The implications of blockchain for responsible investment

Central share depositories

Modern shares are often not directly held by shareholders, but in bulk by specialist depositories (such as the DTC in the US), which then assign shares to their individual owners by keeping a central ownership register. This has drawn attention from blockchain reformers who claim that the depositories days are over, with two ways to decentralise or distribute a central share register:

A single register of share ownership that is held by multiple bodies, rather than one.
Fragment the single digital register into thousands of individual digital tokens that are directly held by the people who own them, and use a blockchain to maintain a record of the tokens’ existence and movements between the holders.

The first option is more akin to the concept of distributed file storage (i.e. we have a single file that is stored in a distributed fashion), but which raises questions around how the file is edited. The latter option is the concept of cryptoequity: the company initially issues its shares as crypto tokens that are transferred using a blockchain protocol. A shareholder holds a token that represents a share, and then uses a blockchain system to initiate the transfer of it to someone else. This is akin to a digital bearer instrument.

Hypothetically, if these systems were to become widespread, central share depositories might be rendered redundant, in that shareholders could directly hold digital shares (although whether they would want to be responsible for that is another question). The state of Delaware has taken the lead in allowing companies to use blockchain technology to issue shares. NASDAQ has worked on making that right a technical possibility by developing its Linq system for private market crypto-equity issuance. In the near-term, however, this type of action only seems likely to be taken up by new companies that do not have legacy shares on existing systems.

Shareholder e-voting platforms

Of more immediate relevance to institutional shareholders are innovations in proxy voting. Several financial institutions and central share depositories (CSDs) have been investigating the use of private blockchain systems to implement shareholder e-voting infrastructure. An earlymover was NASDAQ, which launched a pilot project in Estonia in February 2016 to reduce the time, complexity and cost of shareholder voting. Various national share depositories have been experimenting, including Russia, Abu Dhabi, South Africa and the CSD Consortium Working Group (formed by Russian, South African, Swiss, Swedish, Chilean, Argentinian and UAE central depositories).

These systems use private blockchains and retain control for CSDs. As an example, the NASDAQ system essentially piggybacks on the CSD registers to assign voting rights and voting tokens to identified shareholders, who can then spend those voting tokens on agenda items. Another example is Broadridge, the major investor services firm that runs electronic proxy voting infrastructure. Broadridge completed a pilot project with JP Morgan, Northern Trust and Banco Santander using a private Ethereum-derived blockchain, seeking to “provide an example for how a client could use a distributed ledger to gain daily insight into vote progress” (see the original press release).

Others are campaigning for a more radical use. An Oxford University report from August 2017 by Christoph Van der Elst and Anne Lafarre issued “a plea for the modernization of the AGM with the use of blockchain technology and smart contracting.” They argue that AGMs have become dull rubber-stamping affairs, that investors are provided with inadequate information, very limited forum time, and limited decision-making capabilities. They advocate for a private blockchain system with smart contracting systems in which shareholders can place proposals and upon which other shareholders “are immediately notified and can exercise their voting rights during a short period”.

Proxymity is a digital voting system that enables investors to vote in real time, potentially removing multiple inefficiencies in the proxy voting chain, including traditional deadlines for submitting votes days ahead of company AGMs. It will be rolled out in the UK market for the 2018 Proxy season with plans for additional market expansion later in the year.

Giving voice to beneficiary ESG preferences

London-based CAPITALusM is building a system to provide a direct conduit for individual beneficiaries of funds to express their voting wishes to fund managers, who will in turn split their total votes to reflect the preferences of their clients (assuming that fund managers commit to honouring client wishes). They are also aiming to implement a liquid democracy feature in which people can delegate their votes to NGOs, as well as a process for proposing resolutions.

Real-time tracking of ESG data

There are many generic claims about blockchain technology’s ability to make data more transparent and visible, and yet it is not immediately obvious that blockchain technology specifically is suited to this. Lack of data is either a data acquisition (producing accurate data) or data reporting (making that accurate data visible) problem, neither of which require blockchain technology. The first is the realm of data capture (via, for example, Internet-of- Things sensors, monitoring and big data infrastructures), and the latter is often a political or legal issue, rather than a technical one.

