As the calendar turns to 2019, blockchain’s potential to impact the securities industry has never been more evident and, in many ways, it feels as though we are on the verge of meaningful adoption across a number of key asset classes. We believe that continued guidance and engagement from regulators and legislators, along with strategic institutional investment will help lead the digital asset industry to new heights in 2019.
A Change in Vernacular
As the digital asset industry matures, market participants are increasingly distancing themselves from the ICO phenomena of 2017 and early 2018, offerings that we long argued were unregistered security offerings. This trend is important for both prospective issuers and investors since the underlying properties of an ICO and a digitized, smart security offering could not be more different. As part of this process, the industry will look to move away from terms like “token”, “STOs” and “TAO” and towards terms like “smart securities” and “digitized” or “digital securities,” all of which are part of the broader “digital asset” industry. A recent report by Ownera, NovaBlock Capital and the Security Token Summit entitled “The State of Smart Securities 2019” urged the market to coalesce around the term smart securities because it “accurately reflects the programmability of these new financial instruments,” and we agree. Enterprise blockchain company Symbiont has been using the term “smart securities” since 2015, categorizing tokens as “old technology that didn’t offer the level of sophistication of its smart securities project.” This language transition will be critical in gaining mainstream adoption for digital assets represented by securities. Just as most issuers are unaware of the technology (or lack thereof) underlying traditional equity offerings, distributed ledger technology used to facilitate smart security offerings should be out of sight and out of mind for issuers and investors alike. Few people know how AWS works…it just does, as should be the case for these new programmable financial instruments.
Increased Adoption of Smart Securities
As we predicted in this article, 2018 saw the market for security token offerings and tokenized asset offerings begin to take shape. In 2019, we expect to see growing acceptance and adoption of a regulatory compliant iteration of these transactions involving digitized securities representing a variety of asset classes. Ultimately, we believe that widespread adoption of digitized or smart securities will require certain levels of regulatory licensing and a move to private, permissioned blockchains to facilitate these transactions. While public blockchains can be useful in increasing efficiency and transparency for a range of industries (i.e., supply chain management), we believe that public decentralized blockchains, such as ERC-20, will prove to be unsuitable for the securities industry, especially institutional engagement. To our mind, a move to a private, permissioned blockchain solution will separate smart securities from other solutions in the digital asset and cryptocurrency spaces.
Public Market Volatility = Private Market Opportunities
2018 was the worst year for stocks since 2008, with the S&P, Dow, and Nasdaq down 6.2%, 5.6% and 4% respectively. As central banks globally begin the process of quantitative tightening, coupled with softening economic data, most market pundits have expressed an expectation of continued volatility throughout 2019. And, while many are projecting a robust 2019 IPO market with late stage unicorns such as Uber, Lyft, Pinterest, and Slack all reportedly preparing for IPOs in the first half of 2019, suitable IPO windows will close quickly if market volatility resumes. If this occurs, it would continue a growing trend of companies staying private longer (the median time to IPO in the late 90s was ~3.0 years compared to ~7.5+ years today, underscoring the growing importance of a robust secondary market for private assets).
This trend is particularly pervasive for market leaders, especially in the technology sector. Compared with traditional technology bellwethers such as Intel, which went public 2 years after its incorporation (Amazon (3 years), Apple (4 years), and Cisco (5 years) all followed a similar timeline to IPO), today’s private market leaders have increasingly chosen to remain private for extended periods of time (SpaceX (17 years), Palantir (14 years), Airbnb (11 years), Uber (10 years), WeWork and Stripe (9 years), and Lyft (7 years)). In a recent BlackRock survey of 230 institutional clients who represent over $7 trillion in assets collectively, more than 50% plan to decrease public equity exposure and reallocate into the private market while citing public market volatility. As more value accrues in the private markets, we’ve seen institutional investors move downstream with asset managers and hedge funds raising private market vehicles for the first time. With new investment vehicles deploying more capital into private markets and companies choosing to stay private longer, a continuation of this trend at this late stage in the cycle will only further highlight the importance of smart securities.
