Building Trust in the Private Capital Markets

The Importance of Trust in Financial Transactions

Trust is the foundation of modern financial transactions. Without it, the intricate spider web and rabbit warren of financial processes that form the global financial system would collapse. Every financial contract, whether it is a legal contract or a social contract would be uncertain and suspect. The type of deep and universal trust is hard to build and easy to break. The financial world, with its high stakes and complex dealings, has seen its fair share of trust-shattering scandals and thefts.

Trust is lost when there is unchecked risk-taking, outright deceit, or complicated and opaque financial instruments. The 2008 financial crisis, Ponzi schemes (topped by Bernie Madoff’s scandal), and more recently the SBF fiasco don’t exactly inspire trust. These events are stark reminders of what happens when trust is violated in financial transactions. Bad as the financial losses are, the worst effect is the pervasive sense of betrayal among investors, consumers, and even regulators. Some financial losses may be recouped, but loss of trust can last a lifetime.

Building a Chain of Trust with Blockchain

But what if there was a way to incorporate trust into the very foundation of financial transactions? That would make them transparent, secure, and immutable. Moreover, that would provide the foundation for creating a Chain of Trust. Imagine a scenario where every transaction in a business process is not only connected to the ones before and after it but is also recorded in a way that cannot be altered or disputed. This is not fantasy or sci-fi. It is possible with a correctly engineered permissioned blockchain.

At a very fundamental level, blockchain is a distributed ledger that records transactions immutably after forming consensus among all the appropriate parties. A transaction recorded on the chain is trusted, provided the participants have been verified and vetted. Moreover, the transaction must be compliant with all applicable regulations. Finally, the transaction must conform to contract law. These requirements lead to a new paradigm in the private financial markets: the Chain of Trust. Not only are transactions on the chain technically linked, but they can also be proven to be compatible with regulation.

Unveiling the Power of Permissioned Blockchains

All of the above presumes that the blockchain architecture does in fact support such compliant transactions. Not all blockchains are created equal. In the context of financial transactions, where privacy and regulatory compliance are paramount, permissioned blockchains emerge as the right vehicle to implement this Chain of Trust. Unlike their permissionless counterparts, where anyone can join and participate in the network, permissioned blockchains restrict access to trusted entities only. This setup provides a safe and controlled environment where transactions are recorded and accessed by authorized and mostly regulated participants.

A permissioned blockchain serves as a digital ledger that only pre-approved members can access, ensuring that each participant is known and accountable. This is crucial for investors, broker-dealers, companies raising money, and regulators, who need assurance that their transactions are secure, compliant, and verifiable. By leveraging this technology, we can create a financial ecosystem where trust is not just expected but embedded in the system itself.

Building Momentum for Change

The value proposition of a rightly architected permissioned blockchain and the Chain of Trust it creates is not just in its security features. It’s also about efficiency and speed. Traditional financial transactions, especially those crossing borders, can be slow and fraught with red tape. With blockchain, these transactions can be streamlined, reducing the need for much of the manual intermediation, and cutting down on manual follow up and reconciliation.

Of course, no system is without its challenges. Implementing a permissioned blockchain has the challenge of creating a sufficient base of applications that work seemlessly with each other. Think of these as reference solutions that others can adopt and on which they can build and innovate. This does not require a significant overhaul of existing systems, since the goal is to completely comply with regulation. It also doesn’t require interoperability. If there is no other game in town, interoperability is moot. However, an open-ended architecture and the willingness to work with all the participants in private capital markets goes a long way in creating momentum.

So, to our investors, broker-dealers, companies looking to raise funds, and the diligent regulators keeping watch: the future of financial transactions is not a distant future or a sci-fi fantasy. It’s here now. It creates a future where trust is not a luxury but a given, thanks to the transformative power of permissioned blockchains and the Chain of Trust they enable. The road ahead may be long and winding, but the destination – a more trustworthy and efficient financial system – is clear.

AI and Blockchain: Divergence at the Entropic Boundary

To begin our journey on AI and Blockchain, let’s look up into the night sky.

If in this nocturne period, you look in the direction of the constellation Ophiuchus, you won’t see the nearest (as of this date) black hole called Gaia BH1 (aka Gaia DR3 4373465352415301632), which is a mere 1560 light years away (i.e., practically in our backyard). If you get to within 17 kms from it (please don’t try this at home), no power in the universe can save you from its clutches. This point of no return is called the Scwharzschild radius. From our human perspective, that’s  nothing to worry about.

Now, look up 38.8987° N latitude, 77.0056° West longitude on the third rock from the sun in the Milky Way galaxy. There, you will find another black hole called the SEC (Securities Exchange Commission). Its physical Schwarzschild radius is not really a “radius”, but its physical event horizon (another name for the S radius) is the U.S.A, while its virtual event horizon is the planet Earth (i.e., there’s no escape!). From our private capital markets perspective, this is definitely something to worry about.