In June 2017 the UNFCCC claimed that blockchain could provide “better tracking and reporting of greenhouse gas emissions reduction and avoidance of double counting”, but did not specify exactly how this would be achieved. It launched a climate chain coalition and issued a call-out for collaborations, partnering with groups such as HackForClimate (associated with the Climate Ledger Initiative) to come up with solutions. The tracking use case appears to echo much of what Provenance and other groups are already working on, seeking to verify products being bought by scanning and checking them against a (distributed) database of sustainability information, “to track, certify and transfer sustainability attributes of commodities, like the carbon footprint of a litre of milk”. Much of this remains at the pilot project stage, and not much can be done with blockchain technology alone.

Automating inter-bank coordination

Banks have been interested in experimenting with the possibility of using private blockchain – or distributed ledger – systems to automate the coordination processes between themselves using technology like R3’s Corda system or Hyperledger’s Fabric system. The state aim of experimenting with this is to update the collective infrastructure between banks and other financial institutions, and to increasingly automate the behind-the-scenes co-ordination.

Distributed ledger technology potentially offers benefits whenever there is need for a group of related parties to coordinate an activity. These areas include clearing and settlement, derivatives clearing, syndicated loans, trade finance, core banking systems, international payments and interest in central bank cryptocurrencies – a somewhat misleading way to describe central bank-controlled digital currencies that use elements of crypto systems.

A major issue with commercial banks, though, is getting all the partners to agree on a common infrastructure design and then motivating them to change their legacy systems, which is costly and requires significant resources (in time and training, for example). There is thus emphasis on designing systems that enable banks to continue running their existing infrastructure whilst being able to plug in to a blockchain system, rather than replacing their entire infrastructure.

Cryptocurrencies as an investment asset class

A range of financial institutions have begun offering funds, ETFs and structured products to allow either long or short exposure. There have been a range of diversified crypto venture capital funds (investing in crypto businesses) and cryptocurrency funds (that hold tokens). Greyscale launched the Bitcoin Investment Trust; XBT Provider AB Sweden launched Bitcoin and Ethereum trackers in July 2017; and Swiss structured product providers Vontobel and Leonteq have both released Bitcoin tracker certificates, including Bitcoin shorting products. The design and legal structure of these products is beyond the scope of this paper, but most appear to be backed by holdings of cryptocurrency, rather than synthetic exposure via derivatives. The market for crypto derivatives (e.g. forward contracts, options, swaps) remains small, but the launch of Bitcoin futures by CME Group could assist with the future development of structured products.

However, it is important for investors to consider the energy implications. The proof-of-work concept is energy intensive, with miners competing to process the transaction with more-and-more processing power. Bitcoin has also been associated with criminal activity. The concept of an online wallet (that holds bitcoin) is not regulated, and so, bitcoin (assuming bitcoin can be cashed into real currencies by both sender and receiver) can be used to money launder or for fraud. From 2011 to 2013, Bitcoin was notable for its use on Silk Road – an online market place that combined bitcoin technology and Tor for, among other things, selling drugs.

Alternative capital raising

One of the major blockchain buzzwords that has risen into the public imagination is the ICO, or initial coin offering, presented as an alternative method of raising money for start-ups or enterprises. Originally, most of the businesses raising money using ICOs were attempting to build blockchain-based or decentralised services, but, more recently, “ordinary” businesses have also been drawn to ICOs. This is in part due to the speculative frenzy that has accompanied many of these ICOs, with enterprises able to raise sizable amounts with very little track record or clear business plan. The process is quite simple: a company solicits money from people and gives them tokens in exchange, and the tokens – in theory – represent some claim upon the future success of the company. In this sense, ICOs are similar to share issuance or IPOs, but they are unregulated and the legal status of the tokens issued is far more questionable.

