It isn’t often we write about articles in Wired Magazine, but this one you have to read. Combine bitcoin, blockchain, the CEO of overstock.com, and securities lending and you get TØ.com.
We have been seeing a lot about bitcoin lately, but when you dig into it, the story is really about blockchain, the backbone underneath bitcoin. Blockchain is a distributed database, meaning it is replicated in many places and in some ways the antithesis of today’s central depositories. The blockchain contains all bitcoin transactions from the beginning of (bitcoin) time and is constantly growing as new transactions are added. Because it is distributed – in other words there are lots of independent copies, which have to all match – it is considered secure. But it doesn’t have to be only about bitcoins. Securities — which in a way are a digital asset when held in book entry form — may work too. That was the super shorthand version. Take a look at “Understanding the blockchain” by William Mougayar for the long version.
Going back to TØ.com, there was an article in the August 5th Wired “Overstock CEO Uses Bitcoin Tech to Spill Wall Street Secret”. What was the secret? Securities lending. Patrick Byrne, the CEO of overstock.com (yes, the guys who sell lots of cheap furniture and such on the web) decided to get into the stock exchange business (read: replace the NYSE and NASDAQ), using the blockchain methodology. But in a surprise announcement, he added securities lending to the mix.
“…Many players benefit from this little-discussed market. Sure, the borrowers can make some extra money. But the same goes for those who lend the securities out, including retirement funds and other large stock holders. They charge a fee for that loaned stock. And, yes, middlemen take a cut too, including prime brokers such as Goldman Sachs and Morgan Stanley and dedicated lending houses, or “agent lenders,” like BNY Melon and State Street. The agent lenders alone make about $19.2 million a day helping organizations lend out their stock, and the prime brokers likely make even more…”
This is a classic disintermediate the middle guys through market disruption story. By equity owners lending their stock out directly, gone will be the securities lenders and prime brokers.
Byrne “…wants to break the hold of the agent lenders and prime brokers, arguing that, as it stands, they make untold amounts of money from the loan market without giving stock holders their proper share. “We’re taking a market that’s in the dark,” Byrne says, “and we’re putting it on an exchange…”
How is this going to work?
“…Stock holders will attach bitcoin-like digital tokens to each share of stock. Hedge funds and other traders will bid for the right to borrow shares. And then, thanks to the tokens, known as “Pre-Borrow Assurance Tokens,” or PATs, stock holders can closely track each transaction involving their loaned stock…”
From the TØ website:
“…Hard-to-Borrow Liquidity: Short Tokens partner with some of the biggest clearing firms on Wall Street to provide pre-borrowed liquidity in the most sought after, hard-to-borrow securities. These tokens are available in an open auction/market environment, allowing everyone the same access to liquidity that is typically only made available to large hedge funds…”
There are skeptics, including our own Josh Galper, who was quoted in the article.
“…Galper calls the system interesting, though he questions whether the existing players will end up using it. “As with any closed system, the greatest beneficiaries of that system are the biggest participants,” he says. “Would the largest borrowers and lenders be keen to move to a new system and to provide more equal access to borrowers and lenders? I don’t believe so…What’s more, he explains, lenders are happy with the existing system because the agent lenders (typically large banks) provide what’s called “counter-party default indemnification.” This amounts to insurance for the shares sent out on loan. With TØ’s system, lenders must have a similar assurance that when they loan their stock, they’ll get it back…”
So what about indemnification? Byrne suggests that Prime Brokers can still hold onto the shares and provide indemnification…but they just won’t be doing the lending. TØ will end up being the middlemen, supposedly only cheaper. We don’t see lots of people lining up for this.
Blockchain, from what we have read, looks like a revolutionary messaging system. Perhaps its biggest threat will be to SWIFT. Many describe blockchain as a way to have a trusted transaction in an environment where you don’t trust the players – in other words, reducing settlement risk. Call me crazy, but most people trust their custodians and I/CSDs. Bitcoin cannot say the same. Just Google Mt. Gox, a trading site/repository for Bitcoin, for the story of how in February, 2014 850,000 Bitcoins, worth $450 mm at the time went missing and Mt. Gox went bankrupt.
One of the best things we have read on block chain and banking was a post in the blog “avc.com”. This site is run by the respected and very successful venture capitalist Fred Wilson. His post, “Banks and Brokerages Should Be Mining The Blockchain” takes a look at what is to be done with blockchain and banking. In particular I’d pay special attention to the comments. Some contend blockchain is a solution in search of a problem.
Lots of financials are looking for a way to make bitcoin and block chain work for them. Maybe TØ will be the next Uber for securities lending, replacing the existing infrastructure with something that is more efficient, more fun to use, and on occasion, is cheaper (and sometimes a lot more expensive).
We are going to keep hearing about the intersection of blockchain, securities markets and fintech. One day some developer will get it right and revolutionize the business. Is TØ, and in particular their securities lending effort, that winning application? We are skeptical but will be ready to change our minds when the right thing comes along.