Overstock to CryptoStock
The crytpo-currency industry has been in a tizzy since wired published an article about Overstock’s Radical Plan to Reinvent the Stock Market With Bitcoin. CEO, Patrick Bryne, has seen first hand how Wall Street has been corrupted to the core and is eager to do something to fix it. He has identified two primary sources of corruption, centralized clearing (exchanges) and fractional reserve banking. These systems allow corrupt insiders to sell shares in his company that don’t exist and manipulate the price.
The primary question that has been asked is “How to issue a crypto security” and a major wiki-war among the dozen or so potential solutions on the market. The primary contenders are NXT and BitShares because each allows their users to issue their own assets (though the SEC may call them securities depending upon whether the user makes any promises) and both provide a built-in exchange that is entirely decentralized.
The question is do any of the existing technologies offer a ready-to-go solution for Overstock to dual-list their shares? In my opinion I think that none of the existing systems are able to meet all of the regulatory and business requirements and that Overstock will have to work with someone to customize their block chain to meet the needs.
What is the primary issue? Issuing shares in a publicly traded company that are effectively Bearer Shares which are essentially illegal in most jurisdictions around the world.
Bearer shares are a type of freely transferable securities, which only by ownership demonstrate participation in a company. In registered or conventional shares, the name of the owner is included and will also be entered in the shareholder’s register of the company. If a change in ownership is to be made, the share endorsement and change in the registry will be required.
By contrast, as no name is included in the bearer shares, any person who has them in their possession is recognized as the owner. If you wish to transfer these shares to a third party, it will suffice to just hand over the certificates. There will be no need for any paperwork or changes to the registry of the company (except for anti money laundering control in certain jurisdictions) because only the amount of bearer shares that were issued to create the company and their numeration are shown, without making any reference to their owners. It is similar to the operation of a cashier’s check, whereby any person presenting it can collect the amount contained therein.
The measures against money laundering and tax fraud that many countries and organizations are adopting have significantly stigmatized and challenged bearer shares. The pressure on the governments of tax havens has forced many offshore jurisdictions to limit their use. Normally, these constraints involve the immobilization of securities. That is, the bearer shares must be in deposit and custody of a bank, a trust firm or the registered agent of the company who also usually must maintain a record of the owners. The objective of this measure is to register any change in ownership of the company and to be able to determine at all times who holds the legal ownership. With such limitations, not only the whole essence and flexibility of the bearer shares is lost, but their transmission becomes more complicated, because of not being directly in the hands of their rightful owner. These types of limitations have already been imposed in most tax havens.How to Legally Issue a Crypto Security
The solution to Bryne’s problem is in finding a crypto-system that supports the issuance of registered or conventional shares where the name of the owner is included and tracked in the shareholder’s register of the company. The shareholder’s register is effectively all a block chain is.
While some systems like BitShares with TITAN allow users to transfer shares to an account by name rather than account number. No systems currently support restricting share ownership to certified identities, but BitShares aims to be the first to market with a practical, easy-to-use solution to this critical problem.
The solution is really quite simple, an Identity Authority simply needs to sign the BitShares account with a certification that the owner has provided the necessary Know Your Customer documentation and then the BitShares account needs to digitally sign the shareholders agreement and release their identity information to Overstock.
After these signatures are in place, then and only then, should a block chain allow a particular account to buy, sell, or send or receive these securities. This may not be ideal from a crypto-anarchy point of view, but from the perspective of Overstock it will allow them to achieve their primary goal: a honest and transparent securities market provably free of fractional reserves, naked shorting, and high-frequency trading. Better Market Algorithms
“Byrne says that one of the things he’s trying to eliminate is high-speed trading that serves no real purpose”
In the world of Wall Street the markets move at the speed of light with trades executed in milliseconds. This type of speed is not possible on a decentralized system because even at the speed of light it takes 200 ms for information to travel around the world on the internet. This is no problem for Bryne because it helps enforce his goal of eliminating high-frequency trading.
