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Published on: February 13, 2020
How blockchain brings full transparency to capital raising
The traditional capital raising process is subject to an inherent conflict of interest. Yet, by removing the need for intermediaries, blockchain is going some way toward separating church and state.
Transparency, or lack thereof, is a persistent issue in the conventional capital raising process. Companies raising capital and investors offering it are often clients of the same intermediary, presenting that intermediary with a conflict of interest. This results in the solutions provided not always being the ideal long-term options for the businesses raising capital.
There have been many attempts to address this inherent failing. Crowdfunding, for example, is a recent and much-hyped means of facilitating methods of direct investment; last year around $10bn was raised through 6,455,080 crowdfunding campaigns worldwide. And, with a projected annual compound growth rate of 16.5%, the transaction value of this market will have more than doubled by 2024. However, a real solution on the scale required to replace the traditional capital raising process remains to be found, which is where blockchain comes in.
The current system: what’s broken?
The fundamental conflict of interest conventional investment banks face becomes clear quite quickly when we consider that the bank’s own long-term success will inform its decision making. While this is, of course, the very nature of capitalism and by no means inherently bad, the role of investment banks in the traditional capital raising process means their interests are not always aligned with those of the companies or the investors.
Parties involved in a transaction are inevitably ranked in order of priority (whether implicitly or explicitly) in accordance with their value to the bank as clients over the longer term. While this makes perfect sense from the point of view of the investment bank, it works to the detriment of both companies and investors.
SMEs in particular tend to draw the short straw under the current process. Smaller companies are often neglected by larger intermediaries, which are incentivised to prioritise the needs of large and influential investors. Yet at present these smaller firms account for 99% of all businesses across the OECD and between 50% and 60% of value added, as well as being the main driver of job creation, employing two thirds of the workforce. The financial and economic cost of the moral hazard in the current system is therefore amplified by that fact that SMEs generally seek to raise capital at a very sensitive stage in their development – they are vulnerable and in need of lasting support.
On the other side of the transaction, small investors are also disadvantaged, as their smaller wallets mean an investment bank is significantly less motivated to ensure they are presented with the best investment opportunities. Indeed, asymmetric information is perhaps the most common, most effective means by which large intermediaries play favourites, and therefore incredibly detrimental to the healthy functioning of the market.
The solution: full transparency through automated issuance
Crowdfunding has already succeeded in improving openness and transparency in capital raising: it removes various intermediaries and thereby conflicts of interest. But there is still plenty of room for improvement. For instance, most crowdfunding platforms focus on localised investor segments, immediately restricting the scope of any capital raise. Above all, the main issue remains a lack of liquidity after primary issuance, of which any potential investor in a crowdfunding campaign is of course painfully aware.
Enter, the blockchain.
A blockchain, for our purposes, is a decentralised record of transactions, additions to which must be verified by the entire network. The advantage of such a system is that transactions registered in the ledger are immutable and permanently auditable. While most financial professionals have at least a basic conceptual understanding of this technology, there is far less awareness of the potential it has to revolutionise the capital raising process in terms of efficiency and transparency.
First and foremost, the blockchain makes many key intermediaries redundant and creates a single source of truth, to which all parties have simultaneous and equal access. In the case of the capital raising process, there can be no selective disclosures nor conflicts of interest.
Additionally, as the very nature of a blockchain is that everyone is working with the same copy of the same ledger, updates are continuous and instantaneous. This means all participants are quite literally on the same page. For example, investors can monitor price fluctuations in real time and businesses who have issued share capital can keep track of ownership of the securities, all without the need for any intermediaries. Beyond just the exchange of information, through the use of programmes built into the blockchain itself (smart contracts), agreements between multiple parties can be executed without the need for a trusted third party, while still providing a verifiable audit trail for regulators.
To top it all off, automation of capital raising procedures by means of blockchain is perfectly scalable. Standardised templates allow companies to issue securities around the world, while smart contracts easily modify the templates in order to comply with local regulatory requirements. Investors, meanwhile, can trade those securities with tokens on blockchain platforms, facilitating liquidity in a secondary market largely non-existent for shares issued by conventional means.
Blockchain securities issuance is here now, and this conceptual and technological revolution will in due course exert the necessary pressure on fee structures to transform capital raising globally. The method is tried, tested, and fully regulated; though as a nascent market the awareness of the technology still lags its potential. Exponential as the spread of ideas is, however, there is a new standard for securities issuance, which is transparent, secure, and here to stay.