Coming to Mainstream Capital Markets Sooner Than You Might Think

GUEST COLUMN

Most investor relations professionals are aware of cryptocurrencies like Bitcoin, have some familiarity with Blockchain and its underlying distributed ledger technology, and may have heard of an emergent new asset class called ‘digital assets’ or ‘crypto assets.’ Yet a majority of IROs dismiss the notion these will ever be part of mainstream capital markets, even while admitting to not fully understanding them.

There’s a lot to digest. This Blockchain technological universe, often referred to as “the Blockchain”, has spawned a new global industry and ecosystem. It consists of core technology infrastructure, tools and services companies, application developers, new digital asset products and funds, growing numbers of users and regulation – all evolving faster than most people realize. Growth is being driven by practical business reasons such as speed, efficiency, cost reduction and revenue opportunities, and the impact on capital markets and the IRO’s job could be significant.

The objective of this article is to provide the IRO with a better understanding of digital assets and the Blockchain, current industry developments in finance, and what to expect in the future, including how this might alter the job of investor relations.

Introduction to a Digitized Value and Decentralized Trust

Digital assets, based on the Blockchain, are ushering in a new way of issuing, owning, trading, settling, storing and regulating – not just assets and other financial instruments – but anything of value. This is the architectural underpinning of a better capital market system with new infrastructure that is digital first or ‘digitally native’, and not refashioned from old technology, or based on a paper share certificate era. The transformative impact of the Blockchain is often compared to the advent of the Internet and has been coined the ‘Internet of Value’.

The Blockchain is a distributed (over many computers or nodes), peer to peer (or person to person) computer network that provides an easily accessible, transparent to everyone, immutable (once recorded it cannot be changed) and secure digital ledger that offers ‘decentralized trust’. Using cryptographic methods, trust between two transacting parties that do not know each other is built in. In addition, logic can be programmed right into the computer code, to create a financial agreement between two parties, for example. It is not hard to see why these game-changing properties can dramatically reduce friction and costs in finance and many other industries. This has the power to streamline or reduce the roles of centralized trusted intermediaries we rely on today, from banks to credit card companies to real estate agents and lawyers.

Tokenization of Assets and the Future of Investor Relations

This leads to the ability to ‘tokenize’ assets that are created and stored on a blockchain, into a truly digital, efficient, and more liquid form. A Security Token Offering or STO, may be superior to the traditional IPO as a way to raise capital and manage investors, and provides more democratized access to smaller company issuers, and fractionalized ownership for investors all over the world. The STO offers process advantages including easy access, more streamlined operations, cost elimination, 24-hour availability and faster transactions and settlements. We can flatten the layers and intermediaries that weigh down our current system, as this technology enables regulation, such as accredited investor exemptions and KYC (Know Your Client) and disclosure documents and reporting, to be hard-coded right into a security offering.

Investor relations professionals may have their jobs transformed as regulated security tokens become commonplace. The most obvious change is administration and the elimination of intermediaries such as trust, transfer and registrar services. As multi-jurisdiction regulation will be baked into a security offering’s code, this will simplify and streamline issuing and ongoing disclosure, as well as automate dividends, voting and shareholder identification. Communications with shareholders will be modernized and direct, but there may be many more investors, particularly retail, from all over the world – trading 24/7 at many crypto exchanges. IROs will need more sophisticated digital marketing practices and outreach. There may be more roles for IROs, as private companies will find it easier to tap public markets, and public companies will seek opportunities to tokenize their existing assets to fund specific initiatives or divisions and expand their investor base while reaping cost and process efficiencies.

The Small and Large Companies at the Forefront

Building the groundwork of this new industry, including the core tools and infrastructure layers, are a new breed of hundreds of agile companies and tens of thousands of open-source platform developers. The Blockchain industry, and even its cultural ethos, favours decentralization rather than the centralized traditional business structures. This can obfuscate the sheer magnitude of ongoing global development activity by some of the brightest minds in technology. These companies tend to be both international and virtual in their operations; it is not unusual to find a five-person team located in three different countries and time zones. Their usual busy schedules of international industry conferences where collaboration and learning happen have easily shifted from in-person to online. Consensus, normally held in May in New York, is one of the largest and most important of these conferences; this year it was virtually attended by almost 15,000 people. This points to the high resiliency these companies have in their ability to survive the pandemic and economic cycles.

