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Investment · 4 March '19

Digital securities: a better way to invest in alternative assets

Alternative investments are a strong tool for diversification. Alternative asset classes include private equity, venture capital, hedge funds, derivatives, digital assets, real estate and infrastructure. Alternative investments can comprise just 10% in an institutional investors portfolio, but this could equate to billions within the portfolios of multinational investment banks or asset management firms.

With the lower correlation coefficient, alternative investments offer a better portfolio diversification with greater returns. In combination with traditional investments, alternative investments could be a perfect hedging instrument, allowing the institution or individual investor to compensate for losses which may occur on the public market.

According to PwC Asset & Wealth Management Report, by 2025 Assets Under Management (AuM) will have almost doubled – rising from US$84.9 trillion in 2016 to US$145.4 trillion, including the growth of alternative assets under management from US$10.1 trillion to US$21.1 trillion.

Over 99% of deals involving alternative assets are currently executed offline, involving expensive and time-consuming legal arrangements and manual management of private securities.  This can be resolved with the adoption of best issuance and unified trading practices of the public securities market with the use of blockchain-based issuance and settlement networks.

The alternative assets issued and traded on the blockchain creates broader opportunities for investors, companies and investment banks. An issuance of securities in a digital form allows private companies to leverage the benefits of public capital markets with even greater efficiency: liquidity premium, 24/7 trading, embedded compliance, easy follow-on rounds, automated dividend payment and many others.

A new emerging tokenisation (issuance of securities on blockchain) industry is providing the  opportunity for companies to fundraise capital and close investment rounds at lower cost and it also provides investment banks and brokers with the online software to close investment deals more efficiently and faster in one place.

Not all alternative assets can be traded immediately after primary offering, liquidity applies just to the mature companies’ securities, who have a proven track record and economic results.  But investors have expectations for trading and liquidity of the asset which encourages investors to invest online in private securities, stimulating the growth of the market and brining a liquidity premium to issuers – a higher price of securities derived from higher liquidity.

Despite the benefits which the blockchain brings to the private securities and alternative assets market, a majority of professional investors still confuse digital securities issued on distributed ledgers with cryptocurrencies and utility tokens, which in contrast to digital securities has an undefined level of due-diligence and compliance. The current level of investors’ awareness about digital securities is very low, so 2019 will be very much about education with regards this market, but from 2020-2021 digital securities issued on blockchain will start to operate as a new standard within the private capital market.

The alternative assets under management market (US$21.1 trillion) market of alternative assets under management could migrate into a digital format, giving the opportunity to transfer securities from digital wallet-to-wallet and trade at variety of secondary markets, most of which will need to have the approved status of a MTF in Europe or ATS in US, with the settlement to an native issuance blockchain (permissioned or public).

The settlement of securities transactions is currently not possible for the public securities market, as all public securities must be settled at the licensed and mostly government-owned Central Securities Depositories, which may not, any time soon, be able to migrate to the distributed ledger registers. Due to these regulatory restrictions and technological advancement blockchain is applicable as a settlement network only for the private securities market.

Suitable legal off-line settlement and the implementation of the ownership and compliance logics on the blockchain, is what will define the best platform solutions which are evolving quickly.

The North American market is represented by the majority of the new established digital securities platforms; tZero, Harbor, Vertalo, Securitize, Polymath, OpenFinance, Templum, StartEngine, which provide all-in-one or separate services: initial issuance and management, primary offering and secondary trading. Those companies are already backed by the major Silicon Valley Funds, while on the European continent situation is different. Many European platform are at the conceptual stage, but few have started to onboard customers and run an issuance of securities on blockchain with a fully private or semi-public offering, those platform include HighCastle and Neofund, which have been established since March and September 2016 respectively, allowing them to invest significant time into the technical and legal R&D necessary before the launch of their capital markets solutions.

London-based HighCastle, additionally, provides a Prime Issuance and Settlement Blockchain Network, a permissioned blockchain design in accordance with the capital market requirements and practices; blockchain-based share register, which is blockchain-agnostic and is a good alternative to current spreadsheet-based registers; and a full package of draft legal agreements and a technical framework to issue, distribute and manage private securities in a digital form on the secure distributed ledger.

When issuing digital securities companies need to consider the appropriate legal settlement, security of the blockchain, and licensing of the platform at the stage of fundraising, which would require the approval of the financial promotion by the regulated entity. The issuance, registry, offering, legal offline settlement, trading of digital securities may be executed in a separate manner by different entities, but the most efficient and convenient for investor and issuer is to utilise an end-to-end solution.

Real Estate and venture capital funds are those who most intensively consider tokenization and have migrated their securities on to a blockchain. Assets which currently have a moderate level of risk, but low liquidity would be the first in line for tokenisation, as demand for such investments in assets with the shorter liquidity period is growing.

Distributed Ledger Technology is now disrupting the alternative assets market, generating liquidity opportunities in addition to already existing diversification advantages.