Tony Chapelle / Senior reporter / Agenda – A Financial Times service / 330 Hudson Street, 7th Floor / New York, NY 10013 / (212) 542-1236
by Tony Chapelle October 30, 2017
In this first of a two-part series, Agenda looks at how boards will have to respond to the recent regulation and rise of blockchain technology in stock trading. In part two, we look at monitoring stock ownership using blockchain.
Last month, Jamie Dimon, chairman and CEO of JPMorgan Chase, told an investor conference that digital currency Bitcoin is “a fraud” and a mania “worse than tulip bulbs.” He averred that he’d fire any of his traders “in a second” for dealing in the stuff, calling it against his company’s rules, stupid and dangerous.
Dimon’s strong sentiments notwithstanding, he and executives at JPMorgan do believe in blockchain, the distributed online technology that is the foundation of Bitcoin. Indeed, JPMorgan actually built its own blockchain using Ethereum, the international network for another cryptocurrency, Ether.
To be sure, the Securities and Exchange Commission recently announced a no-action letter in which it decided to allow — and thus to regulate — all transactions that are made on a blockchain using Bitcoin, Ether and other virtual currencies. In a July 25 investor alert, the SEC stated that blockchain initial coin offerings and token sales now “are subject to Federal Securities laws.”
The SEC’s action will effectively require that all cryptocurrency securities transactions between U.S. investors be registered. Previously, virtual trades that allow two parties to create a shared ledger and see the same information at the same time for transactions have been unregulated. A spokesman for the SEC declined to comment for this article.
Blockchain as Game Changer?
There could be some benefits to boards’ approving a move to having their shares traded on blockchain.
It’s been said that blockchain technology will become as significant to corporations as the Internet is today. Blockchain was created during the height of the financial crisis as a transparent party-counterparty ledger to replace the use of cash.
In blockchain, a so-called smart contract lets both buyer and seller settle transactions immediately without a middleman by using the same decentralized ledger. That gets rid of time lag and the need to duplicate records for third-party intermediaries such as regulators.
Advocates of blockchain stock trading say it’s a game changer. “The trade is the settlement,” Patrick Byrne, CEO of Overstock.com, tells Agenda.
Blockchain supporters say decentralized distributed ledgers would eliminate the need for stock-transfer agencies, which could save the average issuing company hundreds of thousands, if not millions, of dollars in transfer costs per year. Blockchain could also prevent high-frequency trading, front-running or hidden orders.
Perhaps one of the most important benefits of blockchain trading is that it could potentially cripple naked short-selling of companies’ stock. That practice might be responsible for wiping out hundreds of small public companies every year, says Garland E. Harris, the CEO of cryptocurrency marketing firm Strategic Global Investments. He says his own publicly listed firm was the target of aggressive short-selling.
Naked short sales — in effect, traders’ selling shares without ever having owned them — may have created an artificially high supply of shares for sale that drove down Wall Street bank stock prices during the 2008 financial crisis. It’s called “failure to deliver.” The seller doesn’t produce the borrowed shares for which they ask to be paid, which violates the contract. That’s a civil offense under the SEC’s Regulation SHO.
Harris says that small firms are especially susceptible to short-selling because they don’t have the financial resources to withstand a violent drop in market price. Short sales can force companies to initiate a stock buyback, increase the corporate dividend or make an acquisition to bolster investor confidence. “Some companies are devastated by [short-selling]” Harris says. “But ours was prepared with the blockchain strategy.”
Harris switched SGI’s stock from being traded on a traditional stock exchange to being traded via an open source blockchain. In particular, Strategic Global Investments used a Bitcoin blockchain called the Counterparty Decentralized Exchange Market, or DEX. Other trading blockchains include tZero (also spelled TØ ), a blockchain subsidiary of online retailer Overstock that also allows a company to issue and even borrow securities.
