The advent of blockchain technologies, especially the emergence of Bitcoin as a digital commodity, in addition to the other cryptocurrencies arising from it, have led to the introduction of a number of disruptions in the financial technology (fintech) and financial services (finserv) space.
According to the Blockchain Wiki, the blockchain is: “…a transaction database shared by all nodes participating in a system based on the Bitcoin protocol. A full copy of a currency’s block chain contains every transaction ever executed in the currency. With this information, one can find out how much value belonged to each address at any point in history.
At a interview during the World Capital Markets Symposium 2015 in Malaysia, cybersecurity expert Lance James described the blockchain as: “…a historical record of transactions.The blockchain is a big file of bitcoin’s distributed data system. And in some kind of Reddit-style platform, it would grant regulators a lot of power. It’s a very powerful and mathematically proven method. Naturally, it’s mathematically secure.”
James added, “It’s a really cool concept and it is solving a lot of problems.The public ledger allows regulators to validate transactions and deters misbehaviour. The cool thing about bitcoin is that it is autonomous. I think its great for analysis and archiving records and keeping a history of transactions in an authenticated way.”
An Economist Insights feature noted that the distributed ledger elements holds the most finance, given the growing interest in “…treating it as a digital notary stamp to authenticate digital transactions, offering irrevocable proof of ownership with a traceable history”.
Given the critical and essential nature of ledgers to the finance industry – with most financial transactions concerned with guaranteeing and tracking assets as they move across ledgers – it is in this particular niche that bitcoin will be able to influence and disrupt the back-offices and technology systems of financial organisations globally.
Opportunity in context
What the blockchain enables is the creation of an encrypted public ledger that preserves the privacy and security of transactors, while allowing transactions to be tracked and reviewed by regulators. It enables triple-entry bookkeeping on a distributed public ledger, also referred to as momentum accounting.
In double-entry bookkeeping, changes in balances such as earning revenues and collecting cash are recorded with two entries, usually as a debit and credit assigned on a given date.
Triple entry accounting is a system where all accounting entries involving outside parties are cryptographically sealed by a third entry, including purchases of inventory and supplies, sales, tax and utility payments and other expenses. Side-by-side comparison of bookkeeping ensure congruency in the records of a transaction between the involved parties.
The blockchain records transactions in the form of a transfer between two electronic wallet addresses in the same distributed, public ledger, creating an interlocking system of enduring accounting records, which are distributed and cryptographically sealed. Falsifying or destroying them to conceal activity is practically impossible, due to the sheer computing power required to do so.
The encrypted public ledger enabled by the blockchain both deters unscrupulous or dubious transactions, while granting regulators an archive of information that can be mined for insights into the the dynamics of a marketplace.
Systems architect Charles Moore has noted: “Bitcoin achieves the first two things for cash payments. By creating and signing a Bitcoin transaction, one generates a cryptographic proof that the transaction happened and they had the rights & obligations to the unspent transaction outputs referenced in the transaction.”
This means the blockchain protocol can augment the traditional ledger accounting system by facilitating a method for parties to share specific transactions as if they were payments. It enables a clarity unmatched by current technologies and auditing methods, especially when reviewing transactions and other deal flow.
This is advantageous for both the transactors and regulators, as it pierces the opacity of a marketplace and provides an archive of transactions that can be reviewed, enabling a longitudinal and historical perspective. There are a number of areas where blockchain-powered marketplaces could enable greater transparency, bringing greater transparency to marketplaces whose transactions have traditionally been opaque.
Two areas where a blockchain-powered online marketplace could supplement and complement existing mechanisms are the mergers & acquisitions (M&A) space and private equity (PE) secondary market deals. These are both areas whose transactions and associated deal flow can be rather opaque.
Given the relative opacity of such markets to the broader business community, blockchain-powered marketplaces for these sectors would enhance regulatory oversight and create opportunities for new players to enter the market, broadening the pie while preserving transaction security and privacy.
