Joel Simon: While the world has been busy battling COVID-19, it has been making startling progress in an area that has held a lot of promise but was struggling at times to gain traction—digital securities and virtual currencies. What just a couple of years ago seemed like a Wild West of scams and frauds has quickly been evolving into a mature, efficient alternative of capital raising and trading, that has been embraced by traditional financial institutions and governments alike. With me today to chat about these developments is a leader of our Fintech practice and head of our Derivatives and Structured Products group, Daniel Budofsky.
First, I’m interested to hear about cryptocurrencies. Just today (the day we are taping), Goldman Sachs stated that Bitcoin is just a bubble that dwarfs all other bubbles, including historic manias like the tulip and dot-com bubbles.
Daniel Budofsky: The first generations of virtual currencies like Bitcoin are simply digital representations of value that function as a medium of exchange. Although they can be exchanged for U.S. dollars or other fiat currencies, they have not been backed by governments or central banks, so their value has been driven solely by supply and demand. As a result, they have been seen to be more volatile than traditional fiat currencies. Interestingly, there are strong signs that this is changing.
First, we are seeing a lot of activity in so-called stablecoins. These are virtual currencies that are tethered or otherwise linked to an existing fiat currency or some other asset like gold or oil. The highest profile example of this has been Facebook’s Libra Project. Originally, Libra was going to be a single digital currency tied to a basket of short-term government securities and bank deposits from different countries, but in the face of strong regulatory pushback, Facebook modified its plan. Now the plan is to issue multiple virtual coins, each tied to a single currency.
And this, actually, leads to a second point. The Libra Project, in the words of Federal Reserve Governor Lael Brainard, “imparted urgency” to the conversation around digital currencies sponsored by central banks. In fact, six countries now have digital currency pilot programs in place. The U.S. is lagging but working on it.
Simon: That’s very interesting. What countries are leading the charge?
Budofsky: China, for one, is a good example. The People’s Bank of China recently launched a pilot program of its own digital currency, known as Digital Currency/Electronic Payment (or DC/EP).
Simon: Moving from digital currencies to digital securities, have there been many developments in the past few months?
Budofsky: It has been so busy. Apparently, crisis is the mother of innovation. Essentially, what we are seeing in the United States is (1) the death rattle of the SAFT (or Simple Agreement for Future Tokens) and ICOs (or initial coin offerings) that were wildly popular (although frequently illegal) in 2017 – 2018 and (2) the transformation of the underlying technology into an infrastructure for digital securities that is designed to be fully compliant with existing regulations. As private companies look for liquidity in the face of the current economic crisis, digital securities can offer an attractive and efficient way to raise funds and for investors to quickly and efficiently trade their financial assets.
Simon: Can you quickly walk us through the history?
Budofsky: Sure. Obviously, this is a huge over-simplification, but I think of this advancing in several stages. First, is the seminal idea of distributed ledger and its incarnation in Bitcoin. For some, this was just a new form of money, but I think it would be naïve not to remember that for some, Bitcoin was a highly political project: a means of creating a new society where economic power would reside outside and beyond the control of the state and the banking institutions and financial sectors (which some saw as evil) would be vanquished.
Next, with the layering on of so-called “smart contracts,” we saw developers seize on the idea of initial coin offerings, or ICOs, as a way to raise capital for blockchain projects in a manner they believed was free of regulation. The instrument of choice starting in 2016 was the SAFT (Simple Agreement for Future Tokens), a financial product based on the Ycombinator SAFE (or Simple Agreement for Future Equity), which is quite popular for startups in Silicon Valley. This was basically an investment of dollars (or bitcoin) today for the right to receive digital tokens at a discount later. By mid-2017, the SEC had begun to make clear that the vast majority of these ICOs were good old-fashioned securities offerings that needed to comply with the securities laws and, for those who didn’t believe it, in April 2019, the SEC issued its Framework for “Investment Contract” Analysis of Digital Assets, a tool to help market participants apply the Supreme Court’s Howey test to digital assets to determine whether securities or not.
Simon: And you say that we’re hearing the death rattle of the SAFT and ICO?
Budofsky: A major case came out of the Southern District of New York this year in which the SEC shut down the distribution by messaging company Telegram of their tokens, TONs, which had been the subject of SAFTs several years ago. The Court accepted the SEC’s argument that the distribution of the tokens was an illegal unregistered sale of securities. More surprisingly, the court found that the original placement of the SAFTs (purportedly done as a Reg D private offering) was merely part of a unified public underwriting of the tokens and failed to qualify for the private placement exemption. The SEC has made the same argument in its case against the Canadian messaging company, KIK. All eyes are now on Filecoin, another project sold through a SAFT, to see if they will escape SEC or third-party investor lawsuits.
Simon: So, what is the phoenix arising from the ashes of the SAFT?
Budofsky: We are seeing the construction of a distributed ledger-based infrastructure to support digital tokens that are compliant with securities laws. This infrastructure will include primary issuances of digital securities, custody of digital securities, secondary trading of digital securities and the ancillary but necessary services of transfer agent and record keeping. And most importantly, perhaps, we are seeing the support for such infrastructure coming from traditional financial institutions.
Simon: How are traditional financial institutions getting involved?
Budofsky: This is really the most interesting aspect of market developments. For example, last month, DTCC came out with proposals for digitalization of assets contained in two case studies. One of those—Project Whitney—is all about tokenization of securities and assets as a way for private companies to access main street investors for capital. This is particularly important as private companies stay private longer.
We’re also seeing the build out of the secondary market with exchanges like Nasdaq joining forces with the digital company R3 and the Boston Security Token Exchange getting close to being approved by the SEC for a secondary token exchange.
All these developments signal to U.S. institutional investors that with real financial institutions getting behind digital assets, the market may now be mature enough for them to fully embrace using blockchain to issue and trade financial securities.
Simon: That certainly is a dramatic turn of event in a relatively short period of time. It’s great to see the potential for a new source of capital liquidity developing at this time when more conventional avenues are filled with uncertainty and hesitation. We will have to stay tuned on this one. Thank you so much for your insights today, Dan.