10,000 or more. Then come stock trade fees, which can be as high as $7 per trade and $50 for broker-assisted trades, and we aren’t even getting into other hidden charges, such as the IRA closure fee, options fees, and more.
In a world where value and DIY have become king, these fees seem archaic, especially in light of newer alternatives. In one survey, 10% of millennials rely upon the free digital trading platform Robinhood instead of paying a broker or utilizing more fee-heavy trading platforms. Other apps are making micro-investing a reality, catering to more budget-conscious investors who are either unwilling or unable to purchase entire shares.
These platforms don’t come with the advice and strategy that an experienced broker can provide, and typically aren’t as well-suited toward the diversification of funds that many investors seek. However, they do provide a window into the future of blockchain-based trading platforms that seek to lower the financial barriers to entry by reducing the sheer number of parties that take a cut of a given transaction.
October 24th, 1929, otherwise known as “Black Thursday,” issued in a decade of misery that would forever change the way that regulation is viewed. In the depths of the Depression, roughly one-third of the non-farmer workforce was unemployed, suicide rates had increased to 17 out of every 100,000 Americans, and the nation’s GDP fell from $103.6 billion in 1929 to only $56.4 billion in 1933. Even the most pro-free market libertarians witnessed this misery, brought on by the failure of 9,000 banks that had lent money wantonly to irresponsible stock traders, and had to admit that some level of insurance and regulation in the financial industry was necessary to avoid a repeat of the Depression.
Yet, while we didn’t see the despair of the Depression repeat itself, hard times brought on by questionable trading practices would recur. “Black Monday” — or Black Tuesday, if you’re Australian — is the notorious moniker given to October 19th, 1987. That day, the Dow Jones sustained a nearly 23% contraction in the market caused in part by overvaluation and market illiquidity. Then there’s the Great Recession and many instances in between. One has to conclude that regulation should never sleep, and regulators should be equipped with the best available technologies.
The interoperability of blockchain technology means that outside entities can be made party to a record or blockchain, given the proper passkeys, permissions, and capabilities required by the ledger’s owner. This possibility adds a facet to blockchain trading platforms that would allow non-certified traders to remain on the right side of the law. By permitting regulators a measure of oversight into these platforms, traders of all experience levels and financial means would be able to save by avoiding unforeseen legal consequences while greater oversight incentivizes more responsible trading practices.
Simplifying Post-Trade Events/Settlement
In August of 2018 alone, 1,526,623 securities trades were processed through the Central Clearing and Settlement System (CCASS), with a total of 200.75 billion shares being transferred as a result. While settlement times have improved from a T+5 standard roughly a decade ago, even the current T+2 standard presents issues in terms of illiquidity. By switching from the T+3 to the T+2 settlement cycle, investors are less volatile to risks associated with price changes, spikes in transaction volume, etc. According to PricewaterhouseCooper, in order to reach a standard of T+1 or even T+0 for most securities markets, a greater level of automation through more infrastructure investment will be necessary. Some believe that smart contract technology built on the blockchain is just the technology to accomplish shorter settlement cycles.
Those who seek to incorporate smart contract technology into blockchain-enabled trading platforms believe that, in place of cumbersome human oversight, those contracts could execute as soon as prerequisite criteria is fulfilled, such as a buyer and seller with an agreed upon price point. Quicker trades means shorter time lags, which frees up the equity necessary to keep wheeling and dealing, or to use the funds for another purpose.
Automated Regulatory Mechanisms
For fiscal year 2018, the Securities and Exchange Commission requested $1.602 billion to support 4,543 positions. There are several recent examples of the SEC’s accomplishments: a $20 million settlement with a Colorado-based biopharmaceutical company that was found to mislead its investors about a developmental cancer drug; U.S. Congressman Chris Collins for allegedly engaging in insider trading; settling with the now-notorious Elizabeth Holmes and her defunct company, Theranos; and the list goes on.
But there are also countless examples of shady investors, both individuals and companies, who either get away with borderline or outright criminal activity or are not found out until it’s too late. Despite a billion-dollar-plus budget, somehow Bernie Madoff was never flagged despite numerous warnings and anomalies, namely consistently sky-high returns even in the worst of times. It’s clear that the SEC needs all the help it can get to monitor the complex, constantly shuffling markets, and algorithms aimed at detecting anomalies, potential fraud, and suspicious trading patterns could do wonders for the Commission.
The ability to include human regulators as overseers of financial transactions is important, but the ability for blockchain-based trading platforms to employ algorithms that automatically flag suspicious transactions could represent a true breakthrough in market regulation. Individual and institutional traders who can effectively recognize these patterns and teach machines to flag them will have a special place in the stock-centric RegTech sphere.