Custody or “Good Control” Locations Will Spur Institutional Flows
Questions regarding the custody of digitized securities will continue to represent a gating factor for many participants eager to enter the smart securities space. We believe, however, that few market participants truly understand that a “custody” solution is not a required element for the issuance and trading of private unregistered securities. The SEC’s rules and requirements around custody, are, in fact, currently applicable only to publicly registered securities. Despite this fact, the SEC and FINRA are questioning potential market participants on how they intend to provide custody solutions around private unregistered digitized securities, creating a good deal of uncertainty and confusion.
In our view, the anticipated high degree of tradability of digitized securities along with institutional demand for “good control” will drive the need to develop a custody solution for private, unregistered digitized securities that will be a key piece of the new market infrastructure being developed around these assets. In our opinion, a well-developed market infrastructure, combined with access to private, permissioned liquidity provided in a transparent and immutable manner, will result in growing acceptance across a wide range of issuers and investors. Institutional capital, bound by fiduciary obligation, will find comfort in the increased levels of security, process and certainty afforded by private, permissioned blockchains.
Increased Activity on The Hill
The rise and fall of the crypto markets and the problematic practices associated with the ICO space over the past few years has resulted in increased awareness and focus on the digital asset industry from Congressional leaders. While there is a recognition that this new asset class is not going away, legislators will continue to grapple with the question of how to best harness this innovative technology so the United States can remain competitive, while also providing important investor protections. This will provide a real opportunity for bipartisan collaboration, particularly around legislation separating utility tokens from digitized securities issued on a private, permissioned blockchain solution. We’ve already seen early evidence of this approach with the proposed “Token Taxonomy Act of 2018,” which attempts to define the term “digital token” and to specify cryptocurrencies like Bitcoin and Ethereum would not be subject to SEC-purview once they become a fully functioning network. This bipartisan bill sponsored by Reps. Darren Soto, R-Ohio, and Warren Davidson, D-Fla, is the first of what will likely be a number of attempts in 2019 to provide legislative clarity around digitized securities and areas where blockchain technology can add efficiency to our existing public market infrastructure, such as proxy voting. The Congressional Blockchain Caucus, led by Congressmen Schweikert, Foster, and Emmer, is likely to increase its activity around these topics as well, leading to meaningful engagement from House Banking Committee Chairwoman Waters and Ranking Member McHenry.
Issuance of Critical SEC Guidance
In 2019, the SEC will continue to provide guidance around the issuance and trading of digitized securities, balancing their aim to not stifle innovative technologies in the securities markets against important investor protections. Additionally, the SEC will continue to use a combination of enforcement actions, investor bulletins and public speaking engagements as methods to “regulate” the digital asset industry. We also anticipate that the SEC will deliver more complete guidance, encouraged by a growing number of letters authored by congressmen and congresswomen, on what types of digital assets are securities, providing clarity on requirements for post-trade functions such as clearing and settlement, and proposing appropriate changes to the rules for qualified custodians. We believe that specific guidance and clear rules and regulations are critical to providing more certainty for issuers, investors and service providers in the digital asset space, enabling significant growth and potentially unlocking tremendous value.
Additional FINRA Exams
Lastly, we believe that digital assets that are securities present unique regulatory challenges that cannot only be addressed by tailored regulation. As the use of blockchain technology in the financial services industry continues to grow in 2019, along with the issuance and trading of digitized securities, we expect to see the development of best trading practices across the space. In light of these developments, we expect that FINRA will integrate the trading of digital assets into its exam modules for market participants who intend to engage in such activities. As with other specialized examinations for specific trading topics, such as the Series 26 Investment Company and Variable Contracts Products Principal Exam and the Series 31 Futures Managed Funds Exam, trading of digital assets requires specialized knowledge in order to be conducted in a compliant manner. This includes an understanding of blockchain technology, its uses and potential risks, as well as regulatory frameworks for different types of assets. As with our other predictions for 2019, we believe that the addition of information regarding the sale and secondary trading of digital assets during FINRA exams will demonstrate the significant progress the digital asset industry has made since the ICO boom days of 2017. Ultimately, this will lead to new levels of engagement and participation from institutions, as well as better protections and certainty for investors.