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By Pamela L. Marcogliese,
Michael H. Krimminger and Marc B. Rotter
Pamela L. Marcogliese, partner at Cleary Gottlieb Steen & Hamilton LLP, New York, can be contacted at firstname.lastname@example.org. Michael Krimminger, partner at Cleary Gottlieb Steen & Hamilton LLP, Washington, can be contacted at email@example.com. Marc Rotter, associate at Cleary Gottlieb Steen & Hamilton LLP, New York, can be contacted at firstname.lastname@example.org.
Overstock.com Inc. (“Overstock”) recently filed a shelf registration statement with the Securities and Exchange Commission (the “SEC”) allowing for the issuance of “digital securities.” 1The SEC declared Overstock's registration statement effective on December 9, 2015. The digital securities described in Overstock’s registration statement will be evidenced only by entry into a publicly distributed ledger and transfers of the digital securities can only be effected on that ledger. They will not be evidenced by physical certificates or notes, recorded in book-entry systems of the type typically used by issuers and transfer agents today, traded through a traditional securities exchange or cleared through an established clearing system. Instead, ownership of digital securities and trades will be reflected in a publicly distributed proprietary ledger maintained by an alternative trading system (“ATS”) run by Pro Securities LLC using the technology of tØ, a subsidiary of Overstock. In June 2015, Overstock completed the first placement of corporate bonds in the form of digital securities pursuant to Rule 506(c) of Regulation D using the technology of tØ.
The digital securities described in Overstock’s registration statement represent a new application of the “blockchain” technology to the securities markets. A “blockchain” is a distributed digital ledger used to confirm transactions and ownership of assets, and it is best known as the technology underlying Bitcoin. Interest in using blockchain technology to increase the efficiency of, and reduce costs and risks associated with, securities transactions has continued to grow rapidly in recent months. For example, Nasdaq Private Market, LLC recently unveiled a platform to allow trading in private company securities using blockchain technology.2 A number of others have argued for use of blockchain technology both throughout the financial markets and more broadly, and are working on projects intended to do so.3 Regulators have taken note as well. The SEC recently noted that “the blockchain, or distributed ledger system, is being tested in a variety of settings, to determine whether it has utility in the securities industry” and asked for comment as to how that may impact transfer agents.4
Many proposals to use the blockchain for securities transactions remain under development and continue to evolve. However, they often (if not uniformly) pursue the same overarching twin goals of disintermediation to reduce risks and costs of transactions and same-day settlement (indeed, this second goal is so central to Overstock’s efforts that the subsidiary it uses to develop blockchain technology does business under the name “tØ” in contrast to the current standard for settlement in the U.S. of t+3). While specifics vary between different proposals,5 generally trades in securities would be verified or verifiable by all participants in the blockchain. Proponents argue this has the benefit of reducing the risk of fraud by making it more difficult for any one person or institution to illicitly modify the record of transactions or ownership for their own benefit. Further, by removing transactions from the traditional system of trading and settlement, proponents argue that settlement can be immediate rather than delayed.
At this early stage, many have expressed concerns about investor education, limited liquidity, cybersecurity and potential technological malfunctions. However, if these issues are addressed to the market’s satisfaction, widespread adoption of the digital securities framework put forward by Overstock would have far reaching impacts across the capital markets beyond reduced costs and faster settlement cycles.
Perhaps counterintuitively given Bitcoin’s association with anonymous transactions, disintermediation could have the effect of radically increasing transparency of securities ownership positions. Traditionally, most publicly traded securities in the U.S. are held in “street name,” or the name of a nominee for the ultimate beneficial owner or its broker. The issuer of those securities does not have direct insight into who beneficially owns its securities. Overstock’s proposal would allow retail and institutional investors to open accounts for trading in its digital securities, rather than acting through brokers. This would afford issuers the ability to see the identity of those holders and the ability to see investors accumulate positions in their securities in real-time rather than waiting for investors to file Schedule 13Ds, Schedule 13Gs, Form 3s, Form 4s and Form 13Fs. Availability of that information could have a significant impact on hostile takeover attempts, proxy solicitation and marketing for follow-on offerings, among other things. Further, because beneficial ownership information would not be included in the publicly distributed ledger, issuers may have the opportunity to develop significantly more detailed information about the market for their securities than would be available to investors. In addition, this increased transparency is likely to concurrently give rise to privacy concerns.
Traditionally, most securities trading in the U.S. is cleared through the facilities of the Depository Trust Company (“DTC”) and the National Securities Clearing Corporation (“NSCC”). DTC and NSCC net transactions, reducing the number of wires that must be sent by participants to one each day.6 It is unclear if transactions in digital securities would be recorded on the blockchain on a gross or net basis, or how payments would be processed. In addition, the increased number of direct retail and institutional participants, rather than intermediaries that could consolidate and net a number of transactions, could substantially increase the number of wire transfers needed for settlement of trades until a netting mechanism develops.