M&A deals & PE secondary markets
With M&A activity at its highest tempo in a decade in the Asia Pacific (APAC) region, despite a decline in the M&A activity occurring in Singapore, the current era seems an opportune time for integrating online M&A marketplaces with the distributed public ledger. Recently, an EY report noted that globally, family businesses face challenges maintaining continuity in family ownership.
Concurrently, many baby boomers are reaching an age where they are seeking to retire and free up capital from their businesses, or otherwise ensure their legacy. This translates to investors and the owners of small and medium enterprises (SMEs) and large local enterprises (LLEs) seeking to exit their ventures.
A blockchain-powered marketplace not only offers greater clarity of the space to regulators and deal engineers, if also offers startup founders, middle-market entrepreneurs, SMEs and sole proprietors a chance to realise wealth via trade sales, opportunities to expand their business.
This is just one of many areas where the blockchain could be applied, given that it protects the interests of regulators, while ensuring the privacy of the transactors using such a marketplace.
Another domain that could stand to benefit from a distributed public ledger system is the private equity secondary market. This PE secondary market is where pre-existing investor commitments are traded between PE firms, asset management firms and hedge funds. The absence of widely established markets tends to render such transactions more complex and labour-intensive that conventional PE deals.
Firms selling PE investments sell not only the investments in the fund, they also sell their remaining unfunded commitments to the funds. This asset class, as a general rule, tends to be illiquid and usually is traded by funds with a preference for long-term investments, such as pension funds, endowments, trust funds and some family offices.
Since 2011, the SEC has been grappling with the regulatory challenges posed by PE secondary markets. With the Wall Street Journal reporting that the US Securities Exchange Commission (SEC) paying closer attention to the secondary market and stapled securities in particular. A private capital market platform facilitating such deals using the blockchain can ease regulator concerns by providing a transactions archive, as well as deterring misbehaviour.
In January 2015, the Wall Street Journal predicted that the secondaries market would see a slowdown in growth, clustering around the same deals, and increased selling as demand outpaces supply.
A Q1 2015 Preqin report noted that the secondary market for fund interests has grown tremendously since 2009, with total secondaries volume estimated at $12 billion. In 2014, boutique investment bank Cogent Partners estimated that secondaries volume reached $42 billion, representing a 350 per cent growth rate over five years.
With the transactions being completed in the secondaries market becoming more sophisticated and its emergence as a viable solution for GPs and LPs seeking end-of-life solutions for fund – whether it’s the sale of interests in tail-end funds or more complex GP restructuring – its maturity and growth, as well as the rise of real estate, infrastructure and private debt secondaries transactions will increase overall market volume.
A blockchain-powered marketplace to track the deal flow associated with such transactions would serve to ease regulator worries, while allowing various players in the market to benefit from the greater transparency of the market.
Areas of opportunity
Research by David S. Evans of the Global Economic Group noted that the economic efficiency and possibly viability of a public ledger platform was dependent on the design of incentive and governance systems embedded in the system.
A decentralised public ledger may offer a superior and more efficient technology for conducting financial transactions securely. However, deficiencies in the incentive and governance systems could render it inferior to existing systems, inhibiting adoption.
Current claims involving the blockchain often do not account for inefficiencies associated with the existing incentive and governance systems involved in the Bitcoin sector in particular. Additionally, there are regulatory costs associated with compliance of platforms and service providers (e.g. wallets and exchanges) in some jurisdictions. Australia, for instance, has recently become hostile to Bitcoin firms.
Bitcoin is an essentially ‘trustless’ protocol, requiring a minimum viable blockchain to begin powering a marketplace. While some criticise its use for illicit purposes, such views are often unfounded, with bitcoin playing a minor role in criminal transactions. In fact, more US dollars are used for illicit purposes than bitcoins ever have been.
Any blockchain-based engine powering a distributed public ledger platform for transactions must not only be more efficient than existing Bitcoin mechanisms. It must possess superior incentive and governance mechanisms, as well as be built up to existing know-your-client (KYC) and anti-money laundering (AML) measures if it wishes to displace and supplant existing systems.
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