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19/04/2019

Three years ago, SGSS published its first Blockchain magazine. This was a few months after a major report had been published on the changes that blockchain technology would bring to financial markets, reducing the need for reconciliations and bringing many billions of annual savings* to the financial industry.

At the time, SGSS’ conclusions were that the Distributed Ledger Technology introduced by the Bitcoin could be a fit for a public decentralised ungoverned currency and that it would require several evolutions to become fit for the financial markets. Firstly, the scalability issue to process the volume, secondly the confidentiality issue to keep transactions private, and thirdly the regulation and governance issue to offer the same level of protection as current markets.

SO MANY ICOS, SO LITTLE ECONOMIC IMPACT

The past three years have seen the launch of thousands of cryptocurrencies, often through an Initial Coin Offering (ICO) process.

Andy Warhol famouslysaid: “in the future, everyone will be world-famous for 15 minutes”2;

it is now possible to create a cryptocurrency in 15 minutes and possibly become famous. However, cryptocurrency issues have generated little interest from regulators because of their relative small size compared to the global economy. The global value of cryptocurrencies is around 250 billion euros3. Just taking the euro currency alone, its fiduciary4 value is 40 times larger5 and there are other legal tenders like the American dollar, British pound, Swiss franc, and Japanese yen with a large supply. Cryptocurrencies do not currently represent a systemic risk for central banks at this stage. However, the introduction of Libra, the cryptocurrency announced Facebook, a company which claims over two billions of users, may encourage central banks to react6.

FROM COIN TO TOKEN

Inceptors of cryptocurrencies have tried to improve the technology to overcome the three main issues: scalability, confidentiality and compliance.

In financial services, most initiatives have, in various ways, reduced their scope to private, permissioned and partially recentralised technology to progress in the digital representation of assets without having to solve the three issues by technological improvements.

Financial regulators are being pragmatic, authorising issues on a case-by-case basis or on a sandbox basis.

The interest has now shifted from coin to token. From an initially complex taxonomy of tokens, only three are really kept in focus in financial services: currencies7, utilities8 and securities9.

Focusing on securities, security tokens have a clear issuer, which is not the case for bitcoin. This is why regulators want to apply and can apply existing securities regulations to the issuers of securities tokens.

In Europe, regulators are making a clear distinction between securities and financial instruments, because they are subject to different regulatory frameworks.

A major buzzword is Security Token Offering (STO). There are solutions available today to issue and maintain a registry of holders for bonds, equities or funds. The next challenges will be the ability to manage corporate events and to organise efficient secondary markets.

INTO THE TOKEN WORLD

As operators see it, a digital representation of assets allows a better circulation of assets, what they call a greater velocity, the capacity to exchange assets almost immediately.

Taking a real estate example, buying a property takes weeks. Buying tokens representing shares of a company holding a property would take only minutes. Furthermore, if the token is properly designed, it could take little time to bundle this property with another one or, on the contrary, to split it into parts. In other words, securitisation and stripping made easy.

In these transactions, the trading, the settlement and subsequently the safekeeping of the representation of the asset could be done at once. Such immediate processing would require the use of a standard unit of account linked to one of the main existing currencies, and this is the reason why there is such enthusiasm for stable coins10  to use them at exchanges or at registries.

This is probably the reason why JP Morgan announced in February 2019 it will issue its stable coin during summer 2019. The current understanding is the holder of the JPM coin will face a JP Morgan risk. There are ways to launch stable coins with a better credit risk.

BACK TO THE REAL WORLD

Issuers and investors need to know and apply the requirements of all applicable laws, regulations and tax systems from their own country. This includes identifying counterparties (KYC), checking the origin of funds (AML), making declarations of threshold crossings, checking foreign ownership restriction, as well as reporting capital gains, or even withholding tax. All these rules (and others) apply to security tokens too.

Considering the number of initiatives relating to securities tokens, these new digital markets should stay fragmented for several years before a cross-chain of integration is built or before a leading platform emerges. In the meantime, many investors will rely on trusted intermediaries to provide a single interface for all these chains, convert cash to and from these chains, to safeguard the keys to access them or even hold tokens.

Imagining this world of digitisation is quite easy. Guaranteeing the reality of the assets represented by the tokens, and possibly the condition of these assets, understanding the applicable rules or assessing the fairness of a joint ownership agreement, or applying taxes, would be services required by issuers and investors from trusted intermediaries.

ONE STEP AT A TIME

Just like AI, DLT is already having an impact on the financial industry.

The current EU infrastructures with RM, MTF, OTF, CCP, T2S, CSD and Target211 have a proven reliability record for issuing and exchanging safely securities leveraging regulated intermediaries. These infrastructures may be able to reduce their turnaround time and extend the types of assets they list.

On the token side, providing that law, regulation and tax requirements are met, granting direct access to retail that are holding 30% of securities will first be an education issue but it might bring an incredible efficiency for other types of assets like non-listed securities or real estate.

The financial markets may witness a race between the existing technologies which need to gain in agility and the new technologies which need to gain in credibility.

THEY ALWAYS SAY TIME CHANGES THINGS, BUT YOU
ACTUALLY HAVE TO CHANGE THEM YOURSELF - Andy Warhol

 

(*) Profiles in Innovation Blockchain by Goldman Sachs in May 2016, p. 5.
2. ‘How to create your OWN cryptocurrency in 15 minutes, https://www.youtube.com/watch?v=d5EipPVafsA
3. 266 billion euro market capitalisation for all cryptocurrencies on 1 July 2019 according to https://coinmarketcap.com/fr/all/views/all/
4. In this context, fiduciary money means banknotes and coins.

5. https://www.bloomberg.com/news/articles/2019-06-18/better-than-bitcoin-facebook-unveils-libra-cryptocurrency
6. Banknotes and coins represent €1,034 billion, and total euros in circulation account for €11,618 billion
7. A token that is a store value and a medium of exchange, not issued by a central bank.
8. A token linked to a network or to an issuer to fund a project and later gives right to goods or services.
9. A token behaving like a security with holders regarded as owners.
10. There are different definitions for stable coin. Here it means a unit pegged to a legal tender on which the credit risk is as almost as good as the corresponding Central Bank risk and better than commercial bank risk.
11. RM: Regulated Market, MTF: multi Trading Facility, OTF: Other Trading Facility, CCP: central clearing counterparty, T2S: Target 2-Securities, CSD: Central Securities Depositary, T2: Target 2