Blockchain eyed for small-cap liquidity

Some financial technology executives are suggesting that if the Securities and Exchange Commission's tick-size pilot didn't enhance liquidity in the small-cap equity markets, blockchain possibly could.

Proponents and developers of distributed ledger technology — the infrastructure called blockchain used in cryptocurrency trading and settlements that connects computers that verify and validate transactions — said it has the potential to make small-cap trading more efficient, transparent and cheaper than forcing wider bid-offer spreads, as the tick pilot required.

They say it could also increase liquidity by turning small-cap shares into tradeable tokens, similar to the creation of initial coin offerings for cryptocurrencies, to trade on blockchain. That, sources said, would fulfill the SEC's original tick-pilot intent of making it easier for smaller firms to make initial public offerings, which would increase the number of small-cap stocks available to trade.

"You get more liquidity when there are more people who'll play in the space, more people willing to make quotes, more people to do price discovery, all at the push of a button," said Kate Lam, managing director, digital capital markets, at digital asset distribution firm Ideanomics, New York. "If returns are affected by lack of liquidity, (blockchain) solves for that. If returns are affected by cost, it solves for that. The more players there are in the market, the more efficient it becomes."

Added Idan Miller, chief marketing officer of The Elephant, a Tel Aviv-based secondary market firm that turns privately held shares in companies into tokens that can be traded on blockchain, "In theory, yes, blockchain could create a new way to trade and make money out of small caps in terms of returns and yield."

The SEC last month announced it was ending the two-year tick-size pilot on Oct. 2, as originally intended, and the agency would continue to gather data on the program for the ensuing six months. The pilot was intended to measure if the small-cap equity market could be made more efficient by increasing tick sizes to 5-cent increments from 1 cent. Several analysts said as early as a year ago that the program didn't improve liquidity. But what the pilot did do was make small-cap trading costly — quantitative trading technology provider Pragma Securities LLC on Sept. 5 issued a report that the pilot eventually would cost investors more than $350 million in reduced execution quality.

"The tick pilot sought to improve liquidity and increase volatility by driving a particular type of trading behavior to widen spreads, but now the spread is tighter than the gap between my teeth," Ms. Lam said. "The cost was incredible for the buyer. Any time you tell me this stuff is illiquid and a new test will cost me more, there's little incentive for investors."

Enter blockchain and its promise of efficient markets, said Gary Brackenridge, New York-based head of strategy and business development, asset management, at Linedata, a financial services software provider.

"What keeps people from finding what to invest in?" Mr. Brackenridge asked. "People like that a publicly listed marketplace has attractiveness because it has information out there. But the marketplace doesn't have a lot of listed companies, maybe only 1,000 in small caps. So where can you apply the technology to better bring to the table who has money to invest and what companies are looking for the money? It's a meeting place."

Mr. Brackenridge said other countries use distributed ledger technology to issue versions of IPOs. "And if you're an existing company, you could represent your version of shares on a distributed ledger or a blockchain, with transactions and evidence of ownership on the chain," he said.

Mr. Miller said The Elephant already is planning to do that with the secondary private equity market, by tokenizing privately held securities that then can trade through the blockchain in a pre-IPO offering process that allows private owners to liquidate their holdings before the company goes on the public market. He expects such tokenization to be ready to implement in the next nine months to a year.

Ideanomics' Ms. Lam said the general benefits of using blockchain — transparency, network security, decentralization and accessibility for market participants — make it an attractive choice for small-cap trading. But market participants are not yet at the level of integration and education needed to use it.

"You also need the belief that the technology can work," she said. "Ten years ago, we would have laughed at such potential. But we're there now. I see (blockchain use for trading) coming down the pike. Is this a speeding train? Stuck in traffic? Hard to say. It will depend on how investors integrate what they do with it."

While the private market might be closer to taking advantage of blockchain, small-cap listings aren't, Mr. Miller said, chiefly because the SEC hasn't yet determined regulations governing tokenization of publicly held shares. Such plans, he added, "are in the childhood stage … that's at least five years down the road."