Large, well-known financial institutions, including Canadian banks, have had teams exploring blockchain use cases and developing new commercial offerings since at least 2015. According to Greenwich Associates, international banks poured US$1.7 billion into development and distributed ledger blockchain technology in 2018. Regulators, including the SEC, are well into their self-education journey and are preparing for future regulatory frameworks, aided by a number of local and international industry groups like the Digital Chamber of Commerce.

The Beginnings of Bitcoin and Blockchain

The dawn of Blockchain came during the financial crash of 2008, ironically when trust in the financial system had eroded. Satoshi Nakamoto, a pseudonym for a person or a group of people, published a white paper outlining a new, open and decentralized digital currency called Bitcoin. It uses Blockchain and distributed ledger technology primarily as a way to move the currency from one point/person to another, and cryptography that is secured across a wide network of computers, rather than being secured or controlled by a single entity. A bitcoin (BTC) was worth only a fraction of a penny at inception before reaching a value of US$0.12 in 2010, then advancing to US$31 in 2011. Price fluctuations have ensued over its 12-year history, leading to a current 52-week high of US$12,669 and low of US$5,017.

Bitcoin is like a global monetary system controlled by a clever and democratic consensus system. There is a limited supply of 21 million bitcoins, issued according to an organized schedule set in the original white paper and also in the source code, until all coins are in full circulation in 2140. Unlike fiat currencies (government issued), where the government can decide when to print new money, Bitcoin has built-in scarcity and inflation controls. It incents ‘miners’ (people or companies operating computer server warehouses) to secure the network, process and validate transactions, and mint new coins. Bitcoin captured everyone’s attention in the early days; it represented the idea of 'digital money', a hot topic since the birth of the Internet. But it was the underlying Blockchain that later grabbed the spotlight as the more important invention and largely fuelled industry development that followed.

Blockchain is a sequential digital chain of ‘blocks’ hooked together in an ongoing chain with transactions and record keeping information inside. The public blockchain is open and available to everyone, whereas private blockchains require permission to use. Blockchain provides a debt/credit ledger of a transaction using a digital signature, not a name, and other information such as date and time. To simplify how this physically works: there are many transactions in one block and these transactions get validated by many nodes or computers (operated by miners) that compete to solve a mathematical problem and then get rewarded in cryptocurrency for providing the validation. The distributed design of the network makes it secure from hackers as there is no central point or server to hack. In addition, the network has built-in economic penalties that control the activities of miners.

The Arrival of Ethereum and Smart Contracts

In 2014, a significant development was the launch of Ethereum, which enhanced the Blockchain’s usefulness by adding logic that enabled a host of digital asset and finance applications. Ethereum is an open-source blockchain development platform fuelled by a currency called Ether (ETH) that acts as a medium of incentive and a form of payment for network participants. It provides a ‘smart contract’, enabling logic or a set of instructions to be programed on top of a blockchain network for agreements, like issuing a security token for an investment contract. Ethereum is the largest platform for ‘dapps’ or distributed applications in finance.

Canadians played a large role in Ethereum’s development as Toronto was an early Blockchain hub. Ethereum was proposed and developed by 20-year-old Vitalic Buterin and a group of others in Toronto. They went on to raise US$18 million to cofound a Switzerland-based not-for-profit called Ethereum Foundation, dedicated to promoting the development and use of the software platform. More than 200 companies – among them Scotiabank, National Bank, BNY Mellon, Microsoft, Deloitte, Broadridge, Accenture and Samsung – have joined the Enterprise Alliance of Ethereum users.

With smart contracts enabling investment agreements, came the ‘wild west days’ of the Initial Coin Offering (ICO), starting in late 2016. Enterprising entrepreneurs now had the ability to easily raise capital through ‘crowdfunding’ for a project or company, by simply describing it in a white paper and launching an ICO to the world. Anyone with cryptocurrency could instantly transfer funds and become an investor; there were projects that raised over US$30 million in minutes.

