By Tristan Abisse, Analyst at Alpha FMC Luxembourg.
Mid-February, the Luxembourg Chamber of Deputies approved the Law Proposal 7363 aimed at authorizing the registration and trading of financial instruments on blockchain technology. This law proposal amends the security law and provides a legal framework to Security Tokens Offerings (STOs). Security tokens can create various opportunities for the financial industry to reduce operational costs and further expand services. These benefits may be achieved, provided that the blockchain technology can prove compliance with high investor protection standards and verification requirements.
An STO (Security Tokens Offering) is similar to the traditional approach of issuing shares, with the exception that the registration, issuance and trading of the security tokens happen on blockchain technology. An STO should not be confused with an ICO (Initial Coin Offering), an unregulated process to raise capital via issuance of utility tokens. STOs raise capital via the issuance of security tokens. The main difference is that security tokens must comply with securities law, as they share the same characteristics as standard securities (i.e. voting rights, dividends, etc.). Unlike ICOs, the legal framework creates a safer investment environment for potential investors which can benefit from the advantages of blockchain technology applied to financial instruments.
STOs and the blockchain technology have potential to disrupt and enhance trade and post-trade processes thanks to automation of necessary, but time-consuming tasks with low added-value.
• MARKET STRUCTURE HARMONISATION: Some blockchain protocols create a unique and shared environment governed by a common set of rules and managed by computer programs called smart contracts. This shared environment ensures that processes run with no friction and reduces human intervention to a minimum. Agreement between participants on a common set of rules enables harmonization of business processes and eliminates discrepancies.
• SETTLEMENT LIFECYCLE IMPROVEMENT: blockchain may facilitate the automation of some trading processes and shorten the settlement lifecycle thanks to a shared pool of information, instructions and reference data stored on the blockchain. Real-time access to trustworthy and up-to-date reference data ensures straight-through processing along the trade lifecycle. Consequently, trade and settlement processes that heavily rely on reference data, such as trade enrichment, would be faster and more cost-effective. Furthermore, a blockchain, as a unique source of information, removes the need for reconciliation between participants.
• POST-TRADE OPERATIONS AUTOMATION: Beyond trade and settlement, shareholders’ rights and corporate actions may also be handled automatically by smart contracts. A blockchain solution speaks for a higher level of transparency between participants, i.e. both organizations and investors may be provided with real-time information on each other. This benefit is even higher when considering a complex chain of holding. In this case, automation highly reduces the processing time and transparency provides investors with a better understanding of their holdings, which may improve shareholder engagement.
• INVESTMENT OPPORTUNITIES EXTENSION: STOs can represent ownership in either tangible or intangible assets and could consequently highly enhance investment possibilities in various new areas that are currently unknown or difficult to access for investors. As an example, future cash flows of a music album or movie could be tokenized into a security token and sold to investors. By doing so, tangible and intangibles assets are put on an equal step as a financial instrument. Consequently, an STO eases access to new investment opportunities and enables investment managers to define new investment strategies and further differentiate from each other with specific and dedicated expertise.
STOs and security tokens represent an alternative to traditional financial markets, but they rely on the same legal basis and requirements. Cost-reduction and faster processing via automation are key benefits for the financial industry. Considering regulatory topics, one can argue that security tokens represent sustainable solutions for improvement of the settlement discipline and shareholder engagement, respectively highlighted by CSDR and SRD II. However, various hurdles must be removed. Especially, social and further regulatory considerations are to be addressed and represent the greatest threats to the adoption of STOs.
• TOKEN ISSSUANCE STANDARDS INADEQUATION: A common standard within the crypto community for token issuance can hardly be applied as such to financial markets, provided that currently, the mostly used standard only requires the recipient's address and the transfer amount to send tokens. Requirements and processes for traditional securities provide investors with a much higher level of security regarding trading activities, settlement and safekeeping of their assets. While it is still unclear how the standard for issuing and trading security tokens will include the necessary requirements and verifications that apply to traditional securities, it is likely that advanced standards will rise in the future, with the objective to improve the security for trading of security tokens.
• COOPERATION COMPLEXITY: Usefulness of a blockchain solution for trading and settlement of security-like instruments highly rely on the network effect, where the marginal utility of each participant increases with the total number of participants. Therefore, STOs would reach maximum usefulness and benefits if most participants cooperate and agree on a path to follow. However, difficulties to harmonize views and processes also increase with the number of participants. A blockchain solution would require full cooperation and coordination of market participants to define a set of common rules all participants agree to follow.
• MARKET FRAGMENTATION: It is likely that each participant comes up with its own solution, resulting in a fragmented market of several organizations offering tokens issuance and providing a secondary market. Provided that each solution would be governed by different rules, where no interoperability link is available, benefits of STOs would be restricted in terms of process harmonization and automation, investment offering and market liquidity.
• PARTIAL COVERAGE OF THE TRADE LIFECYCLE: Benefits would only be maximized if applied to the entire trade lifecycle. Similarly, partial implementation of the technology to specific processes or tasks within the trade lifecycle would limit the benefits as the integration and connectivity with a centralized architecture may create frictions. Besides, the technology is relatively new and, despite the high potential for process improvement, may not immediately be as effective as current traditional processes. The absence of a viable cash leg on ledger remains a significant issue.
• SCALABILITY: If the network is expected to grow to maximize benefits of the blockchain technology, scalability of the network shall be ensured in order to process the growing amount of transaction and information. Otherwise, the blockchain could experience slowdowns or system disruptions.
Cooperation and agreement on a set of common rules and practices from major participants of the industry represents the hardest path toward adoption of security tokens, but also a more sustainable solution. Provided that market participants coordinate actions and as the technology matures, financial markets could drastically change in the coming years to achieve a higher level of automation. This change would result in the creation of new investment opportunities, higher market efficiency and more cost-efficient trade and post-trade processes.
Publié le 24 mai 2019