Distributed ledger technology provider Equichain is working with regulators in Abu Dhabi on a platform to allow companies to issue – and investors to buy and sell – stock and bonds on a blockchain.
In October last year, Equichain entered the Abu Dhabi Global Market (ADGM) Regulatory Laboratory (RegLab) to further develop the blockchain platform it had built to issue and trade cryptographic equity securities. The company now has two years in which to build a platform that enables issuers and investors to exchange value efficiently and securely, and which the ADGM finds compliant with its regulatory requirements. Once the experiment is deemed successful on both counts, Equichain will list its own stock on Equichain Exchange (EQX), as the first of what Equichain CEO Nicholas Bone calls “cryptographic IPOs” to take place on a fully regulated exchange.
“Once we have an exchange, it can become a mechanism for issuing equities, bonds, derivatives, depositary receipts and insurance-linked securities on a blockchain,” he says. “It will create new investment opportunities and an evolving asset class for investors, with all the upside of blockchain, and all the downside limits of a traditional exchange.”
After a year in which 895 initial coin offerings (ICOs) raised more than $6 billion, according to icodata.io comparisons between cryptographic IPOs and ICOs are inevitable. Though Bone agrees that the success of the ICO model has helped prove the case for EQX, he points to distinctions in regulation, investor protection and design. “A large number of ICOs are masquerading as securities,” he says. “They are not compliant with securities laws or regulations. In fact, they are circumventing regulation, albeit not always consciously. We are actively seeking to build a fully regulated market hosting not tokens or coins, but digital equities – securities themselves, not representations of securities.”
It is an important distinction. According to recent research by EY, investors in ICOs are exposing themselves to risks they would not encounter with regulated investments. The EY researchers found more than 10% of funds raised through ICOs were lost or stolen in cyber-attacks.
Assets issued on a blockchain regulated as securities
The Financial Services Regulatory Authority (FSRA) in the Emirate has deliberately decided not to create bespoke regulatory requirements for blockchain issuance but to incorporate the platforms and instruments issued and traded on blockchains into its current regulatory framework for securities. In a sense, EQX is a test of the ease with which existing securities regulations can adapt to new technologies that have the potential to prompt fundamental changes in the nature of a capital market.
“Globally, we see regulators choosing one of several different approaches in terms of ICOs and their regulatory treatment,” says Richard Teng, CEO of the FSRA in Abu Dhabi. “Some have implemented a blanket ban, some are considering the establishment of a bespoke set of requirements for ICO issuers and market operators, and some have looked at ways to include these instruments and markets in their current regulatory framework. The FSRA has adopted the third regulatory approach – that is, we have reinforced our regulatory approach of regulating financial services activity that sits within our regulatory perimeter.”
In operational terms, that means the FSRA regulates the offering, listing and trading even of tokenised versions of securities, such as equities, debentures and units of a fund, as securities. “The practical outcome of this is that issuance and the trading of securities, whether through a distributed ledger technology (DLT) platform or other means, should see no difference in their treatment under the FSRA’s regulatory framework,” explains Teng.
Both ADGM and Equichain believe securities can be issued and traded on a blockchain without as well as with tokenisation. “Wouldn’t it be great if you could couple the market efficiencies of an ICO with the regulated governance and investor protection of a traditional equity IPO?” asks Bone. “That is why we are building EQX.”
Post-trade operations will be different but reassuring
One risk investors will not have to face is settlement failure, according to Bone. Settlement will take place between accounts on the blockchain but the accounts from which settlement proceeds are paid will be pre-funded, and ring-fenced for particular trades, and the equities to be delivered will by definition be stored in the digital wallets which can access the blockchain.
Bone accepts that pre-funding will impose costs on some participants. This will inhibit those that trade on credit and, less obviously, those that prefer to incur a net funding requirement at the end of the trading day rather than meet a gross requirement trade by trade. A solution to that inhibition, says Bone, is a smart contract that nets trades between particular pairs of counterparties that trade with each other frequently.
“There will be no settlement process of the kind that exists today,” says Bone. “Indications of interest, execution and settlement are collapsed into a single process on a blockchain, in which the cryptographic assets are delivered against payment simultaneously. Cash and assets will cross at exactly the same point, so there is no risk of anyone being left short, or left holding cash and securities at the same time. It is true delivery versus payment (DvP). There is no need for anyone to intermediate between the principals. There is no exchange of SWIFT messages between fund managers, brokers, custodians and central securities depositories. Nor is there any need to settle to a standard settlement timetable. You can settle real-time gross, instantaneously or on trade date plus two days (T+2), or T+5 or T+10, or whatever you want.”