Technology has been rapidly changing the way we live, making services we took for granted much cheaper and more efficient by removing layers of intermediaries. Yet, one of the industries that has remained heavily resistant to change is the financial sector. Apart from being able to carry out basic operations online, financial services have not changed very much. Transactions and settlements remain relatively slow and expensive.
The level of disintermediation that we have seen in other industries has not happened, largely due to the regulatory hurdles that potential disruptors face. In the meantime, the costs of traditional banking - from maintaining branches to building out robust compliance platforms - are generally passed to the consumer.
Yet, change is afoot, as new technology begins to transform some traditional services in the financial sector. Major global banks like ING and JPMorgan are using blockchain to settle international money transfers faster, lowering transaction costs by cutting out intermediaries.
Many more banks are exploring how to develop custodial solutions for digital assets for their customers, and, just this month, the Office of the Comptroller of the Currency (OCC) in the U.S. ruled to allow national banks to use stablecoins and blockchains to facilitate the settlement of payments.
We've also seen pioneering moves from large players like Santander issuing bonds on the blockchain and CBA in Australia successfully completing a blockchain trade finance trial. Slowly but surely, blockchain is becoming a powerful force for disrupting finance, but there is still more to be done.
The Problems with Capital Raising
There is considerable potential for improving the processes and also the costs related to raising capital for customers. Traditional IPOs, although popular, are still relatively expensive and sometimes unsuitable for most early-stage companies. This can leave them with the option of raising capital through debt or equity financing in bespoke trades often with a small group of investors – another expensive and potentially unscalable solution, as liquidity is limited.
Even that route is challenging. According to data from Fundable, just 0.05% of early-stage businesses are able to raise money from venture capital (VC) firms.
Blockchain and Capital Raising
We began to see the potential for blockchain in capital raising during the Initial Coin Offering (ICO) boom of 2017/18, showcasing what the technology was capable of. In fact, between 2017 and Q2 2019, BBOs (blockchain-based offerings) helped companies to raise in excess of $30 billion.
While this sounds compelling, clearly there were insufficient safeguards in place and many retail investors lost large amounts of their capital from their investments in some of these offerings.
Now with increasing regulatory clarity, there is an opportunity to raise funds using digital technology in a way that is safe, cheap and fast.
Digital asset token issuance, for example, offers a solution for companies to circumvent the heavy costs associated with raising capital through traditional means like an IPO. They can cut through layers of intermediaries and move the due diligence, pitch books, models, and analyses usually carried out by the banks into the public domain by making all their company information available on a public blockchain viewable by all potential investors in real-time.
There are demonstrable opportunities for blockchain in capital raising when it comes to asset-backed securitization. Blockchain can bring real benefits of scale, given that the cost of raising capital is the same, whether you're transacting with one or 1000 people. What were previously singular financing rounds can now be offered to a wider audience – and create secondary markets at the same time.
This is not to say that blockchain-based digital asset raising is going to hasten the demise of the IPO. More likely, blockchain will begin to be used in the background, making inefficient processes work better and cutting out several layers of middlemen and barriers to investors.
The Transparency and Veracity of Information
Using blockchain as a single source of truth with its immutable record-keeping and transparent ledger making every entry viewable to all, can make many key intermediaries redundant. It also removes opaque practices and prevents selective disclosures or conflicts of interest throughout the capital-raising process.
All company updates are constant and viewable in real-time. Potential investors can monitor changes in price as they happen and gain a real understanding of the challenges and opportunities that a company faces.
Beyond this unprecedented flow of comprehensive, transparent, and verifiable information between businesses and investors, programs built into the blockchain itself in the shape of smart contracts can ensure that agreements between multiple parties are executed automatically – without the need for a trusted intermediary – and, better still, leaving a verifiable audit trail for regulators.
This automation of capital raising allows blockchain-based solutions to provide enormous scale and scope for businesses. Companies can issue securities around the world, and smart contracts can ensure that they comply with the local regulatory requirements of different jurisdictions.
At the same time, investors can trade these securities on the blockchain, giving companies access to liquidity in a secondary market.
Practical Examples - The ESG Sector
The ESG (Environmental, Social and Governance) sector is a prime example of where blockchain solutions have been useful. There is a lot of capital in ESG funds now that investors are more proactive about how they want to invest. In fact, the value of global assets applying ESG data to drive investment decisions has more than tripled over the last eight years, reaching a staggering $40.5 trillion in 2020. Yet, how reliable is the quality of this data?
ESG funds offer the promise of investing in companies that comply with explicit ESG requirements. But this data is not always transparent or readily available. In practice, many companies still have to scramble to meet their ESG compliance duties when they know they're about to be audited.
If companies were able to place all their data on the blockchain, it would be inherently easier for investors to make informed decisions by themselves and really make an impact with their ESG investment. Just imagine a product that could automatically charge the company a higher cost of capital if their output of pollutants, such as CO2, increases – and conversely decreases if it reduces. A smart contract digital security could offer this incentive to companies to reduce their environmental impact.
In short, the more environmentally friendly a company is, the less it pays for capital – thereby aligning with investors' requirements of investing in truly ESG-compliant companies.
Blockchain also bakes in much-needed layers of accountability. Say a company's emissions go over a certain amount; this is immediately visible on-chain. ESG investors can then decide whether to amend or even repeal their investment.
Tokenization of Assets
Blockchain solutions for capital raising do not necessarily have to be driven by environmental and social forces but by pure economics as well. Let's take the example of a building that chooses to tokenize its assets and place its information on the blockchain.
Investors can monitor all pertinent information surrounding building maintenance, costs, gross rental income, structural repair, and so on, and then make informed decisions about whether they want to invest; placing more power in their hands than ever before.
Blockchain offers an opportunity for commercial real estate to raise capital by providing a platform for them to tokenize their properties, manage their digital securities, and access secondary liquidity. The St. Regis ski resort in Aspen raised $18 million when it sold security tokens to accredited investors in October 2018.
And, of course, it does not stop at real estate. We're seeing the tokenization of high-value assets such as fine art allowing for fractional ownership and lending liquidity to previously illiquid assets. Some stock markets around the world are beginning to embrace blockchain, from the Merj exchange in Seychelles to Bursa Malaysia that recently embarked on a bond on blockchain proof-of-concept to explore the opportunities afforded by the tokenization of assets.
Australia's main stock exchange, the Australian Securities Exchange (ASX), is also set to become the world's first global market to replace its current clearing system with blockchain technology. And Nomura Holdings recently issued Japan's first digital bond offering using blockchain technology.
Removing friction for all investors
It’s a well understood phenomena that when it comes to valuing assets, those who own them believe they are marked at a discount, whereas those who buy believe they're paying a premium.
Blockchain resolves that disconnect by providing information for investors and liquidity for sellers, helping to find an acceptable price for both sides. Investors have timely, relevant, and fully verifiable information allowing them to effectively price an asset, while companies gain access to secondary liquidity. Capital is raised in a frictionless way that makes selling on an exchange, either peer-to-peer or broker-to-broker, easy in a completely compliant way 24 hours a day.
And we're really still scratching the surface of how blockchain can improve the capital-raising process. In the not-too-distant future, it might just have the potential to set a new standard for securities issuance that is transparent, secure, and here to stay.
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