Innovation in the Private Capital Markets
Technological innovations have been better utilized in public capital markets compared to private capital markets. The reason is that technological developments have primarily focused on improving efficiency in trading and gaining easier access to liquidity based on the availability of the secondary market. Despite the liquidity opportunity of public capital markets, I observe a trend of more companies wanting to stay private as long as possible and more public companies wishing to go private. Based on this observation, this article considers whether we are at the tipping point where we can leverage the well-advanced technological development to change the landscape of private capital markets via digital transformation.
As one of the leading participants in the global FinTech initiatives, I certainly see a ray of hope for such turn of the tide with the blockchain technology. Briefly put, innovation in public capital markets targets at better access to liquidity, and success depends on how securely it can deliver liquidity to companies in the primary market and investors in the secondary market. Therefore, I believe that private capital markets innovation should strive for the same goals.
Blockchain-powered solutions can be quite effective in enhancing liquidity in private capital markets with the potential to expand its utility to public capital markets over time. Without going into too much technical details, I want to point out some important aspects of the functionality of blockchain technology in relation to the capital market application. In this article, I use the term “blockchain technology” as a distributed ledger technology with critical technical components of cryptography, wallets, and a consensus mechanism.
One of the most important functionalities provided by the blockchain technology is safe custody of securities. With the technological development and innovation, investors should be able to hold their own securities and create liquidity without any friction. In other words, investors should not rely on an intermediary to prove the validity of the securities or to trade such securities. In the legacy public capital markets system, investors deposit their securities with a dealer (or its broker) in the book-based system to have liquidity of their securities. Registered dealers manage investors’ ledgers as custodians. By contrast, blockchain technology enables investors act as their own custodians and access liquidity online without going through a dealer, thus eliminating the need for an intermediary.
On a blockchain, investors’ wallets hold securities and cash. We call securities in wallets “security tokens” or “digital securities.” We also call cash in wallets “crypto cash” (even if fiat currency is used to fund the crypto cash in the wallets). These security tokens are issued in a legally effective manner; therefore, issuers no longer need to issue paper securities, or book-based securities. Moreover, investors can initiate transactions involving such security tokens and complete the transactions with secure private keys. With such secured platform in place, blockchain technology can efficiently facilitate P2P transactions. On the other hand, in the legacy public capital markets systems, buying and selling securities have to go through multiple intermediaries or ledgers to complete a transaction. In addition, there is a heavy regulatory burden for mitigating the related risks in this process. Yet, these highly complicated legacy systems have been the best we have for a long time until the emergence of blockchain technology.
In essence, blockchain technology has the potential to displace our legacy systems. With blockchain technology-enabled online P2P transaction model, we can simplify the process of buying and selling securities, resulting in a lower risk profile and less requirement for regulation; hence, reducing the overall regulatory burden on the market participants. The distributed ledger can verify the authenticity of each transaction and the validity of securities ownership. With this new digital system, we can go back to the simple trading arrangement between three parties: buyer, seller, and witness.
While it is not possible to provide all the details of P2P architecture for public capital market transactions in this short article, I would like to briefly introduce Finhaven’s liquidity mechanism for private securities, or private security tokens.[1]
The price discovery process for private vs public securities is different. Public securities find their best price or the right price in marketplaces only when they have good liquidity. When a public security struggles to have enough liquidity, its market price does not accurately reflect the true value of its underlying asset. As private securities having even less liquidity than public securities, a mere replica of public marketplaces for private issuers and investors won’t adequately support the price discovery process for these private securities. Against this backdrop, Finhaven’s liquidity solution is based on the following premises. First, the value of a private security token can be appropriately determined with an investor’s proper due diligence. Therefore, the Finhaven Investment Platform provides investors with timely and accurate information to help their due diligence work for primary and secondary tradings. Second, the marketplace should ensure fair price-determination process. As often said, value is in the eyes of the beholder; thus, investors on the Finhaven Investment Platform can send Requests For Quotes (RFQs) to other investors and negotiate with other investors to arrive at the right value of a security. They can also transfer their security tokens securely using their private keys. Most of all, investors can do all of these legally effective transactions online without worrying about physical delivery of any documents, signatures or in-person closing, which is definitely an added benefit under the current climate with much restriction due to COVID-19. This liquidity solution will certainly open the door for more enhanced liquidity to non-reporting issuers.
Although the hype of blockchain technology is gone and there may be some negative perception of the crypto assets, the recent technological development is poised to innovate private capital markets with multiple advantages before pressing onto public capital markets. The impact of this innovation will be real and meaningful. Most of all, investors and issuers will significantly benefit from more secure custody and enhanced liquidity from the blockchain-powered solutions.
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[1]Finhaven Technology Inc. (“Finhaven) is a Vancouver-based financial services and technology company with a capital markets platform built on distributed ledger technology (DLT) and digital securities. Finhaven Private Markets (the market-facing name for Finhaven Capital Inc., a registered exempt market dealer in British Columbia, Alberta, Saskatchewan, Manitoba, Ontario and Quebec) is a marketplace built on the Finhaven Investment Platform connecting private companies with accredited investors.
