Private equity has become one of the most popular alternative assets over the last couple of years, but investing in PE is complex because there is no secondary market for it. However, one expert suggests security tokens based on a blockchain could solve some of the issues keeping many investors out of the PE space. Thus, blockchain technology could one day become the future of private equity.
In his second-quarter report, Richard Johnson of Greenwich Associates described the most promising applications for blockchain-based security tokens, and private equity was listed as the strongest possible application.
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Benefits of blockchain-based security tokens
Cryptocurrencies are based on blockchains, which are distributed ledgers which hold a full record of the ownership and transaction history of the assets recorded on them. This is how bitcoin transactions can be completed without a third-party payment intermediary. Smart contracts can also automate servicing for securities and embed regulatory compliance, he adds.
Johnson explained a number of advantages which could be enjoyed through the use of blockchain-based security tokens. His firm surveyed executives to find out which benefits are the strongest and what potential applications they might offer.
He recalled that a major problem Dole had with its shares could have been prevented if blockchain-based security tokens had been in use. Former shareholders were entitled to a payout of 49 million shares from a 2013 class-action lawsuit, but at the time, there were only 37 million outstanding shares. He argues that this wouldn't have been possible if Dole's shares were recorded on a blockchain.
Other possible advantages include regulatory compliance via smart contracts, unlockable liquidity premiums via secondary trading, rapid settlement and clearing of transactions, and new access to previously illiquid markets. Other possible benefits include lower costs for servicing securities and new issuances and continuous trading around the clock.
The future of private equity?
Johnson notes that private equity could be a strong application for security tokens because there is almost no existing trading and settlements market technology. Thus, building a new infrastructure based on blockchain technology could make sense because it isn't replacing anything and could unlock benefits for the PE market.
He said almost half of the executives they surveyed about security tokens named private equity securities as one of the top three applications for security tokens. He added that in the PE market, the biggest challenge is regulatory compliance rather than technology. Regulators generally see private securities as riskier than public ones, so they restrict investments in private securities. Some restrictions include the type of investor allowed to invest, transaction holding periods and resale rules.
"These restrictions and a lack of a public marketplace for these securities means there is hardly any secondary market trading as compared to public equities," he explained.
Unlocking the liquidity premium
Johnson suggests that with smart contracts, compliance rules can be programmed into the token protocol to ensure only allowable types of investors can purchase the security token. Programming rules into the protocol smooths out the process, enabling a liquid marketplace to form. He explained that an asset's liquidity premium is unlocked when it can be traded in the secondary market.
He added that when the numbers of buyers and sellers increase, price discovery is improved, and some investors might be more likely to invest in private equities if it isn't a one-way trade. Currently PE investors don't expect there to be a secondary market, so they require higher expectations for returns to make up for the liquidity risk.
Another potential use case for security tokens is for start-up capital formation, which bears some similarities to private equity. He also notes that this is why the initial coin offering market took off a couple years ago because they were crowd-funding blockchain start-ups. However, unlike the tokens issued in ICOs, the security tokens issued for this use case would need to be fully regulated.
Johnson describes the ICO boom as "a wake-up call for regulators, who realized that existing regulations were often inappropriate for digital tokens like utility tokens." Thus, in some areas, regulators are working to define a new digital asset class that isn't a digital security. U.S. regulators use a 1946 Supreme Court ruling to decide when something is a security. That covers most collective investments in expectation of profits.
Which blockchain could be the future of private equity?
He also dug deeper into the possibilities by asking the executives he surveyed which blockchain might be the best option for security tokens such as those which could be the future of private equity. Security tokens are different from cryptocurrencies.
He found that Ethereum was the blockchain suggestion of choice. It makes sense because open-source public blockchains such as Ethereum do have the largest number of developers working on the codebase, and numerous open-source applications are already available, including a number of security token protocols.
However, he also explained that these advantages could turn out to be disadvantages. For example, a blockchain with a decentralized developer base could form the way Ethereum did in 2016 and the way bitcoin has several times. This could pose a problem for security tokens. He also warned about the possibility of a so-called "51% attack," in which a majority of bad actors take control of the blockchain. For this reason, he said the Securities and Exchange Commission could consider forcing crypto miners to register as broker-dealers. The SEC is faced with a petition asking "whether the verification of security-token transactions on a public blockchain network is akin to a broker confirming trades."
Johnson suggests that permissioned blockchains like those being used in enterprise blockchain initiatives could solve these problems. More than 60% of those he surveyed preferred a permissioned blockchain, although he also said it makes sense because regulated financial institutions had a strong presence in their study. Ultimately, he said the consensus was that it doesn't actually matter which blockchain technology is used.
This article first appeared on ValueWalk Premium