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Blockchain Emerging as a New Vehicle for Securities

Blockchain Emerging as a New Vehicle for Securities

By: Daniel Selznick

Earlier this month, NPR’s Planet Money podcast released an episode titled “Blockchain Gang,” about bitcoin pioneer Charlie Shrem. Shrem was sentenced to prison in December 2014 for his indirect involvement in the infamous, Silk Road, a massive online bitcoin exchange used largely for anonymous illegal transactions. The podcast did not focus, however, on Shrem’s sentence (two years for aiding and abetting an unlicensed money transmitting business) but rather on the potential applications of “blockchain,” a major technology underlying bitcoin.

 

Simply put, blockchain is a digital ledger designed to keep accurate records of all bitcoin transactions without having to rely on a trusted centralized administrator. In lieu of a centralized administrator, transactions are vetted and approved by anonymous, decentralized programmers (referred to as “nodes”) spread throughout the network. To be validated, a transaction must be confirmed by a majority of nodes on the network. Once approved, the transaction is grouped with other transactions that ultimately make up what is called a “block.” Blocks are then strung together in a “chain” that makes up the complete, accurate, and unalterable history of all transactions ever made. This process allows bitcoin users to confidently exchange funds on a peer-to-peer basis without using a financial intermediary.

 

Since its inception, Bitcoin itself has been viewed with skepticism for various reasons. First, from a purely financial standpoint, critics point out that the crypto-currency’s high volatility and unpredictability makes its exchange-rate risk particularly high. Additionally, unlike traditional currencies, bitcoin largely lacks any form of government oversight or regulation, leaving bitcoin users without reliable forms of insurance (like the Federal Deposit Insurance Corporation in the U.S. or the Financial Services Compensation Scheme in the U.K.) on their digital wallets. Furthermore, from a technical perspective, some fear that the large increase in transactions resulting from bitcoin’s rise in popularity has slowed the rate that transactions can be processed, causing significant delays in certain circumstances.

 

However, it is the blockchain technology¾not bitcoin itself¾that has excited many who see great opportunity in a technology that enables businesses to transact with high levels of trust, accountability, and transparency with much more efficiency and much less reliance on third- party intermediaries. IBM has touted blockchain as potentially valuable in industries ranging from finance and banking to healthcare, retail, media and entertainment, and manufacturing.

 

Over the past few years, a particularly interesting application of blockchain has emerged in private equity and securities trading. In 2015, Nasdaq launched Linq, a platform that enables private companies on the Nasdaq Private Market (a marketplace that handles pre-IPO trading among private companies) to utilize blockchain technology as a means to increase efficiency and transparency in their trades. In addition to Nasdaq’s private equity application, the Wall Street Journal has pointed out that several other major financial players are developing blockchain systems designed to settle transfers of securities in real time. Blockchain’s potential ability to greatly improve settlement efficiency could reduce counterparty risk and increase liquidity of market participants, which, in turn, could make regulatory compliance more manageable. Some tout this technology as an opportunity to save banks billions of dollars.

 

The application of blockchain to securities trading is attracting bitcoin stalwarts like Charlie Shrem. Upon his release from prison, Shrem recently co-founded Intellisys Capital (“Intellisys”), an investment fund that, alongside another fund, Mainstreet Investment LP (“Mainstreet”), is marketing the upcoming release of “the first securitized blockchain asset.” This asset’s Initial Token Offering (“ITO”), is targeting $25 million in raised capital and is expected to be invested in two major areas: blockchain/bitcoin start-ups and privately-held U.S. middle-market operating companies. Intellysis’ first major project is a Michigan-based sanitary waste business that Intellisys hopes to help greatly expand through acquisitions of several smaller Mom and Pop waste companies. Mainstreet hopes to dedicate a substantial amount of its capital to private middle market companies like this one.

 

Mainstreet and Intellysis’ investments in these middle market companies seem to be at least partly driven by the need for some extra stability to offset the high risks of their other substantial investment category: bitcoin. The reasons mentioned above for the public’s skepticism of bitcoin (high volatility, lack of regulation, technological restraints) are just a few of the reasons why investors could¾and arguably should¾be hesitant to start investing heavily in bitcoin and blockchain technologies.

 

With regard to regulation, it appears that blockchain in particular has made enough waves in the financial community to start gaining the attention of the Securities Exchange Commission (“SEC”). While Mainstreet’s ITO will not be available to United States citizens to avoid registration and compliance with the SEC, the SEC has proven its willingness to work with companies who wish to utilize blockchain in their offerings. In December, Overstock.com (“Overstock”) became the first publicly traded company to issue shares via blockchain. Additionally, the SEC recently hosted a forum to discuss innovations in the financial services industry, such as blockchain. Generally, the SEC’s openness to the idea of blockchain securities offerings is certainly an encouraging sign to blockchain and bitcoin enthusiasts such as Charlie Shrem.

 

All in all, it is still too early to know what the future is for bitcoin and blockchain in the mainstream financial environment. There are obviously significant risks associated with bitcoin and blockchain that would and should make any good lawyer or investor nervous. However, this technology seemingly provides tremendous opportunities if regulators and participants in financial markets are able to work together. It will be especially interesting to see how private equity funds like Intellysis and Mainstreet fair in this period of regulatory uncertainty and whether other publicly traded companies like Overstock will begin releasing blockchain securities of their own. Whatever the outcome, strong legal guidance will be paramount for those looking to utilize blockchain in broader applications and it will be fascinating to see how this all plays out.