Blockchain and SEC

Public blockchains in the financial markets today have one leg within the SEC’s event horizon while, with the other leg, they are trying very hard to escape its clutches. Any guesses who is going to win this tug of war? The SEC has far more resources and staying power than the advocates of the public blockchains. The SEC’s event horizon is the JOBS Act and securities regulation in general.

Now, imagine a bright blue luminous star. Stars don’t have the equivalent of a “clutching” boundary like a black hole does (you can thank Newton for that). But, there is a boundary beyond which there isn’t enough energy or influence to sustain life. Think of it as an “entropic boundary”. Beyond that boundary, there are no laws, no order, no life, just a frigid waste. Inside the entropic boundary and way closer to the star is the hot crucible of innovative hype that can destroy wealth, demolish dreams, and diminish hope.

It is only at or close to the entropic boundary that responsible and game-changing innovation is to be found. The public blockchains were spawned far outside the entropic boundary of investor-centric responsible innovation, out in the dark, frigid, lawless, and wild space, wandering dangerously close to the SEC’s event horizon. 

Beyond Decentralization: AI and responsability

At KoreChain, we believe in the power of a distributed ledger and subscribe to the benefits of decentralized data and processing. But, we stop far short of decentralizing intelligence and common sense. Unconditional freedom is the hunting ground of crooks and free-loaders.

Surprisingly, artificial intelligence (AI) has had a much more responsible evolutionary path. For decades, AI could only be found in the halls of academia. With increasing computational power and availability of massive amounts of transactional data, AI found another home in the corporate world. Because the corporate world values monetization over privacy and ownership of data, it was inevitable that AI stepped over the entropic boundary. With the dramatic Cambrian explosion of large language models (LLMs) such as ChatGPT and hundreds of other AI tools (numbering at the present time to over 100 and rapidly growing), AI clearly broke free of the protective fence of the entropic boundary.

Watch in the evolution of AI and Blockchain: Insights and Considerations

On the other side of the entropic boundary there are dangerous black holes lying in wait for the unwary users of AI (let’s call these the ‘dark’ holes to distinguish them from the blameless astronomical black holes). Some of these dark holes are independent criminal organizations and terrorists, others are state-sponsored hackers, yet others are the misanthropes and misfits whose motives are death, desolation, and destruction. Like black holes, you can’t spot them easily.

The difference between these dark holes and the SEC is that the dark holes are out to catch the good guys while the SEC tries to catch the bad guys. Unfortunately for us, there is no equivalent of the SEC in the AI world. I doubt there will ever be one. Putting any guardrails around AI at this point in time is like smoking a cigar outside in a hurricane and trying to stuff the cigar smoke back into the cigar. Any bets on how this will play out?

At KoreChain, we focus exclusively on using AI for good within the strictly defined universe of the global private markets. We use AI to help, to protect, and to guide. The KoreChain empowers the convergence of AI and blockchain around the right side of the entropic boundary.

Tokenization: Navigating the Friction between Reg A+, Web 3.0, and Today’s Transacting Landscape

Web3 technology, which is based on blockchain and decentralized systems, introduces unique challenges when it comes to complying with regulatory frameworks like Regulation A+ (Reg A+). 

Reg A+ is a regulation that allows companies to raise up to $75 million* from the public through a streamlined process, similar to an initial public offering (IPO), but with certain exemptions.

One of the key requirements of Reg A+ is the need for an SEC-Registered Transfer Agent—a designated entity responsible for maintaining a book of records that tracks ownership and transfers of securities. The Transfer Agent ensures compliance with regulations, such as recording share ownership changes, processing transactions, and maintaining accurate official records.

However, Web3 was not designed with this requirement in mind.  The concept of a centralized Transfer Agent is difficult to reconcile with the decentralized nature of blockchain technology. Here are a few reasons why Web3 poses challenges for Reg A+ compliance:

  1. Custody and Ownership: In Web3, users typically control their assets and interact directly with decentralized applications using their digital wallets, and transactions need not go through a central intermediary to be validly recorded in the blockchain. This introduces complexities in determining ownership and custody of securities. The traditional role of a Transfer Agent, which maintains custody and records ownership in a centralized manner, is not easily replicated in a decentralized environment.
  2. Decentralized:  The main thesis of Web3 is that it operates 100% decentralized, in its operations and data management.  This is in complete conflict with how the regulations like RegA+ have been written by the securities regulators.
  3. Anonymity and Compliance: Web3 technologies often emphasize user privacy and pseudonymity, which can make it challenging to meet the regulatory requirements for identifying and verifying investors participating in a Reg A+ offering. Ensuring compliance with Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations becomes more complex in a decentralized and anonymous environment.
  4. Regulatory Oversight: Reg A+ requires regulatory oversight and reporting to ensure compliance. In a Web3 environment, where transactions occur directly between users without intermediaries, it becomes more difficult for regulatory bodies to monitor and enforce compliance effectively.