In 2017 and 2018, more than US$6 billion was raised in ICOs, but most were unregistered securities, risky investment propositions or even scams, and enforcement action followed. In December 2017, in the middle of this mania, the price of BTC advanced to its all time high of US$19,340; it was like the world woke up to digital assets and this went from a fringe topic to mainstream news. While enforcement action largely ended the ICO practice by the end of 2018, and the price of BTC slid to a low of about US$3,191, the industry has continued grow.

Scattered in the ICO issuers mix are many legitimate companies, which today are still engaged in core development of the blockchain economy. These include – in addition to Ethereum – NEO, Polkadot, tZero, SingularityNET, Filecoin and many others. The newer entrants are likely to be private or venture capital funded companies, keenly watching future advancement in security token funding opportunities and regulation.

We are currently in the post-ICO era of the regulated Security Tokens Offering (STO). These are being pursued by many companies right now, they are being studied by regulators, and the industry infrastructure buildout of custody, controls and platforms is continuing to mature. STOs are legal in the U.S., via crowdfunded vehicles, for raising up to US$50 million. Europe has new prospectus regulations for STO public offerings of up to EUR$8 million.

In Canada, Tokenfunder and Zed Network are two of the first companies to receive exempt relief from prospectus and dealer registration to offer distribution of digital tokens on a blockchain under the CSA Regulatory Sandbox. Canadian-based company Blockstation has worked with the Jamaica Stock Exchange; enabling it to be one of the first to launch digital currency trading and STOs for all market participants on a regulated exchange.  

Digital Assets Today and Developments to Watch

Bitcoin is considered a currency by the SEC, the precedent setting regulator, but it, like the OSC, has not yet finalized regulatory frameworks. Bitcoin is also considered a store of value or investment, a payment network, an asset class, and a commodity by the CRA for tax purposes. Bitcoin is the most widely accepted digital asset by investors, with an early May 2020 market cap of approximately US$170 billion, trading at a price of about US$9,300 per BTC. While this might sound expensive, trades and transactions can take place in any fractional quantity. The next biggest digital asset by market cap is Ethereum’s Ether, or ETH, at US$23 billion, followed by eight other coins such as Litecoin, Tether, XRP and EOS, which together make up approximately 85% of a US$250 billion digital asset marketplace as of early May 2020. There are at least 3,000 other traded cryptocurrencies, but many have very small values. Coinmarketcap is regarded as the price authority of the crypto world and lists trading information for the major traded digital assets and exchanges.

Who are the holders and traders of digital assets? Historically, the answer has been largely retail investors/individuals. Over the last few years, a growing list of hedge funds, venture capital investors, family offices, endowments and other private investors have stepped in and this list keeps growing. According to Statista, there are 42 million Bitcoin wallet users globally, including 7.4 million actively doing regular transactions/trades. It is also estimated that 5% of all Americans own Bitcoin and Millennials (18-to-34-year-olds) is the largest age group demographic, followed by 35-to-44-year-olds.

The Crypto Exchange World and On-ramps

Bitcoin and other major cryptocurrencies can be easily purchased through an online crypto exchange that provides a fiat dollar to crypto on-ramp and offers a simple exchange of currencies, or may also offer a full traders user interface with price discovery. In Canada, these operate as regulated money service businesses, providing Bitcoin and major coins that can be bought using Interac e-transfer. Here is a list of local and international exchanges that Canadians may use with some comparative research. At a minimum, users should have a wallet app on their phone or computer to hold their coins and store their private keys, which are alphanumeric character sequences.

The largest crypto exchanges in the world include U.S.-based Coinbase, with 35 million users, and Malta-based Binance, with 15 million users. Average daily trading volume for Binance in 2019 was reported to be US$2B. There are more than 200 and possibly closer to 500 global cryptocurrency exchanges. Soon we will see familiar lines blurred as crypto exchanges apply to become regulated exchanges, and traditional stock exchanges explore offering digital assets and regulated security tokens. All of our Canadian regulated exchanges, like their international peers, are exploring blockchain technology for back office applications such as faster settlements, and are looking at other opportunities to meet growing marketplace demands for digital assets, with an eye on regulatory status.

