Blockchain technology was one of this year’s hottest buzzwords among stock market investors. Early in 2019, that technology could begin to reshape the stock market itself.
On Jan. 10, a tiny financial operation called tZero will introduce a quiet but significant change in the way slices of company ownership are bought and sold. Owned by Overstock.com (OSTK), tZero in October closed a $134 million private digital security token offering. In plain English, such tokens are blockchain-based digital securities, essentially coded investment contracts.
In January, the tokens will come available for trade on tZero’s own trading platform by institutions and affluent individuals that meet the SEC’s accredited investor standard. In August, the trading will open up to all investors. By the end of the year, Overstock CEO Patrick Byrne hopes to have as many as 60 blockchain-based security offerings underway on tZero.
The January launch of trading marks two critical early changes for the stock market. First, it appears it will be the first time an SEC-cleared digital security token will be traded via a public blockchain, the shared database technology known best as the foundation for bitcoin and other cryptocurrencies. Second, it is the start of an independent, secondary market where individual investors will be able to buy and sell private equities.
At least on the fringes, it means the bold line separating markets accessible to the public, like the New York Stock Exchange or Nasdaq, from the much more restricted private equity markets would begin to blur. More important, it spins the first wrenches in what could be a retooling of the behind-the-scenes plumbing that enables day-to-day stock market trades.
“It sounds almost too big to believe,” said Byrne of a potential blockchain stock market revolution. “But what we’re talking about is upending the nation’s capital markets and introducing a better mousetrap. It’s a better capital market.”
The Coming Blockchain Stock Market Transformation
The tZero offering was carefully groomed to meet emerging Securities and Exchange Commission rules on blockchain-related market activity. The company has worked hard to distance itself from the Wild West initial coin offerings, or ICOs, of 2017.
Byrne contends the tZero offering, once it starts to trade, “is the world’s first, properly SEC-kosher security token.”
The scale of the introduction fits the SEC’s aim to limit blockchain technology’s impact on the stock market to “incremental disruption.”
Blockchain is “a technology with the potential to transform, or at least greatly improve upon, the way in which securities are issued, transferred, tracked and regulated,” said Trevor Dodge, an attorney in the blockchain group at the Proskauer Rose law firm.
Byrne’s view is more expansive. He sees blockchain-based securities cracking the door to a change that ultimately will reshape global equity and financial markets.
Blockchain Stock Market Players
Stock market powerhouses Nasdaq (NDAQ), NYSE-owner Intercontinental Exchange (ICE) are among the early blockchain companies — each has poured millions into blockchain technology initiatives in the past several years.
ICE announced in August it was creating a federally regulated bitcoin market. ICE has reportedly spent more than $1.1 billion in 2018 to create a scalable, open platform that can handle digital assets of all kinds across global markets and commerce. That platform, named Bakkt and based in Atlanta, is set to launch as a bitcoin futures platform Jan. 24. It does not yet offer digital securities to the public.
Nasdaq has unveiled a steady stream of blockchain-based initiatives since diving into the technology in 2015. A Nasdaq spokesman says the company has “a number of (blockchain technology) use cases and successful tests completed.” Some have been released to the cloud, but only on a limited basis. All are, the spokesman says, “pending launch at this point.”
What Is Blockchain Technology?
At the most simple level, blockchain is a database innovation. It provides a shared public ledger where transactions are tracked, encrypted and transparent to all parties.
Sounds simple. But blockchain technology allows the distribution of ledgers to participants who can independently verify if, when and where a change is made to the database. That offers 100% visibility for participants, as well as regulators.
Every time something like a security token transaction is initiated, computers hustle to confirm that the order or deal fits into the chain of prior transactions for those accounts and that security. Once confirmed, the trade is completed. A new “block” is then added to the ledger’s database “chain.” Once added, blocks are unalterable.
Also called “distributed ledger” technology, blockchain comes in two basic formats: public and private. In a private blockchain, access is by permission only and transactions are verified by in-house computers or specific contractors. Public blockchains are typically open access; anyone can participate or read the chain’s information. Verification is computed by an essentially unlimited number of competing, independent operators, also called “volunteer” computers, or “nodes.” The computer that confirms the transaction first, earns a payment for its service. The others earn zilch — better luck next time around.
There are also permissioned public blockchains, which restrict access but retain the volunteer verification component.
SEC Guidance For Blockchain Technology
The early disruptive potential of blockchain technology flashed across investors’ screens during the cryptocurrency offerings of 2016 and 2017. The offerings raised billions of dollars in capital. Many of the currencies soared in value, then collapsed. Many were also found to have skirted regulations.
