Not all digital assets are created equal. Institutions and other participants can be forgiven for any confusion, given the near religious fervor over cryptocurrencies and the widespread use of the term digital securities.
Happily, regulators and politicians are increasingly drawing lines between cryptocurrencies and smart securities. So, while politicians scrutinize bitcoin and other cryptocurrencies, the Securities and Exchange commission and other securities industry regulators are indicating an increased understanding of the potential of digital, or "smart," securities to reinvent the market for private unregistered securities.
These developments provide an opportunity for institutional investors to access enhanced liquidity and transparency for private alternative investments, enabling more dynamic allocation strategies.
Cryptocurrencies are digital or virtual stores of value that use some form of encryption and a distributed ledger to guard against cybersecurity risks. A distributed ledger is a system that enables independent participants to reach consensus on the validity of a set of shared data, eliminating the need for trust in carrying out transactions, according to law firm Cravath, Swaine & Moore. A blockchain, meanwhile, is a type of distributed ledger in which data is grouped into blocks and then chained together in chronological order.
The term digital assets is used as somewhat of a catch-all, encompassing a range of assets, including tokenized securities and cryptocurrencies, both represented on a public blockchain distributed ledger.
Smart securities, on the other hand, relate only to digital assets that are securities for purposes of U.S. securities laws and are represented on a private blockchain distributed ledger. To put it differently, smart securities are digitized versions of traditional securities such as common or preferred stock or bonds. Smart securities are structured in the same manner as traditionally represented securities and carry the same rights and privileges. Smart securities, as with traditional securities, provide investment exposure to virtually any asset class.
But smart securities aren't tokens. Because smart securities are represented on a private, permissioned blockchain, holders don't have to store them in a wallet, so they aren't subject to the cybersecurity risks of hacking associated with assets represented on a public blockchain. Smart securities are not held anonymously and investors in smart securities are subject to the same legal and regulatory requirements that apply to traditionally represented securities. Smart securities are emerging as a means for transforming the way investors access and trade private, unregistered securities, as well as other alternative investments. The private markets have grown significantly in recent years and institutional capital allocators (pension funds, endowments, etc.) have been a driving force, seeking the strong absolute returns of these investments to help meet their return objectives. The impact of these assets is no secret — over the past 20 years, endowments and foundations that allocated less than 5% to private markets achieved a gross portfolio-level annual average compound return of 6.4%, while those that allocated more than 15% achieved 8.2%, according to a recent report by Cambridge Associates.
This growth in private alternative investment issuances has occurred despite a lack of investment infrastructure, significant transactional frictions, and most importantly, efficient secondary liquidity, which is particularly problematic for institutional investors. Although investors in private offerings are compensated for illiquidity (along with the complexity and structuring risk of these deals) with higher rates of return, they still rely on liquidity for their spending needs, capital calls, tactical allocation and portfolio rebalancing. The issue of illiquidity has the potential to curb growth in private markets in the years ahead and may prevent institutional investors from accessing some of the most high-alpha investment opportunities available.
Compounding this issue is that fact that the limited infrastructure that does exist for private asset liquidity is operationally inefficient and manually intensive. The private markets ecosystem is also highly fragmented and challenged by incomplete, siloed information, and a significant degree of information asymmetry between buyers and sellers, GPs and LPs, investors and issuers, and various intermediaries.
The result of this inefficiency is that an institution looking to liquidate a private investment faces high transaction costs, a lengthy transaction closing period, and, most importantly, the risk of taking a sizable discount on its investment.
Smart securities provide solutions for many of these challenges, helping to eliminate transactional frictions that have limited private investments from trading on liquid secondary markets. Legal, regulatory and other issuer-designated trading parameters are rendered in code and enforced automatically. The use of "smart contracts" embedded in smart securities enhances the quality and speed of execution of secondary market transactions and eliminates costs — e.g., automated transfer restrictions alleviate administrative burdens, cut settlement times to potentially T+0 from T+90 and reduce legal fees.
Assets can be bought and sold far closer to fair value. In addition, the speed at which transactions can be vetted, executed and settled makes it far more feasible that an institution could liquidate a position in days, rather than months. These developments all lend themselves to improved liquidity.
When institutional investors have the ability to exit their holdings in a relatively rapid and non-punitive fashion, their investment strategies become more dynamic. Institutions can more effectively conduct tactical allocation and portfolio rebalancing. Smart securities help institutions enhance portfolio construction and better customize risk exposure.
Regulators are helping to separate the signal from the noise in digital assets. Their growing understanding of the technology behind smart securities and its potential to open private alternative investments to a larger range of investors highlights the possibilities of digitization in finance. Delineating smart securities from other digital assets helps to better differentiate the potential of smart securities to reshape how private institutional investments are made.
Frank Barbarino, is director at Templum Inc. New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.