But the speed of trading is not the real issue at play, but instead an artifact of a fundamental flaw in the order-matching algorithm used in traditional markets. If you stop to think about what a price really is (an estimate of the value of a company) you will see that this estimate should only change when new information becomes available and can be processed by the shareholders themselves. Human judgement cannot possibly operate at 200 ms and is even challenged to operate on the 10 second intervals supported by BitShares or the 1 to 2 minute intervals of Nxt.
High speed trading is the result of Wall Street insiders attempting to “front-run” orders placed by people who have access to real information. When someone learns some news that causes them to buy the insiders can see the buy order in advance and place automated trades to buy up any asks lower than your bid and then sell to you with almost no risk.
What this means is that traditional order matching algorithms where you get the best price for your bid are an illusion because anyone closer to the exchange than you are can steal that advantage and give you what you asked for and little more.
BitShares recognizes this process and thus implements a system that effectively eliminates front running by insiders. All executed orders always receive the price they asked for and nothing more or nothing less. There is no opportunity to squeeze risk-free profit out of market participants by executing orders that take up any overlap between the bid and ask.
To be fair the block chain becomes the ultimate insider. What this algorithm really does is take all of the money that could have been earned by front running (over lap between bid and ask) and collect it as fees for the network. If forces market participants to place orders at prices they are willing to pay based upon their opinion of fair value. By removing the profit potential from front-running, BitShares is the only system that will not see attacks by high-frequency traders attempting to squeeze profit out bid/ask overlap.
Another side effect of this market matching algorithm is that those that attempt to walk-the-book in a single trade in an attempt to manipulate the market will pay a much higher price than someone who walks the book at a slower pace. Once again the trading algorithm punishes “fast traders” and rewards “value traders”. Minimizing Counter Party Risk
There is one other aspect that companies looking to list their shares on a decentralized exchange must consider: what are the shares going to be trading against? In the case of everyone but BitShares X, the only thing you can trade against are shares in the system (ie: Nxt) or shares in other assets listed on the system.
So if Overstock wants to trade against USD then someone must issue bearer bonds denominated in USD. These bearer bonds would be a promise to pay $1 on demand and would be a 2nd highly regulated security.
Overstock would likely have to issue their own Overstock USD bond to trade on the system against their own shares. This once again opens up a huge regulatory challenge centered around Know Your Customer laws. If not Overstock USD then the USD issued by some exchange that is subject to potential fractional reserve issuance.
Because fractional reserve issuance is one of the primary issues Patrick Bryne has identified that needs to be solved, it seems counter-productive to rely on an crypto-IOUs for your users to trade your stock. Using a block chain for order matching is moot if you are still relying on a 3rd party to manage the IOU.
At the same time, absent crypto-dollar IOUs the only assets left for Crypto-Overstock shares to trade against are other crypto-assets which all have market caps of less than 10% that of Overstock.
This is where BitShares X with BitUSD collateralized by shares in BtShares X provides a unique advantage over all other systems. BitUSD is not an IOU issued by a central party, but a crypto-asset that has no counter-party, is not a security, and confers no legal obligation on any party. It is created by free market forces and is backed by 1.5 to 2 dollars worth of BTSX.
Only with BitShares X can companies like Overstock allow their shares to trade against trust-free assets pegged to the dollar, gold, silver, or other national currencies. Conclusion
Only BitShares X with the addition of certified accounts is able to meet the regulatory, philosophical, and business objects Patrick has laid out. It resolves fractional reserves, naked shorting, and high-frequency trading manipulation. But more important than all of those factors, the leaders of the BitShares ecosystem is not hiding behind anonymous internet identities and are available to customize their solutions to the needs of Overstock and similar companies.
As nice as it would be to see Overstock issue a crypto-stock for their company in the next few months, I think it would do far more harm than good. Without taking the time to make sure the plan is air-tight from a regulatory perspective Patrick could make Overstock the target of regulators and scare away everyone else from the amazing potential of tracking their shares on a crypto-ledger.
I would appreciate it if someone could take some time to clean this up prior to posting it on bitshares.org and then linking it to the Wiki at overstock.