Returning from Sibos 2017 in Toronto, most delegates probably had at least one of the following words or acronyms ringing repeatedly in their ears on the flight home: blockchain, artificial intelligence (AI), big data analytics, open banking, application programming interface (API), cyber-security, global payments innovation (GPI), GAFA (Google, Amazon, Facebook, Apple), and Swell, an alternative event hosted by Ripple just a few miles away from the Metro Conference Centre. For those working in securities services, initial coin offerings (ICO) can probably be added to that list.
ICOs, an equity fundraising mechanism used overwhelmingly by tech companies through distributed ledgers (DLT) with transactions typically taking a bitcoin or ethereum form, have divided the industry between people who believe it is a slow motion regulatory train wreck in the making versus those who see it as a lightning rod for disruption in the securities services industry. In its most basic incarnation, a start-up technology company could leverage an ICO to bypass elusive venture capital money, and simply raise cash from retail investors or cryptocurrency enthusiasts.
If ICOs do, however, transition from being cryptocurrency-based into real currencies and major corporates start raising equity finance from institutional investors through DLT infrastructure, then securities services is going to have to remodel itself significantly. “Once you see what a car looks like, you do not want a faster horse,” mused Monica Singer of ConsenSys and former CEO at Strate, the South African central securities depository (CSD), speaking at Sibos. In effect, a mature ICO infrastructure could eliminate the need for custodians, CSDs and central counterparties (CCPs) as the issuer and investor will be directly connected on the DLT.
“ICOs are popping up and they do not need to be listed on an exchange. In fact, anyone can subscribe to an ICO instantly, and it offers real-time settlement. This means there is no need for a CCP or CSD,” said Singer. “The reality is that the world is changing much faster than we think, and concepts like ICOs will be happening in our lifetimes,” she added. There is certainly some truth to this, but the ICO model is going to have to mature dramatically before this becomes a reality.
At present, ICOs are miles away from institutionalisation although a handful of relatively sizeable fundraisings have happened, most notably Tezos which amassed $230 million through such an offering. Nonetheless, most institutional investors – due to risk and regulatory constraints – will not touch anything that smacks of bitcoin or ethereum let-alone an ICO. The reason is simple and that is because ICOs are unregulated, which means capital would be at serious risk should something go wrong.
Equally, the level of disclosure provided to ICO investors is laughable. Unlike a traditional public listing, investors in ICOs tend to receive de minimis information about the product or company they are acquiring equity in. One expert attending Sibos acknowledged some consumers bought into ICOs based on materials they had seen posted on Facebook or other social media. The UK Financial Conduct Authority (FCA) has warned investors that ICO documentation may be misleading or incomplete, adding this could potentially expose them to serious fraud risk.
Meanwhile, the Securities and Exchange Commission (SEC) also urged caution about ICOs, and has since confirmed it will begin to bring such transactions into the purview of existing securities legislation. Other major regulators – most notably the People’s Bank of China (PBOC) – have proceeded down the London/Uber path and initiated an outright ban on ICO activities. The regulatory clampdown is hard to argue against, as a fraud would most likely taint the reputation of ICOs, but also blockchain and DLT.
Fraud is not the only risk facing ICOs. ICOs – in their current form – are a hotbed for potential criminality given the anonymous nature of the transactions. Falling foul of AML and KYC rules, or inadvertently violating sanctions legislation, is not a trivial matter for financial institutions. Penalties entering into the billions have been issued by lawmakers and regulators against major banks for such breaches. Again, some regulators have alerted investors to this, most notably the Monetary Authority of Singapore (MAS), which said that ICOs were vulnerable to money laundering and terrorist financing activities.
It could be quite a few years before ICOs enter the institutional domain. Even then, regulators – as they have with blockchain – will not allow untried technologies to be unleashed onto the financial system without some form of oversight, and this will most likely be delegated to market infrastructures. Any transition to an ICO market will also take time, and most probably require a parallel ICO infrastructure to co-exist with legacy technology and processes. Technologies like blockchain or ICOs are not going to remove the need for custodians, CSDs or CCPs, but rather result in an evolution of their core product offering.