Establishing a Market for Security Tokens
2018 has been referred to as the year of the security token. Some key questions remain, including the viability of secondary market trading and lingering regulatory ambiguity. However, these uncertainties haven’t stopped startups from issuing STOs, or security token offerings, in an effort to establish tokens as securities, not utilities. The SEC reported that filings relating to token sales continue to rise. 93 such filings have been issued since August 2017, and May 2018 saw an all-time record 15 token-related filings with the SEC.
This cooperation between startups and the SEC is an indication of security tokens’ momentum. Already, specific security token ICOs have proven the willingness of investors to sink their capital into non-utility tokens. Harbor/R-token raised $28 million in April to “re-engineer” private securities for blockchain technology, while financial services company VRBex sought $100 million in its April security token ICO. With easier sale, fewer legal hurdles, and clearer trading practices, security tokens have emerged as the safer bet when it comes to token issuance.
Security tokens issued through STOs have obvious appeal; startups and investors see them as a simple means to exchange financing now for return on investment later. However, too many security tokens are not as legitimate as they profess to be. Establishing a marketplace much like the stock market that would allow the purchase and sale of verified security tokens would lend a new level of legitimacy to the ICO market. Think of this concept as the difference between the penny stock market and the New York Stock Exchange, which is more closely regulated and therefore populated by businesses that are not likely to make off in the night with their investors’ cash.
Facilitating Dividend Payments
Being a shareholder in a company that pays a dividend, especially a hefty one, is like the cherry on top of traditional returns on a climbing stock price. And while some companies decide to pay a dividend, rewarding its shareholders and offering evidence of strong financial projections, other companies choose not to, whether it is because they want to invest as much as possible back into the company or because they simply cannot afford to. Some of the most well-regarded stocks, included Apple (AAPL), Exxon Mobil (XOM), and Microsoft (MSFT) all pay dividends, much to their shareholders’ delight.
Dividends account for a significant portion of returns, though this percentage varies by the market. An analysis of the S&P 500 reveals that, based on a model of a $1,000 investment, adding dividends to rises in stock prices increases the typical investor’s total returns by 50%. And the majority of stocks are now paying dividends. Recent alterations to tax policy have only increased the amount of dividends paid out to investors, with overall payments increasing 13.85% since January, as of May. Again, more cash on hand and in their pockets is music to investors’ ears, but as is the case with any payment, the money cannot come in fast enough. And companies could perhaps spare even more by injecting a bit of automation into the dividend payment process.
As is the case with so many payments, the blockchain offers the ability to issue payments in a self-executing manner, increasing timeliness and reducing the human cost necessary to execute dividend disbursement.
Token-Facilitated Micro Investing
Many of the most desirable, consistent stocks priced themselves out of the budget of the typical investor long ago. Berkshire Hathaway, the inimitable brainchild of investing legend Warren Buffett, hit its all-time high of $285,950 in October 2017. Unless one feels like putting their home up as collateral, there’s a fat chance that the average investor will be a proud member of the Berkshire Hathaway club within their lifetime.
Even stocks that you might guess would be well within a reasonable price range aren’t. Take AutoZone Incorporated, for example. Your neighborhood auto parts retail and repair shop has whipped up a hefty per-share price of roughly $652. Then, of course, you’ve got your usual suspects leading the market. These are the stocks that we all look back on and say, “If I only knew….” At the time of writing, Amazon is going for $1,641 per share, while its ever-rising partner in market-leading, Google ($1,071), and Apple (at a more modest price point of just over $200) are representative of the many investors who feel they are either not getting strong value at current price points, or the price is simply too high, in the former cases.
Security tokens offer the opportunity for investors to invest in much smaller increments than full shares of traditional stock do. While there are relatively untested apps for micro investing in traditional stocks (see: the Stash app), these platforms are somewhat unproven, especially when compared with successful ICOs that allow users to invest incrementally in accordance with their budget. This proven model, exemplified by both ICOs and cryptocurrencies, offers promise for security tokens as an alternative to traditional stocks for micro investors and those who want to derive greater value from their limited budget.
Fundraising and Asset Management
Fundraising can tell us a lot about a publicly-traded company. For example, Tesla’s management has admitted that it often runs negative cash flow, and even if we weren’t privy to such an admission, their relatively frequent return to the fundraising well would have clued us into the reality that they burn through cash like Montag burns through books. Elon Musk’s automotive baby raised $270 million in capital in 2010, $451 million in 2012, and over $18 billion in total between 2010 and 2018. Experts don’t expect Tesla to be cash flow positive for quite some time, so it’s fair to think that Elon Musk knows what he’s doing when he goes back to the fundraising well once again. But perhaps Musk — and the many other publicly-traded companies who require capital — would conduct fundraising processes even more efficiently and cost-effectively should they adopt blockchain technology.