Overstock’s registration statement makes clear that digital securities would not be fungible with traditional securities that have the same terms.7 That could have significant impacts on trading in both digital securities and traditional securities. In addition, unlike in exchange traded products such as American Depositary Receipts, there is no clear arbitrage mechanism (such as removing shares from a depositary) built into the terms of the digital securities that would be expected to keep pricing of digital securities in line with equivalent traditional securities.
We expect that the regulatory and competitive landscape around the use of blockchain technology to facilitate securities transactions and its impact on the capital markets will continue to evolve rapidly.
2 See Pete Rizzo, Hands on with Linq, Nasdaq’s Private Market Blockchain Project, November 21, 2015, available at: http://www.coindesk.com/hands-on-with-linq-nasdaqs-private-markets-blockchain-project/. Nasdaq recently announced that the first issuance of securities using Nasdaq Linq’s blockchain technology has taken place. See Globe Newswire, Nasdaq Linq Enables First-Ever Private Securities Issuance Documented with Blockchain Technology, December 30, 2015, available at: http://www.nasdaq.com/press-release/nasdaq-linq-enables-firstever-private-securities-issuance-documented-with-blockchain-technology-20151230-00115.
3 See, e.g., Cade Metz, Tech and Banking Giants Ditch Bitcoin for Their Own Blockchain, Wired (December 17, 2015), available at: http://www.wired.com/2015/12/big-tech-joins-big-banks-to-create-alternative-to-bitcoins-blockchain/. John M. Jacobs, Strategic Perspectives—Blockchain technology: eliminating the middleman by digital disruption, Securities Regulation Daily Wrap Up (Oct. 14. 2015); Mike Gault, Forget Bitcoin—What is the Blockchain and Why Should You Care?, re/code (July 5, 2015), available at: http://recode.net/2015/07/05/forget-bitcoin-what-is-the-blockchain-and-why-should-you-care/.
5 For example, Overstock’s proposal would have transactions published to the public proprietary ledger maintained by the Pro Securities ATS. Overstock expects that transactions would become verifiable through the following process:
“[A]fter a set of transactions in our digital securities have been executed and recorded to the proprietary ledger, the Pro Securities ATS will send a de minimis amount of Bitcoin from an ATS-controlled Bitcoin wallet to another ATS-controlled Bitcoin wallet using the blockchain protocol. This blockchain protocol provides for an editable field that can be used to implant code or other data within the Bitcoin transaction that will be embedded into the blockchain, and the tØ software will use this field to implant anonymized cryptographic hash functions for the digital securities transactions reflected on the proprietary ledger into the Bitcoin transfer made by the ATS. The blockchain will validate this de minimis Bitcoin transaction and embed it, together with the implanted anonymized cryptographic hash function, into the Bitcoin blockchain. As a result, once the Bitcoin transaction is immutably embedded into the Bitcoin blockchain, an immutable record of the digital securities transactions reflected on the proprietary ledger is also recorded within the Bitcoin blockchain. The Bitcoin blockchain participants involved in validating the de minimis Bitcoin transaction do not have any access to the underlying digital securities transaction data. The transaction costs associated with this process relate to the de minimis costs of the Bitcoin currency transaction conducted by the Pro Securities ATS…Although the anonymized data publicly available in the Bitcoin blockchain will be encrypted, the tØ software will automatically publish to the internet information necessary to prove the validity of any copy of the proprietary ledger. This process ensures that anyone with basic cryptographic technical skills will have access on a near real-time basis to the embedded data necessary to prove the validity of any publicly available copy of the proprietary ledger.”
Overstock notes in its registration statement that this process could be changed if and at the time it issues digital securities.
6 See http://www.dtcc.com/matching-settlement-and-asset-services/settlement/end-of-day-settlement. The number of wires may be further reduced by netting at the settling bank.
7 As noted above, the digital securities described in Overstock’s registration statement are evidenced only by entry into the publicly distributed ledger. An alternative approach would be to issue traditional securities and provide investors with the opportunity to attach “tokens” to them that could be traded via a blockchain. It appears that may be the approach taken by tØ’s “Short Token” platform, which is intended to facilitate borrowing of publicly traded securities. See Cade Metz, Hedge Fund Borrows $10M In Stock Via the Bitcoin Blockchain, Wired (Oct. 14, 2015), available at: http://www.wired.com/2015/10/hedge-fund-borrows-10m-in-stock-via-the-bitcoin-blockchain/.
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