Byrne’s assessment of the ICO craze: “At least 50% of them were junk, and 90% of them broke the law,” he said.
At that point, Byrne and his companies were already deep into the tZero blockchain project. Byrne had taken a master’s degree from Cambridge University and a doctorate from Stanford, both in philosophy. He stepped into the CEO post at online retailer Overstock.com in 1999. The company had just crept above $1 million in annual revenue.
Overstock revenue was nearing $1.1 billion in 2012, when the company began to accept bitcoin as payment. Through tZero, Overstock began tinkering with its own crypto-securities. In 2015, it raised $5 million in a digital bond offering. The next year, it upped the stakes and received SEC permission for a $13 million offering. At the start of 2017, it launched the $134 million offering that would be delayed by the regulatory scramble amid the ICO blitz.
Alternative Trading Systems And Blockchain
The SEC has, for years, closely monitored and worked to manage the arrival and spread of blockchain technology. In July 2017, the commission released findings of an investigation into a cryptocurrency linked to “The DAO,” a decentralized autonomous organization that had existed only as a virtual entity.
The offering raised $150 million. The total value of the currency rose as high as $250 million. Then the blockchain was hacked. Reports later cited flaws in the design of the “smart contracts” underlying the digital tokens. In its efforts to protect investors and capital, The DAO dissolved. The SEC investigation, commonly called “The DAO Report,” determined the “currency” and its launch should have been handled as a security.
The report set out some clear guidelines in the differences between digital securities and cryptocurrencies. It also included “just a couple of lines which anyone in the industry will tell you have had tremendous impact,” said Dodge.
First, the report determined that parties trading blockchain-based tokens as securities must comply with securities laws. In addition, Dodge said, “If the tokens are securities, then anyone operating a trading platform or market for them needs to be registered as an exchange or operate under an exemption” as an alternative trading system, or ATS.
SEC compliance for an ATS is no small feat. Nor is it easy to earn the waiver that lets an ATS trade blockchain-based securities. The SEC currently lists 88 entities that have applied and met the requirements of an ATS. It does not say how many have earned the waiver permitting blockchain-based trade.
But so far, tZero-owned Pro Securities appears to be the only ATS with a waiver permitting trade in blockchain-based securities.
Blockchain Stock Market Disruption
Blockchain technology’s eventual impact on the overall stock market ecosystem seems, according to many industry watchers, limitless. But the early targets for blockchain stock market disruption focus on two areas: trade clearance and settlement, and private equities liquidity.
The private equities marketplace often has trouble mating buyers and sellers. In many cases, companies have reasons to stay private, explains Robert Greifeld, chairman of high-frequency trading firm Virtu Financial. But employees or early-stage investors who want to sell part of their stakes in the company can force a public offering.
A blockchain-based secondary market provides a possible solution for such companies, if they are willing to go the security token route. Greifeld was chairman and chief executive of Nasdaq at the time of its initial blockchain technology efforts in 2015. In October of that year, Nasdaq unveiled its Nasdaq Linq blockchain ledger technology to enable and track private securities transactions. That blockchain is private.
Public Blockchain And Digital Securities Tokens
TZero’s token release is on a fully public blockchain. Trades are effected over its Pro Securities alternative trading system. The high-speed Pro Securities platform itself is not based on blockchain technology, but it is set up to conduct trades in blockchain-based digital securities. In that way, it sidesteps a roadblock to an actual blockchain stock market — slow transaction processing speeds.
To buy the tZero tokens, for example, investors must go though a broker with Pro Securities access. They do not, however, need to use cryptocurrency to make the trades.
The clearing and settlement behind those trades are done using the Ethereum blockchain. A “blockchain agnostic” shop, tZero is constantly researching and testing other chains. On Tuesday, Dec. 19 Overstock’s Medici Ventures unit announced it took a 29% stake, for $3.6 million, in Chainstone Labs, a specialist in digital securities and decentralized asset management. That deal used the Ravencoin blockchain.
Ethereum earned high marks due to its support of smart contracts. Smart contracts — a key advantage of digital securities over traditional stocks — mean the tokens themselves can be programmed to perform an almost endless array of tasks.
In these early phases, they primarily handle tasks such as verification of parties and compliance with SEC rules and trading restrictions.
Blockchain Technology And Trade Settlement
It doesn’t sound like a lot, but that series of confirmations and verifications must occur to clear and settle each trade. It is the reason for the market’s current T+3 (trade + 3 days), or in some cases T+2, settlement times that leave investors waiting for funds to come available.