When it comes to raising capital to fund business operations, companies in a pinch have the option of selling stock directly to the public at any time. Though the investors derive future returns on that stock, the company has a guaranteed way to raise capital to increase cash flow. The automated nature of blockchain technology, as is the case with so many of its use cases, derives value from the fact that it can conduct fundraising sales and agreements without a middleman, instead using more cost-effective and immediate smart contracts to execute the transactions.
E-Voting for Bond and Stockholders
While we go in-depth into how the annual general meeting (AGM) of shareholders may be improved in the corporate governance chapter — in short, blockchain can help make the AGM a more practical, remote affair — it’s also important to consider how bondholders could also benefit from blockchain technology. After all, bondholders are technically creditors of a company, and so their voices deserve to be heard. Futren, the company formerly known as Theolia and the host of a wind farm, detailed how its bondholders could participate in its bondholder meeting held on October 29, 2014 in France. They could personally attend, have a proxy attend for them, or mail in any relevant votes via mail. Now, if you were a bondholder not living in France, this would be less than practical.
Here’s an even more dire — and real — scenario. Say you are a creditor of the Venezuelan government, which owed $60 billion in bond repayments to creditors from around the world as of November 2017. How would you feel about attending a bondholder meeting in the war-torn, poverty-stricken capital of Venezuela, Caracas? In case you’re on the fence about President Nicolas Maduro’s proposal to host his government’s bondholder in Caracas, consider that the city’s murder and kidnapping rates rival actual warzones. Such a plan is simply poco realista…unrealistic.
The blockchain, which allows secure participation by bondholders from remote locations (thanks to its strong personal, cryptographic identifiers), would be a tool well-suited to fostering greater participation among bondholders. As it stands, the difficulty inherent to attending in-person bondholder meetings renders these meetings an oft-avoided formality, if not a complete joke (Caracas?!), but that could change if technologies that allow remote participation without the threat of impersonation of hacking could be implemented.
Tracking Securities Lending
In April 2017, the total market for ETFs (exchange-traded funds) nearly totaled $3 trillion. ETFs are a popular form of investment, as they mitigate the risk of owning any single stock, bond, or commodity and have a strong record of returns. Well-regarded financial institutions and hedge funds have conceived sound strategies for lending out these ETFs or their components as a means to create additional low-risk revenue streams for their investors. Make no mistake, there are currently at least five ETFs who are in heavy on the same sort of leveraged loans that caused widespread misery during the not-too-distant financial crisis. But for those ETF managers making sound investment decisions, lending their securities to short sellers is a little-sweat proposition with potential upside.
Like many of the concepts in market finance, securities lending is not exactly a widely understood topic amongst the general population. Essentially, ETFs (packaged securities, whether they are stocks, commodities, or bonds), or single commodities within the ETF, are lent out to other parties by their owners — often short sellers — in exchange for collateral. These trades can be a source of additional revenue for the lender, and can allow short sellers to sell a stock that they don’t technically own.
We won’t further complicate things, but only say this: tracking the prices of these ETFs, both from the perspective of the borrowing short seller and the lender, is important. Blockchain platforms, imbued with relevant metadata, can assist in both parties tracking the values and status of borrowed ETFs, as well as trigger the issuance of collateral (through smart contracts) if the short seller becomes overleveraged.
Blockchain-Based Mutual Funds + Crypto ETFs
According to Investopedia, an exchange-traded fund, or ETF, is “a marketable security that tracks a stock index, a commodity, bonds, or a basket of assets.” By comparison, a mutual fund is “an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets.” While similar in that they contain diversified forms of equity, ETFs trade as a common stock would, while mutual funds function in a way similar to a hedge fund — your money is in it, and the manager is tasked with ensuring you see returns. Some of the largest funds include Primco Total Return ($263 billion in assets), Vanguard Total Stock Market Index Fund ($190 billion), and American Funds Growth Fund of America ($115 billion). Many investors are more comfortable with these diversified investment funds, and see steady returns to boot.
Now imagine that these funds or ETFs were comprised of tokens and blockchain-utilizing companies. For enthusiasts of blockchain technology, this would represent a chance to see significant returns and mitigated risk through the bundling of diversified asset classes that have the common thread of blockchain technology. For those who believe in the fundamental principles of the technology, these tradable crypto ETFs and mutual funds are likely an exciting prospect that is in its nascent stages.