The Road to Institutional Adoption

All Canadian banks are researching blockchain technology, building/piloting use cases or working on launching applications to improve areas of their business. They are looking at business opportunities to derive benefit from a digital asset future, such as creating their own token, as JP Morgan did, to lower costs and create more efficient institutional client payments. Many companies have formed international consortiums, collectively working on leveraging blockchain initiatives. More than 300 companies are part of the R3 consortium, an open platform for blockchain development in finance and multiple industries. Since 2012, Ripple has been working to improve global payments, creating a better SWIFT network, utilizing its blockchain network and XRP coin, with more than 300 financial institutions participating.

Increasing numbers of Fortune 500 companies are launching major digital asset initiatives, embolden by institutional-grade infrastructure and traditional risk-management practices entering the space. They want to leverage new revenue and customer loyalty benefits. Facebook has formed a decentralized consortium to offer the Libre token, digital payments and a digital wallet to its 2.4 billion active users. While the consortium has encountered pushback, including some original members dropping out, this initiative continues to move forward. A former senior U.S. Treasury and HSBC executive is the new CEO and the partnership still includes Shopify, Uber, eBay, and Spotify, among others. Fidelity, State Street and other trusted traditional institutions now offer third-party custody solutions and offline storage for digital assets. They join crypto industry custody companies like Bitgo and Xapo. Lloyds of London and AON provide digital asset insurance in a market expected to generate premiums worth US$1billion in the next 5-to-10 years.

New digital asset markets and funds have arrived, indicative of any early stage but maturing asset class. Futures markets for Bitcoin are offered through the CME (Chicago Mercantile Exchange), and ICE (Intercontinental Exchange) through its innovative new company, Bakkt, with constantly growing trading volumes. CME recorded US$1 billion in daily trading volume of Bitcoin futures earlier this year. Grayscale is a U.S. digital asset fund manager that recently reached US$3.7 billion under management in mostly Bitcoin Trust funds. It trades over the counter and is the first digital currency investment vehicle to be an SEC reporting company. Fund managers at VanEck want to issue a digital asset ETF to give mainstream investors more convenient exposure to Bitcoin; they and other fund managers have applied multiple times for SEC approval but the SEC continues to evaluate. In Canada, fund manager 3IQ finally received OSC approval and listed its close-ended Bitcoin fund for retail investors on the TSX in May, raising $14 million.

The Advent of DeFi and Stablecoins

DeFi, or Decentralized Finance (sometimes called ‘open finance’) is a growing and important trend using smart contract ecosystems like Ethereum to provide more complex financial operations and new products. DeFi represents a shift from a centralized and closed financial system to a more universally accessible economy based on open protocols that are global, interoperable, programmable and composable – like interchangeable Lego blocks – and require only a smartphone or the Internet to participate. A host of innovative companies are working on new products and services in the DeFi area.

Decentralized borrowing, lending and offering interest on Bitcoin holdings are available from companies like MakerDAO and Compound. Digital asset lending, both decentralized and centralized (using in-house risk management procedures), now exceeds US$10 billion in total loan origination value since it started in Q4 2017, according to industry analyst Credmark.

Nexus Mutual plans to replace insurance companies by offering a decentralized risk-sharing platform funded by members, who decide on risk level and insurance policies underwritten through a tokenized mutual model. Completely decentralized exchanges, or DEXs, such as Ox and Uniswap, offer instant trading and automated market making. An interesting new area is prediction markets, where participants can instantly create a market – and potentially realize a profit – from betting on a future event, like a stock price or the outcome of an election. This is offered by upstart companies like Augur and Gnosis.

An area of growth related to the DeFi world is stablecoins. This includes the QCAD stablecoin recently launched in Canada. Stablecoins are collateralized and pegged 1:1 to a stable asset such as the dollar or gold. For traders, it is easier and less expensive to switch from a cryptocurrency to a stablecoin to ride out periods of volatility rather than convert to dollars and back again, incurring high exchange conversion fees. Stablecoins also are attracting the interest of governments (including Canada) and central banks around the world, as they consider the viability of a digital asset representation of a sovereign currency.

