From Overstock to Issuing Stock: Taking on Asset and Securities Distribution on the Blockchain

Issuing Securities on the Blockchain

While the ability for businesses to distribute assets and securities through blockchain technologies has been around for some months, recently this innovation has achieved greater focus following Patrick Byrne’s comments that Overstock is looking to distribute stocks using digital asset technologies. On October 6, 2014, at the recent Inside Bitcoins conference in Las Vegas, Byrne announced that Overstock will utilize Counterparty (a peer-to-peer financial platform built on top of the Bitcoin blockchain) to do just that.

While technically feasible, there are a few things that Counterparty, or really any protocol, will most likely need to address in order for such a solution to be accepted by the broader financial services industry. A few of these issues are covered below, however there are no doubt many more: while a hugely promising application of a blockchain, implementation of this solution is not straightforward, thus the Counterparty team may face significant legal and technical challenges.

Breadth of issue and identification

The first consideration is regulation on the breadth of issue. While there has not yet been any guidance released by securities regulators, in many ways current regulations can be extrapolated. One example is the breadth of issuance. In most jurisdictions there are regulations around how widely financial instruments may be distributed, and to whom, without certain disclosures or before a company must undergo an IPO.

Issuing debt or equity among a small number of known investors on a blockchain may not pose any significant problems, in the same way that a private contract among five business partners starting a partnership may be organized independently of a regulator. The issue, however, is that in their current form, most of these protocols have no way to stop one of the business partners from selling their share to 100 other miscellaneous parties or unaccredited investors, and consequently breaching securities regulations on the breadth of issue. While the legal duty of the initial security issuer to ensure the initial security holders met the requirements of qualified investors may have been met, the security issuer may be unable to differentiate between legitimate holders and the illegitimate holders in dividend distribution.

In short, the majority of these protocols do not allow entities to control the distribution of their securities. An inability to control the distribution will make it difficult for the issuer to keep track of certain regulatory obligations, particularly as they relate to private placements versus public offerings.

Consequently, the identification of owners of the assets will also be an important factor. Regulators will likely require a record of ownership tying blockchain addresses back to real world individuals or entities to not only manage distribution but to protect against financial crimes such as money laundering or market abuse. Counterparty may require off-blockchain services to manage such requirements: distributed application development platforms such as Ethereum may be able to code these directly into contracts.

Trading and block confirmation times

The timing of block confirmations also leads to some interesting considerations. A company that dual-lists on both a real-time stock exchange and allows for direct trading on a blockchain, even with Ethereum’s proposed 12 second confirmations, will allow the potential for front running. Such a delay is a lifetime in trading: through identifying offers and bids travelling through the network before they are confirmed and trading ahead on real-time exchanges, any blockchain trading would have a disadvantage over a real-time market. From a regulatory standpoint, if a trader cannot demonstrate that they achieved ‘best execution’ – that is, the best possible price for their client – they will avoid such a platform, and this will be difficult to achieve on a blockchain for the above reason. The inability to confirm that a transaction will be accepted in a particular block against a particular contract makes such demonstration of best execution even more difficult.

The blockchain – an incomplete solution?

This leads to what could be the most likely solution, off-blockchain processing. Services could match the buying and selling of securities in real- time, then use the blockchain to record ownership. Such services could reduce the risk of front running or trade execution issues.

Using the blockchain to record ownership, however, then has its own considerations. The trading behavior and holdings of traders and asset managers are usually considered proprietary knowledge; however an open, transparent blockchain publicly recording holdings makes such practices difficult without modifications. Therefore, services managing such holdings and orders may be requisite to ensure proprietary information is kept confidential while allowing the registration of ownership by a central regulatory authority.

Ultimately, with many of these proposals, it may come out that the blockchain is not a complete solution, which is why it is likely that there will always be middlemen. Hopefully, however, it will mean that this technology can reduce barriers to entry to allow many more services to develop.

 

Edited and posted with author’s permission from: http://bankingbytes.com/2014/10/12/issuing-securities-on-the-blockchain-a-few-thoughts/

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A software engineer and white hat hacker by background, Angus now serves as a Senior Manager in Ernst & Young’s Regulatory Compliance Technology practice in New York. While in this role he has worked across a number of aspects of regulatory compliance, over the last four years he has specialized in anti-money laundering remediations at top tier banks following regulatory consent orders and other action letters. Angus has worked on and led teams that have established industry leading AML practices in these banks, often requiring the development of customized technology and applications to address tactical and strategic compliance needs. In recent months, Angus has established EY’s cross-competency Digital Finance task force, which is researching how blockchain and consensus technologies may assist our financial services clients. Angus also serves on the Advisory Panel for LibraTax, the first comprehensive tax and accounting software solution for digital currencies.

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