Washington has a capital markets problem

Washington policymakers seem not to have noticed that while global capital raising is at an all-time high, the general public’s access to these markets is in competitive free fall.

Along with the industry’s cautious response to fundamental technology change in its post-trade processes, policymakers should fear losing the United States standing as the world’s leading financial center.

Industry and regulators together need to rethink the public’s access to capital raising and unlock the control of infrastructure by powerful financial infrastructure institutions.

{mosads}While the U.S. capital markets have been in a sophisticated, high-tech race to publically trade all manner of financial products in real-time, innovation to stem the decline in the public’s access to capital raising has been stymied by those that benefit from earlier and easier access. More money is now raised privately from wealthy institutions and rich individuals than through debt and stock sold to the public.

According to the World Federation of Stock Exchanges, the number of public companies listed on U.S. exchanges has fallen by nearly 50 percent from a high of 8,090 in 1996 to 4,331 in 2016.

In this same period, research at the University of Florida shows operating company’s initial public offerings (IPOs) fell from its high of 676 in 1996 to 74 in 2016; and Preqin research reported private-equity financing had risen over 10-fold, from $31 billion in 1996 to $347 billion in 2016.

This shift from public to private financing is all happening while initial coin offerings (ICOs), a use-specific capital raising mechanism using blockchain technology and social media sourcing, is becoming a popular capital raising mechanism. According to Coin Schedule, ICOs have gone from a standing start in 2016 of raising $95 million to nearly $3.9 billion at year-end 2017.

A first attempt at invigorating public offerings, the initial public price-setting of Google stock, was conducted through a public internet “Dutch auction” in 2004. It gave any investor the ability to obtain shares in Google (now Alphabet) at the offering price set through the auction, prior to its trading on a public exchange.

Prior to this event, large institutional investors were accorded an exclusive first opportunity to purchase shares by investment banks before they traded in the public markets. Now, another approach to capital raising is being tested. Spotify is to offer its securities directly to the public through a listing on a public exchange without the underwriting aid of investment bankers.

These approaches are directly competing with the IPO process previously controlled by the largest U.S. investment banks. The Google approach democratized the availability of shares, offering it to the general public as well as to institutional investors.

The ICO approach, still in its nascent state, has been a source of debate as to its regulatory status. Some regulators see ICOs as a security subject to regulations and the ICO ‘tokens” that are sold as a commodity. Others are not sure how it should be regulated if not banned entirely.

The Spotify public capital-raising approach lets existing private-equity stakeholders start trading their shares on an established public exchange. It cuts out the underwriting fees and restrictions on stock sales by current owners in traditional investment-banker-driven capital raises.

This method also doesn’t dilute the holdings of executives and private investors as with a traditional investment banking IPO. In the end, it gives the general public an opportunity to buy Spotify shares directly at its offering price.

These changing capital-raising market practices are evolving while post-trade market structures are also being transformed.

The Australia Stock Exchange has begun a transformative project to replace its post-trade processes with distributed ledger technology, which, along with blockchain, is the underlying technology of bitcoin and other cryptocurrencies.

The Canadian Securities Exchange has announced a project to list “crypto tokens” as securities, then trade, pay for and custody them in near real-time.

The U.S.’s NASDQ market has developed a private-equity issuance platform on blockchain technology, enabling an issuer to digitally represent a record of ownership of a private-equity security. It significantly reduces settlement time, eliminates the need for paper stock certificates and provides issuers and investors an ability to complete and execute subscription documents online.

The United States’ Depository Trust and Clearing Corp., a centralized financial infrastructure intermediary that has supported the post-trade processes of reconciliation, payment and custody, is creating a derivatives trade warehouse and a credit default swaps platform on distributed ledger technology.

Such efforts, however, are simply point solutions, replacing existing supply-chain components with blockchain technologies, not the fundamental change of removing supply chain intermediaries promised by this technology and now being implemented in other market centers.

The front end of the global financial system executes trades in real time. The post-trade processes, those components that complete these trades by actually transferring traded values, runs at the speed of days. Today’s blockchain speeds, measured in minutes, are far quicker than the two days it takes for a trade currently to be reconciled, paid for and its value transferred (settled) between buyer and seller’s custodians.

The real transformative vision of blockchain and its distributed ledger technology is replacing the financial system’s infrastructure of multiple ledgers owned by a myriad of supply-chain participants with a standard secure distributed ledger coexisting with the transformative communication standard of the internet.

Doing this would enable authenticated immutable financial transactions to be processed easily, efficiently and equally by all as is now the case in communicating via the internet.

It comes down to solving a collective action problem. Competitive institutional investors and financial institutions by themselves will not give up their self-interests for the common good. A government-industry partnership must align these interests with transformative capital-raising practices to assure robust public markets can be sustained.

Similarly, the blockchain ethos of global standards, cryptographic authentication and elimination of reconciliation must be fostered through a protocol standard for a secure blockchain-enabled financial network and distributed ledger.

Allan Grody is the president of Financial InterGroup Advisors — strategists, consultants and researchers in financial services with particular focus on bank regulation and the design and implementation of innovative enterprise solutions.