- August 25, 2017 IBM, Nestlé, Tyson and Others Form Partnership to Test Blockchain Benefits
- August 1, 2016 The Board’s Guide to Blockchain
One downside is that no regulator can stop trading in a stock over blockchain. A regulatory agency or an exchange could prohibit new shares from being issued. Yet there’s no switch at an exchange that could be tripped or market makers who could be instructed to quit offering prices in a company’s shares. This opens companies up to the risk of market meltups and meltdowns at lightning speeds, similar to what Bitcoin (which operates using blockchain technology) experienced when its prices rocketed from less than $3,000 to more than $4,700 and then fell back below $4,000 in August. Bitcoin has since rebounded and surged to a record of more than $6,000 before falling again below $5,500 in October on rumors of increased government regulation.
In a way, the advent of blockchain trading didn’t come soon enough for Byrne.
In highly publicized lawsuits beginning in 2005, Byrne accused a hedge fund and an equity research firm of conspiring to short-sell his company’s stock by writing and disseminating false news reports about Overstock, and then in another lawsuit, he charged several investment banks – includingGoldman Sachs Group and Merrill Lynch — with taking illegal naked short-selling positions against his firm.
In the first case, the hedge fund was indeed found to have hired the research firm to allege that Overstock’s financial reports failed to comply withFinancial Accounting Standards Board rules and generally accepted accounting principles, and that several of its directors were not independent. The hedge fund settled with Byrne for $5 million in 2009. The research firm retracted the claims and apologized.
In the second lawsuit, the Wall Street banks that Byrne accused of naked short-selling settled out of court with Overstock for $24.4 million. According to Law360.com, Merrill Lynch Professional Clearing paid $20 million of the total.
To be sure, Byrne is credited in some circles with providing the SEC’s then-chairman Chris Cox and then-Federal Reserve chairman Alan Greenspan with the background to understand how traders had put Fannie Mae, Freddie Mac and the major Wall Street banks under short-selling pressure during the financial crisis. In fact, the SEC issued an emergency order in June of 2008 that stopped naked short sales of selected stocks.
Byrne claims that blockchain trading could be a remedy to some of what he and other companies have experienced.
Overstock is a rare U.S. company in that it allows its stock to be traded using cryptocurrency. In fact, in 2015, Byrne’s company launched its tZero blockchain-based trading platform, which can facilitate trades in either private or public equities.
“This puts all traders on a level playing field,” according to Harris. This year, his trading firm was the first company incorporated in Delaware to trade shares on blockchain using the DEX. He says any cryptocurrency can be used for trading and then be tracked on the blockchain. That’s what the Delaware legislature allowed this summer by passing a law that allows corporations there to trade and track who owns shares on the blockchain.
Harris explains that a company that sells its shares using blockchain can do that without stock-transfer agents. “You don’t have to register to do your own stock transfer, but you do to be a third-party transfer agent,” he says.
In addition, crypto-trading could potentially remove the Depository Trust & Clearing Corporation (DTCC) from the settlement process entirely. Peers would trade directly with each other. They could record their own trades using blockchains operated by miners — that is, computer nodes — behind the shared ledgers. Each side would need to open a counterparty wallet and place either stock or currency in it to complete a trade. In 2017, DTCC completed proof-of-concept blockchain transactions on Treasury and other federal agency repurchase agreements. Yet Depository Trust hasn’t taken on stock trading yet.
Harris, whose brokerage firm facilitates companies’ offering shares via blockchain initial coin offerings, says one of the biggest obstacles to adoption of blockchain trading will be that it eliminates the need for brokers for common trades. “So, there will be [Wall Street] people fighting it,” he warns. While he says blockchain trading may not end the need for financial advice, it does do away with the need to use a third party to facilitate a trade for a commission. The blockchain miner charges a small transaction fee ranging from 25 cents to two dollars no matter the size of the transaction.
“Now enter the blockchain where I can sell a million dollars’ worth of stock for a quarter,” says Harris.