Blockchain technology collapses that time to almost nothing. Thus the name tZero, as well as the company motto: “The trade IS the settlement.”
Looking down the road, that change spells big change for select tiers of the stock market.
“Blockchain, properly implemented, eliminates the need for the trusted intermediary, which is, by definition, the clearing house,” Greifeld said. “That will happen.”
That puts Depository Trust & Clearing Corp., commonly known as DTCC, in the disrupter’s cross hairs. DTCC handles the clearing and settlement for most stock trades in the U.S.
A similar question mark hangs over Cede & Co. Cede is the custodial bank that technically owns all the shares of all the stock publicly issued over U.S. markets. Shareholders are not technically share owners; they are parties in a chain of contractual rights that ends with Cede.
Using blockchain technology, digital securities would remain in digital wallets. So the more new issues that trade digitally, the less the need for Cede to act as a repository and for DTCC to clear and settle.
“I wouldn’t be predicting the demise of DTCC. But they have a challenge, probably more acute than most,” Greifeld said. “As a legacy provider: how do they adapt and provide value in the new world?”
Cryptocurrency Vs. Digital Security
The stock market is no stranger to disruption. Beyond its periodic stock crashes, it has experienced its share of technology-based seizures.
But one of the examples used most to explain public blockchains’ potential impact on the stock market is not related to the stock market at all. It is Napster, the Internet-based peer-to-peer file-sharing service launched almost 20 years ago. Widely seen as a music-pirating service, it was quickly shut down by lawsuits and regulatory concerns. Yet it introduced a technology that has revolutionized how music is distributed and purchased.
The 2017 ICO blitz has been described as blockchain’s “Napster moment.” Investors and the media often focus on the scams, the hype and the losses suffered by over-optimistic cryptocurrency investors.
“What sometimes gets lost in that discussion is the unbelievable technology actually being applied that enabled small teams, sometimes with very little capital, to conduct a global offering of something that looked an awful lot like a security,” Dodge said.
The shift from cryptocurrencies to security tokens, Dodge said, “enables these tokens to act as representation for real world assets, including ownership rights and rights to a dividend stream from a company.”
TZero: Ready To Enlist Blockchain Companies
Byrne and tZero are more than ready to charge ahead. After the tZero token begins to trade, Byrne says privately owned electric auto maker Elio is preparing an equity offering over tZero. Next, the company has a pipeline of 60 other digital security offerings, he says. How long until they roll onto the market?
“I don’t even want to say all of (2019),” he said. “I would love it if they would happen faster than that.”
Also, tZero is launching a joint venture with Boston Options Exchange, which is one of 12 SEC-listed security exchanges which together comprise the National Market System network. The joint venture seeks to launch a marketplace able to deal in both public securities and digital tokens.
That would move direct trading of blockchain-based assets a step further onto public markets. And it would open tZero to listing stocks of publicly traded entities. Timeline for launch: late in the second quarter.
“It’s going to take years for someone else to make that step,” Byrne said.
If that barrier to entry holds, it could give tZero time to hit its early target of several thousand listings. That would potentially provide an early mover advantage similar to the early years for eBay (EBAY) in online commerce.
“I’m hoping to dominate the U.S., but I can tell you that people are pawing at us from around the world,” Byrne said. Eventually he sees tZero set up to operate in Singapore, India, and even Kazakhstan.
“It can democratize capital,” he said. “And I think it is going to open sort of a new era between investors and companies.”
Predictions For The Blockchain Stock Market Era
In the short term, Greifeld sees blockchain technology infringing on the clearance and settlement industry, as well as taking market share from trading instruments that suffer from liquidity issues.
“The less frequently (an instrument trades), the more likely they are to find their way into a blockchain-based trading system,” he said.
Further down the road, current hurdles such as trading speed challenges and other questions are bound to be resolved as the blockchain stock market revolution plays out.
“There will be people solving the performance aspects of blockchain a decade from now and opening it up to trade and clear just about anything,” Greifeld said.
Byrne looks at the picture from the side of public blockchains, and reflects back to Napster’s launch of peer-to-peer file sharing.
“That same architecture could create a peer-to-peer stock market, where you don’t even have stock exchanges and brokers,” he said.
But Byrne makes clear that the SEC has been consistent, in discussions with his company, in taking a moderating position on the rollout of the technology.
“They would prefer to see incremental disruption,” Byrne said, “because no one really knows where the hell this thing is going to go.”
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