Stock market trading is moving to the blockchain and this trend is going to ultimately extend to a large range of assets, argues a new 94-page report by industry experts across the globe. We recently spoke with one of the report's lead authors and researchers, Demelza Hays, about the explosion in "security tokenization" and what this means for investors.
Here's what she had to say in a recent interview on FS Insider (see People Are Now Trading Stocks on the Blockchain and Eventually Everyone Will Be As Well for audio).
Benefits of Distributed Ledgers
The basic idea is that the advantages of trading based on blockchain technology are going to supplant traditional securities exchanges. A security token is a digital representation of an investment contract that is held on what's called a distributed ledger, Hays noted.
This allows a copy of an investment contract to be stored on many computers all around the world, preventing fraud and increasing security. Under the current systems in place, securities such as stocks and bonds are stored on a single server or a central clearing house.
A distributed ledger makes this central clearing house model obsolete, at least in theory. Of course, there are many hurdles and possible challenges to such a system, including regulatory issues.
One iteration of the idea envisions a system where two copies of an investment contract are created. One is held by a central clearing house for regulatory purposes, with a corresponding copy stored on a blockchain. The blockchain version is what would be traded, Hays stated, which would allow users to hold a private key that controls a wallet containing their stocks and bonds.
If the user wants to trade a security, they would find a buyer and complete the transaction directly, with the buyer sending payment in the form of stable coins, such as a dollar representation on the blockchain or some derivation of a centralized digital currency.
There are already several marketplaces that are licensed for people to trade tokenized securities and tokenized stocks, Hays noted.
“In the marketplace, we're seeing only one version trading, which is basically not backed up and people are taking on a lot of risk right now,” Hays said. “But over time, we foresee this to evolve into basically two copies — one for regulatory purposes, so that exchanges can comply with anti-money laundering and know-your-customer regulations, and so that users can benefit from blockchain technology when trading stocks.”
Innovation Drives Demand
Investors want some of the same features they enjoy when trading cryptocurrencies to be available when they exchange securities, Hays said. Investors want 24/7 access to markets. They want to be able to use their stocks as collateral for margin trading or loans.
They also want more transparency, for example in terms of the total number of shares in existence. Naked shorting can lead to inflation of the number of shares in existence, and investors want to know when this happens, which is possible when trading is done on the blockchain.
Additionally, there is a big push to go back to bearer instruments, where a third party is not needed to verify a transaction, Hays stated. Peer-to-peer technologies can address all of these concerns.
“There's a big push to go back towards that bearer instrument tradition,” Hays said. “Some investors want to embrace it, but other investors want to basically use some of the benefits of blockchain, but not all of them.”
Early adopters are bearing all the risk, currently, but these changes are inevitable, Hays stated. Regulation will play a role, and there is a large divergence in the approach that different countries are taking to address the security token market.
For example, China has outlawed security tokens for the time being. Several countries have taken similar approaches, with investment limited to those going through the traditional issuance process for a security.
That is the approach that the European Union took, Hays added. It announced a new law last year that basically requires MiFID II — the EU’s regulatory framework for securities trading — to apply to security tokens, limiting who can issue these tokens, giving regulators a better hold on the market as a whole.
A variety of models and approaches are likely to emerge, Hays stated, and there is no clear direction token-based securities exchanges will take. However, the shift is going to happen either way, she argues.
“Basically, where property rights are strong and the regulators are understanding and allow for innovation, that’s where the talent and the capital is going to flow overall,” Hays said. “Some markets are going to have innovation, and others are going to be stymied by the regulations. But I think the change is inevitable in the end. A decade from now, I do think a large portion of the securities will be tokenized.”
Demelza offered substantially more insights into trading stocks and securities on the blockchain in our recent interview with her on FS Insider. If you're not already a subscriber to our FS Insider podcast where we interview book authors, strategists and industry experts from across the globe 3 days/week on all things economics, finance and markets...
Written by Ethan D. Mizer