While Web3 technology faces challenges in directly implementing a Transfer Agent-like function for Reg A+ compliance, it’s worth noting that the technology is still evolving. It is just not here today, and bringing together governmental regulatory oversight and web3.0 looks to be a ways off.

Efforts are underway to address some of these challenges through the development of decentralized identity solutions, regulatory frameworks for digital assets, and the exploration of hybrid approaches that realize the benefits of Web3 while meeting compliance requirements.

Ultimately, striking a balance between the decentralized nature of Web3 and regulatory compliance will require further innovation, collaboration, and regulatory adaptations to accommodate the unique characteristics of blockchain-based systems. 

So for today if you wish to transact and tokenize your digital assets, and most importantly transact utilizing RegA+ you can; just not yet with web 3.0,  and digital wallets in a decentralized blockchain.  

KoreChain is the solution for today and ever-evolving for tomorrow.

 

What Does “Clarity” in the Financial Markets Mean

First we had Chaos

The collapse of FTX has revealed the inherent chaos in the financial and capital markets. In the weeks and months to come, we will have better clarity on what really happened at FTX.  However, regardless of the actual details, one thing remains clear: the financial markets are subject to various types of uncertainties: economic, demand shifts, competitive pressures, global events, and acts of nature. The one type of uncertainty that is in our control is the integrity and credibility of its participants. Emerging details of the shenanigans of FTX reinforce the idea that incompetence and unethical behavior is frequently hidden in the complex organizational structures and revenue-share arrangements between the underlying entities.

Innovations in the cryptocurrencies and various digital assets emphasize the need for clarity. These innovations have introduced radical new business models. They have promised frictionless transactions without intermediaries. However, such promises require clear-headed analysis, since it is generally very difficult to disintermediate risk. Since the crypto space has been plagued by scandals involving hacking and fraud, it is difficult to differentiate between genuine mistakes and deliberate criminal activity.

The foundational philosophy of the cryptocurrency markets is privacy and anonymity. While this is laudable from one perspective, it also creates lack of transparency. Much of the regulation in the financial markets exists to promote separation of concerns, mitigate risk, and provide safeguards. By seeking to eliminate such regulation by claiming that it is onerous and intrusive, the crypto world eliminates all of the advantages of regulation. This lack of clarity and lack of regulatory oversight has encouraged bad actors to engage in fraudulent activities, from theft, front-running trades, collusion, Ponzi schemes, insider trading, and market manipulation. FTX is only one, though the largest, of highly questionable models that includes a Byzantine mess of relationships, organizational structures, and rapid and complex transactions, apparently with a view to dazzling any cautious investor from unraveling the truth.

Since the private capital markets are private, it is all the more important to be more transparent than ever. Without this clarity, investors find it hard to understand what they are investing in,  to monitor the continuing prospects of the company, and the nature of the risks they are taking. This is especially true of private markets since the very nature of private markets results in complex financial structures that are not subject to the same level of due diligence, analysis, and public disclosure as the public markets.

What can be done to improve clarity in the private markets? It is a combination of regulatory reform and self-governance. While the SEC and FINRA are moving in the right direction, private market participants can do much more on a voluntary basis. For example, partners in the private market ecosystem should disclose revenue-share arrangements, since these may result in conflicts of interest. The participants who are directly regulated by FINRA and SEC, such as the broker-dealers and securities attorneys should adopt a more fiduciary attitude and desist from revenue-share or commission arrangements between themselves. Their fee structures should reflect their agnosticity and keep the interests of their clients foremost in their mind. The issuers, auditors, KYP providers, and other parties entrusted with the examination and communication of various risks in the investments should go the extra mile in their due dilegence. Since the private markets offer more opportunities for innovation in business models, the participants should desist from “testing the waters”, which is a euphemism for trying to sneak questionable business practices past the regulators, hoping for nothing worse than a token slap on the wrist when detected.

The participants should also subscribe to a code of ethics. This should include not only desisting from harmful practices but also self-policing each other in a constructive and proactive way. Participants should create safety nets in case of errors. They should act much more conservatively, perform greater due diligence, and adopt a stronger sense of fiduciary duty than the minimum necessary for regulatory compliance.

