Look through enough Silicon Valley pitchbooks these days and you’ll quickly realize that one of most overused adjectives in the venture-financing world is “disruptive.” Everyone, it seems, is disrupting something. Start-up CEOs love to describe what they’re doing this way, especially when speaking to potential investors. However, the vast majority of innovations are not disruptions at all, but merely the logical next step in the development of a product or service and not something that turns the status quo irreversibly on its head. True disruptions – those that involve the complete invalidation of whatever came before – are relatively rare.
Sometimes, such disruptions come from the introduction of a particular product, like Apple’s iTunes, that instantly render every other competing product obsolete. Others can be traced back to a catalytic moment, a thunderclap that forever redefines the current state of the art – Chuck Yeager’s breaking of the sound barrier in 1947, for instance, which changed the trajectory of an entire industry in a single morning.
Overstock’s Patrick Byrne, Modern Trader’s CEO of the Year, and already a successful veteran of the Internet’s wholesale disruption of brick-and-mortar retailing, describes the events of Dec. 15, 2016 in a similar vein. That’s the day Overstock (OSTK) raised $10.9 million in a rights offering partially executed on its T0 blockchain-based platform, becoming the first company in history to issue registered securities that exist only as digital assets to the public, and the first to see those shares subsequently trade on a blockchain-based registered alternative trading system (ATS).
Like Yeager’s X-1, the offering was largely a proof-of-concept demonstrator. It is less important for what it actually raised than for what it portends – which, if Byrne is correct, is a system that ultimately renders a vast swath of Wall Street’s back office as obsolete as a cassette player. “Blockchain [is] transformative to the financial industry,” Byrne said in an interview shortly after the conclusion of the rights offering. “It takes out 80% to 90% of the settlement cost, we believe. It doesn’t take three days [to settle], it takes out systemic risk, it takes out derivative risk and it reunites settlement with the trade. That’s magic. That’s like trading when you were little kid, ‘here’s my baseball card for that stick of gum.’ It is a whole new world.”
Plus, Byrne says, the blockchain is the first time trust has been technologically introduced via a cryptographically secure, decentralized system. “People don’t inherently trust each other,” he says. “That’s why we need third-party institutions like exchanges, (clearinghouses), and registries and the like, because they inject trust into a trade. Some are from the government, some are private; but trust is the common denominator. But these centralized institutions can be compromised. The blockchain is the first time in human history where that trust can be independently and cryptographically protected.”
Seal of approval
Importantly, the system used for the offering was fully blessed by the Securities and Exchange Commission (SEC), which means future blockchain-based offerings will now not only have the technical model, but also a blueprint for getting similar deals through a labyrinth of legal and regulatory hurdles.
“We built a capital market within the four corners of the U.S. regulatory system: The SEC, FINRA (and other regulatory bodies) were peering over our shoulders the whole time,” Byrne says, alluding to the regulator’s keen interest in exploring blockchain applications. “The SEC has been a very productive partner,” he adds. “They understand that this will make for a fairer market, one where it’s impossible to do the kinds of things they’re in the business of preventing.”
Byrne’s interest in a system that prevents abuse and fraud lies close to home, having waged a bitter campaign 10 years ago against sellers of Overstock shares that were so-called “naked shorts,” -- traders who shorted the company’s stock without getting a clear borrow on them. With a three-day settlement window, plenty of time exists for brokers with complex systems to lend out (for a fee) shares to traders, which sell short but then close the trade without actually ever settling the borrowed shares. This creates an illusion of more stock sold short than is actually the case, while also placing downward pressure on the share price, and thus helping the trader profit from selling shares that never existed in the first place. At one point, more shares of Overstock were listed as sold short than were issued by the company.
The experience, says Byrne, led to a realization about just how much “slop” existed in the securities settlement system and the loopholes that existed through which hedge funds, prime brokers and other large institutional players could manipulate stock prices.
“Back then, the SEC was really asleep at the switch,” he says, noting that it took the global financial crisis to really shine a light on what was going on behind the scenes in financial markets. “Alan Greenspan went before Congress in October 2008 and said this has to do with three things,” Byrne says. “Fraud, settlement and securitization.” And while the SEC has since gotten serious about policing the mechanics of short selling, it’s no surprise that T0’s solution specifically uses the blockchain to provide what Byrne characterizes as an “impenetrable, immutable chain that takes all the slop out of the locate system for short selling.”
The eternal battle
Of course, as with any disruption, there are legacy players with vested interests in the status quo that are unlikely to cede billions of dollars of revenue without a response. In this case, most global financial institutions are also looking at ways to utilize blockchain applications, and more than 50 of them have joined forces within the R3 consortium of financial institutions involved in research and development of blockchain applications. But it has led to what Byrne characterizes as a Game of Thrones situation in which the banks, the exchanges and the clearing agents are each aware that whoever perfects this technology first can disrupt the other two.
“They all pretend to be in the same boat,” he explains, “and they’ve made alliances like R3. But at the end of the day, there are such enormous incentives to get this technology right that everyone will jockey for a dominant position. It will create a period of tremendous disruption within the establishment.
“It’s an extinction event for the legacy players in the capital markets,” he stresses, agreeing with the analogy of dinosaurs gazing skyward as the comet that killed them streaked across the sky. “Some will survive, and some will adapt, and the guys at the top will do everything they can to milk the old system for as long as they can. But if a new approach takes 80% to 90% of the cost out of doing something, competitive forces will be just too overwhelming for it not to ultimately take over. That’s what will happen here.”
For the moment, Byrne plans on licensing T0’s technology to other companies, while also watching carefully to see if a premium opens up for the blockchain-traded shares over the conventional ones. In the meantime, he is having conversations with everyone from exchange traded fund providers to ATS operators about how the technology underpinning his rights offering could be adapted to different environments. Eventually, he might consider opening T0 or its parent, Overstock’s wholly owned subsidiary Medici, up to outside capital or spinning it off, although no such plans are currently in place.
In the meantime, Overstock remains heavily engaged in the buildout of blockchain applications. “We realized that if the blockchain is a new age coming to mankind, what are the fundamental processes we want to be part of?” he explains. “So we looked around and decided we wanted to have a stake in, say, blockchain meets capital markets, so we built T0. Then we thought about blockchain meets central banking, and blockchain meets voting, etc., so we’ve invested in startups like PeerNova in San Francisco and Bitt in Barbados, that will be very important in bringing this technology to a wide range of different areas.” On the short list: AML/KYC, fraud prevention and equity crowdfunding.
Byrne admits that for Overstock’s investors, the moves may have raised some eyebrows. “We’ve been taking some of our cash flow for three years to build out a stable of assets that doesn’t seem to make much sense,” Byrne says, adding, “Investors who own us because we’re a retail company have wondered what we’re doing. But there’s a real logic to it. Blockchain will do to a lot of industries what the Internet did to publishing.
“Speaking as a guy who’s been both an internet entrepreneur and a blockchain entrepreneur, blockchain will have a more dramatic effect on society than the Internet did,” he adds.
Disruptive, indeed. As for timing, Byrne says blockchain financial products will be ubiquitous very soon. “It’s just a question of how quickly [it] supplants legacy systems,” he explains. “The costs are so much lower. If someone introduced a new car that was 80% cheaper than the current cars on the market, how long would it take them to take over? It’s that powerful. I don’t see how it doesn’t really blossom over the next three to five years.”