Regulatory Status and Developments

More regulatory clarity is needed and progress toward this is underway all over the world. Today we have a global patchwork of countries, such as Japan and Singapore, which look favourably on digital currencies and have legalized them. Others, such as Canada, the U.S. and a number of European countries, are regarded as favourably disposed towards owning digital currencies but have incomplete or inconsistent regulations with respect to their use. Countries such as India and China currently ban digital assets but not Blockchain use.

Ontario offers a regulatory sandbox in which companies engaged in digital assets trading, investing or advice can operate by registering with the OSC. Crypto exchanges operate as legal money service businesses (MSB) and must register through FINTRAC.  IIROC recently formed a crypto-asset working group focused on developing a regulatory framework for its broker-dealers and exchange members. The CSA has asked for industry input to a consultation paper and published results last year, but regulatory clarity is still a work in progress. AML (Anti-Money Laundering) and KYC (Know Your Client) compliance practices are a requirement for crypto exchange MSBs.

Outstanding Industry Issues to Solve

Some key issues will need to be addressed as this industry matures, and the work of providing solutions will be led by its legions of clever entrepreneurs, developers and industry professionals. Among these issues are the excessive energy consumption of mining operations, long transaction timeframes (e.g. 15 seconds in an ETH network transaction and 10 minutes or more for BTC) that limit use cases requiring speed like point of sale purchases, and bad actors using cryptocurrencies to evade law enforcement.

Excessive energy consumption of mining is a thorny issue, but Ethereum and other blockchains are switching from proof-of-work to less computationally intense proof-of-stake and this will help. These are mechanisms used for confirming validation of a mining transaction and generating a new block in the chain. Also, wind and solar powered mining operations are gaining increasing interest and use and will alleviate some of the energy use concerns.

The Lightning Network, first proposed in 2015, has teams working on adding an overlay to speed up blockchain-based payment networks to boost scalability to meet future demand. This would solve the problem of instantly buying your morning coffee using Bitcoin. We may see this soon as Starbucks is currently testing mobile apps and cryptocurrency payments through its partnership with Bakkt.

Blockchain networks such as Bitcoin are not perfect havens for criminals and illicit behaviour, contrary to what many people think. All coins from time of minting, and all transactions and wallets, can be tracked by their alphanumeric identifiers; this puts criminals at a disadvantage. Also, as the use of data analytics and artificial intelligence increases, it will be easier to follow the trail and match data to criminals. There are many analytics companies, such as Elliptic that have been helping law enforcement with this since 2013.

Laying the Groundwork for Growth and IR Leadership

At the end of the day, financial services companies view these innovations through a lens of revenue generation, cost reduction, acceptable risk management and compliance. Digital Assets and blockchain distributed ledger technology are clearly ticking the boxes on the way to mainstream and wider adoption.

Blockchain application spending by global banks and financial services firms has been growing by up to 118% per year since 2017 and reached US$2 billion last year; this total is expected to grow to US$31 billion by 2025, according to UK analyst firm Research and Markets. An R3 Conference survey in late 2019, which included 100 financial services professionals from 50 major international companies active in digital assets, indicated that they plan to have new products and services in the market over the next five years.

IROs should take an active interest in the transformational forces of the Blockchain, digital asset tokenization and product advancements, to arm themselves with the understanding their future job and industry may require. Some good educational sources to keep up-to-date include Coindesk and Cointelegraph, two of the most widely read online industry news publications. Security Token Academy offers a newsletter and video content covering the evolution of the security token industry. Anthony Pompliano has a popular podcast on business, finance and Bitcoin. And Fortune magazine’s The Ledger is an informative newsletter covering latest developments in cryptocurrency.

It is time to dig in and embrace these innovations, as mainstream institutional adoption and regulatory clarity increases. There is a new generation of millennials and millennial investors who have ‘grown up digital’. They view digital assets, the idea of digital money, and even decentralized and virtual business structures quite differently. IROs need to continue their leadership – marketing their companies’ equity in this new digital asset age.

Linda Montgomery, BA, B.Comm.(Hon.), CPIR, is an IR Professional, and a Marketing and Growth Executive for FinTech companies engaged in Blockchain and Digital Assets. She writes and speaks on various Startup and Technology Industry topics. LinkedIn @Lindamont3