Many ICOs have been criticised as being scams, or at the very least, akin to Dot Com Bubble shares issued by teams without robust propositions. Unsurprisingly, a major debate that has sprung up concerns whether ICOs should be regulated, partly hinging on the legal characterisation of the tokens being issued. Many instigators of ICOs have been at pains to prevent the tokens being characterised as securities, whilst simultaneously marketing them to people as an investment opportunity. The main loophole to address this is to characterise the tokens not as shares but as utility tokens that will enable the holders to interact with the future platform or product once it is built. In this sense, the process is somewhat analogous to a management team of a non-existent gym selling gym memberships that promise access to a future gym as a way to raise money to actually build that gym, which in turn will accept the memberships. To many regulators, such a process looks very similar to issuing shares to obtain money to build an enterprise that will later benefit the shareholders. The tokens, however, often do not carry any of the legal rights that shares would (such as rights to dividends and voting), so they appear to be neither shares nor, for that matter, utility tokens, given that the platforms that would give them utility do not yet exist. Many appear to be a form of quasi-equity that are sold on the promise that they will later convert into utility tokens when the enterprise builds something that will have utility. To some extent, they are similar to crowdfunding projects that raise money by promising people products in future, but differ in that the tokens can be traded on secondary markets.

The ICO markets are currently too small to be of major interest to institutional investors, who also dislike the legal ambiguity of the tokens. That said, and despite widespread market fraud and abuse, they are important test beds of hypothetical future hybrid financial instruments. The sophistication of tokens issued is increasing, and authentic shares and bond instruments could one day be modelled in crypto token form.

Blockchain for environmental, humanitarian and social services

Much activity in the blockchain space is motivated by people speculating for profit, or cutting business costs to optimise profit. Nevertheless, there is an emergent “blockchain for good” or “blockchain for impact” community, attempting to use it for non-commercial purposes. Individual humanitarian organisations, UN agencies and social enterprises have launched private initiatives, and coalitions are emerging. These include the Blockchain for Impact Coalition, set up as a conduit for UN agencies to engage with private blockchain technology vendors, the Blockchain for Social Impact project run by ConsenSys (a major for-profit Ethereum application developer), and the Blockchain for Good think tank. Meanwhile, the EU Commission has put out “blockchain for social good” calls.

The major categories that tend to be focused on include:

Financial inclusion: Remittances, microinsurance (Stellar)
Ethical or transparent supply chains: Tracking the origins of raw materials (Provenance) or conflict-free diamonds (Everledger)
Open government: Finding ways to promote greater visibility of public spending
National e-voting systems for tamper-proof election results
Direct democracy systems: Enabling people to participate in democratic decision making
Securing property rights: Land registry systems
Humanitarian aid distribution systems
Charity donation systems
Identity systems: Self-sovereign identity or the ability to control one fs own identity
Sustainability and climate change
Distributed renewable energy: For example, energy trading systems
Education: Secure recording of educational certificates, for example
Healthcare: Storing and access to medical data, for example
Decentralised platforms for a collaborative economy

It is important to note that many projects within these areas are, firstly, aspirational in that they are not widely deployed; secondly, address problem areas that do not necessarily require blockchain technology; and, thirdly, do not necessarily address the problems they claim to solve. A healthy dose of scepticism is advised when assessing them.

Conclusion

It is important to note that many blockchain technology projects are not claiming that “this cannot be done without blockchain”. Rather they are normally saying “we can do this previously centralised function in a decentralised way”. As Provenance notes, “Until now centralised data systems were the only way to power a traceability system for materials to ensure data was trustworthy … We believe [blockchain] can disrupt how we track the attributes and journey of every material thing - powering a system everyone in the supply chain can be part of”.

The value proposition is either phrased in terms of 1) efficiency - “this will work better” or else 2) participatory democracy - “this will be more inclusive and responsive to people’s needs” - posing questions of ethics and philosophy, which is unique to the application of blockchain and the investor.

Feedback, further resources and suggestions for future work on blockchain can be sent to [email protected].