A year ago talk about potential uses for the blockchain technology – which originated with the virtual currency Bitcoin – was mostly limited to hypothetical terms, typically used by dreamy-eyed pioneers at technology start-ups. How quickly things have changed.
As early as April major banks, including UBS and BNY Mellon, acknowledged the technology’s potential when they announced initiatives to explore blockchain uses. Eight months on, as we approach year-end, one of the biggest security-exchange companies anticipates customers starting to use its blockchain-based service to distribute shares of private companies. Indeed, it appears that corporate finance departments dealing with the many facets of corporate funding could end up being among the earliest beneficiaries of the technology.
“We’re offering the ability for companies to digitise what are now paper-based certificates and track more easily who owns company shares, giving them greater control over their capitalisation table,” says Fredrik Voss, vice president, blockchain innovation initiative at the US’s Nasdaq stock market.
While the Bitcoin currency has had its reputation sullied by a string of frauds impacting currency users, the technology powering it remains robust. That technology packages data into blocks – data representing currency transactions in the case of Bitcoin, although any computer code is possible – that it sequentially encrypts into a regularly updated electronic public ledger, which it shares among all participants in the network.
Since the ledger is shared by protocol applications on multiple servers, or nodes, and breaching the chain would require changing the majority of copies scattered across these nodes, the chain is viewed as immutable. That is especially as the number of nodes increases into the hundreds or many thousands – as is the case with Bitcoin.
The technology can also be applied to private networks – such as inside a large organisation – to secure and make more efficient internal transactions, or among the finite and known members of a group of organisations. Such applications will probably find first use in a capital markets context, in which blockchain technology appears likely to have a significantly disruptive impact.
In the pipeline
“As emergent technologies go, blockchain has the potential to be the blockbuster technology that could revolutionise the way the capital markets settle and clear transactions,” comment analysts Shagun Bali and Terry Roche of the New York-based researcher Tabb Group, in a November report entitled ‘Blockchain Technology: Pushing the Envelope in FinTech’.
The report adds, “A crypto-currency support technology, blockchain is emerging from behind the shadow of Bitcoin as the go-to investment technology within the capital markets.”
For example, the distributed ledger start-up R3 CEV – a project backed by 30 of the world’s largest banks – aims to create such a private network reduce costs by creating a shared ledger to reconcile inter-bank transactions. More imminent is the Linq service, which Nasdaq anticipates starting up by year-end. It will apply blockchain technology in a private network, to make the distribution and record-keeping of shares issued by private companies much more efficient and secure, and less costly.
Nasdaq is also working on applying the technology to the proxy voting process, initially in Estonia’s relatively small stock market that is already supported by the exchange company’s front- and back-office technology, with the intent of extending it to larger markets.
Another initiative benefiting corporates is tech firm Digital Asset Holding’s effort – in conjunction with several large banks – to introduce blockchain technology to the syndicated loan market by next spring. Also looking at corporate-friendly blockchain solutions is financial technology (fintech) firm Symbiont, which recently conducted its own share offering using its blockchain-enabled “smart contracts,” a technology it is further developing for other securities-related uses.
The companies that have signed on so far to Nasdaq’s Linq service, unsurprisingly, are technology-focused: ChangeTip, PeerNova, Synack, Tango and Vera.
Prakash Linga, chief technology officer (CTO) of Vera, a mobile and cloud data security company, believes that distributing shares of private companies is an arcane, paper-based process that can result in errors – if, for example, the same paper certificate is submitted twice – and can prove hard to track through a company’s life cycle.
“Our finance team was very excited to see this new technology, which from a single portal enables the distribution of shares to employees and tracking shares through events such as additional funding rounds or reverse option splits,” says Linga, adding that it will enable Vera to track the shares more easily should a secondary market for the shares emerge.
Linga says that the first markets employing blockchain technology will, almost certainly, be finite in size and currently heavily paper-based and so in more dire need of a solution that increases efficiency and reduces the risk of errors and fraud. Before it migrates to broader markets, he adds, several regulatory and legal issues will have to be resolved, and the industry will have to agree on a standard to authenticate users.
Tapping the potential
Nasdaq’s Voss notes that Linq will not be a trading platform, since private companies typically pre-determine who will receive the shares. However, the application will enable issuers and investors to track the transfer of shares and how they are impacted by corporate events. For existing shares, Nasdaq has mapped out the legal process to convert paper certificates into digital versions.
The data blocks are represented by computer-code hashes that are encrypted in the blockchain; in the case of Linq a brand new blockchain that uses the same distributed ledger protocol as Bitcoin – but without the Bitcoins themselves. Nasdaq developed the technology with fintech Chain.com and purposely made it agnostic. This gives it the ability to switch distributed ledger protocols, enabling it to offer services over both new blockchains and established ones, such as Ripple or Ethereum.
One initiative to apply blockchain technology to proxy voting is in Estonia, where the stock market from trade to settlement is more open-ended in terms of implementation, in part because it would engage a broader swathe of users. The intent there is to enable remote voting by shareholders and a solution for proxies to demonstrate they have fulfilled their obligations to investors.
Given that participants in these services will be sharing the same electronic ledger, the changes in ownership shares will be settled and visible immediately. Because they are encrypted into the blockchain that is continuously double checked by independent participants, they are immutable.
Terry Roche, Tabb Group’s head of fintech research, says that loan syndication, in which corporates’ large commercial loans are divided among multiple lenders, is currently almost entirely a manual process; using emails, spreadsheets and the phone it takes 20 days on average for the transactions to settle. “Block chain would seem to be a good use case to bring transparency to the market and a much shorter settlement time,” he says.
Digital Asset, headed by Blythe Masters, a former JP Morgan top executive who played a major role in the development of credit derivatives, declined interview requests.
Symbiont, a finch also seeking to develop blockchain solutions applicable to corporate finance departments, already distributed US$1.25m of its own shares in August using blockchain technology. Adam Krellenstein, co-founder of Symbiont as well as Counterparty, another blockchain-focused fintech, says that the firm’s smart contract technology can be applied to virtually any type of financial contract. The shared ledger should greatly simplify the reconciliation and settlement processes and reduces the need for intermediaries, slashing costs.
“Right now, there are independent clearing and settlement processes, but with smart securities [Symbiont’s trademark for its smart-contract technology supporting securities transactions] the trade, clearing and settlement processes are all one step, because the instruments are existing in a distributed ledger,” says Krellenstein. “You also have the records of all these transactions on one shared ledger, rather than multiple databases across different institutions, and that’s a massive improvement in terms of efficiency, security and transparency.
In addition, smart contracts essentially imbed the logic and current state of the securities in the blockchain, automating actions such as share splits and dividends that would otherwise have to be calculated manually.
“You can also automate, simplify and expand the functions of traditional back-office operations; for example, you can create a security with a coupon payment, and it will pay automatically, trustlessly, on the blockchain,” adds Krellenstein. “Smart contracts and blockchain are almost tailor made for the use cases we’re tackling: private equity [PE], syndicated loans and corporate debt.”
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