One way to increase clarity in the private capital markets is to implement better disclosure requirements for private equity and venture capital firms. This can include requiring firms to provide regular financial reports and disclosures, such as regular updates on the performance of the investment and any potential risks. Additionally, regulators could require private equity and venture capital firms to make certain disclosures, such as information about their investment strategies, conflicts of interest, and any related-party transactions.

Another important step in increasing clarity in the private capital markets is to improve the quality and accessibility of data. This can involve collecting and publishing data on the performance of private equity and venture capital investments, as well as data on the financial health and stability of the firms that manage these investments. This data can be used to help investors better understand the risks and opportunities involved in private capital investments.

Finally, it’s important to create a regulatory framework that promotes clarity and transparency in the private capital markets. This can include setting standards for financial reporting and disclosures, as well as implementing rules to prevent fraudulent activities. Regulators could also implement measures to ensure that private equity and venture capital firms are operating in a manner that is consistent with investor protection and market stability.

In conclusion, clarity in the private capital markets is essential to ensuring that investors are able to make informed investment decisions and to build trust in the market. The prevalence of scandals in the cryptocurrency space highlights the need for clear and transparent practices in the private markets, including improved disclosure requirements, better data, and a strong regulatory framework. By taking these steps, we can help to promote a more stable and trustworthy private capital market for all investors.

The Demise of the Public Chains for Securities

The Australian Stock Exchange (ASX) made a big splash recently announcing the cancellation of their blockchain project after spending—and writing off—$165 million. While this sounds disastrous for blockchain technology, it is actually a cautionary tale since the blockchain project of ASX is based on Ethereum.

We have been saying this for over three years: public blockchains for securities and derivatives is a bad idea. In fact, Vitalik Buterin, one of the principal developers of Ethereum, himself noted back on May 19, 2016 that “…the weaker argument, that for high-value assets the economic security margin of public blockchains is too low, is entirely correct and depending on the use case is a completely valid reason for financial institutions to explore private and consortium chains.”  He was alluding to various versions of the settlement finality problem that he describes in that blog. From the subsequent failures of the ICO and the STO initiatives, it appears that very few of those developers read Vitalik’s article or understood it.

In ASX’s case, it appears that their blockchain is based on VMWare’s DLT, which is itself built on Ethereum and apparently addresses the limitations of Ethereum. The VMWare blockchain team had to go through (and probably continue to go through) considerable engineering to extend Ethereum’s functionality to make it useful for enterprise chains. Enhancements include a privacy SDK, governance, and scalability. The amount of work necessary to make Ethereum play nicely with securities is a bit like trying to convert a Ferrari into a cruise ship. It can be done, but why not start with a decent boat instead?

There are two main reasons why public blockchains are not best suited for financial securities. The first reason stems from a massive confusion about the nature of non-payment financial instruments, such as securities, derivatives, and asset-backed digital securities (such as NFTs). These financial instruments (the securities) are not bearer instruments. Transactions involving them are subject to corporate law and securities law. While some of these laws may seem onerous, they are there for good reasons that evolved with several hundred years of experience. Mainly, these laws ensure that transactions are subject to the judicial doctrine of contract law. Entities (companies or individuals) who act as intermediaries in these transactions provide valuable services, chiefly that of assuming counterparty risk. For this reason, the participants in transactions involving non-bearer instruments are either the principals or intermediaries who have fiduciary responsibilities. To put it simply, an ostrich farmer in Kenya has no business validating a securities transaction between a seller in Kansas City, KS, and a buyer in Los Angeles, CA.

This is, or should be, a powerful deterrent for using unverified participants (as in a public blockchain) to validate securities-based transactions.

The second reason why public blockchains are unsuited for such financial transactions is due to technical limitations of public blockchains. Scalability, recourse, recovery, privacy, and safety become paramount. Can a public blockchain provide all that? Yes, but at what cost, when there are permissioned blockchains available for such a use case?

To put it another way, the first reason says,”Don’t let a drunk drive a Ferrari.” The second reason says, “Don’t try to modify a Ferrari into a cruise ship when there is a cruise ship readily available to use.”

At KoreChain, we come from a multi-decade background in the financial industry, as executives, entrepreneurs, and traders ourselves. We are painfully aware of the issues in the existing legacy technologies. We also realize that regulation can be onerous even when well-intentioned. Our concern was not to waste time re-engineering Ethereum or any other public chain for that matter, but instead to focus on solving the business problem. Addressing the friction in the private capital markets was more important than going on a technology goose chase and attempting to shoe-horn a public blockchain for a very different purpose.

For this reason, we built the KoreChain on a solid base of an enterprise-ready, industrial-strength permissioned blockchain. We focused on the business architecture and design of the blockchain application.

None of this is a polemic against Ethereum itself, which is an ambitious technology that brought awareness to the power of smart contracts. It’s just not the right tool for this particular job.