An old journey ends and a new journey begins
Earlier this month, I concluded my public service, which began in August 2009. Following the Global Financial Crisis (GFC), the CFTC was tasked with regulating the global OTC derivatives market. This market had contributed to the failures of AIG, Bear Stearns, and Lehman Brothers. The GFC had caused economic convulsions that led to millions of job losses and trillions of dollars in economic losses.
Since the Dodd-Frank reforms were implemented at the CFTC and elsewhere, the derivatives markets have been a pillar of financial stability. How? The CFTC returned to the first principles enshrined in its statutory mandate: protect against fraud and manipulation, promote fair and competitive markets, ensure financial integrity, and encourage responsible innovation. The CFTC's rules mandated electronic databases for OTC derivatives confirmations. They also encouraged centralized electronic trading, which reduced fraud and improved price discovery. Additionally, they required price transparency and extended existing leverage risk management rules from commodity futures to financial OTC derivatives. There was no genuflection about whether electronic trading was better than trading on a phone or in a pit. Rules around, for example, processing derivatives were developed as a function of “technological[] practicab[ility]” and mandatory streamlined electronic processing was promoted even though it eroded the moats of incumbents.
Late in 2023, I was given the opportunity to return to public service, this time at the SEC, but the attitude around technology had shifted (though the same leader was in place). Technology was no longer a tool in the regulatory tool kit, but rather an unwilling sparring partner in a conflict that yielded no winners. The SEC squandered an opportunity to shape the use of the technology toward its public policy goals, alienating 21% of Americans who invest in crypto.
U.S. securities laws were born from the 1929 stock market crash that lead to the Great Depression, which devastated investor trust. The drafters of securities laws considered and rejected “merit-based” regulation which would have put regulators making investment decisions for investors. Instead, the solution that was enshrined in our securities laws is one that protects investors by making sure thorough and accurate information is disclosed so that investors, and not the government, makes investment decisions. In the U.S. we therefore have a model of regulation where private market forces are channelled toward better market outcomes through rules set by policymakers. For example, better disclosure means informed investors means better investment decisions means a more efficient capital market. To be fair, our regulatory architecture doesn’t just reject “merit-based” market governance by the public sector but also market governance led entirely by the private sector, e.g., the unfettered capitalism of the Roaring 1920s that led to the frauds and malinvestments that contributed to the Great Depression.
There’s a shift now at the SEC, the agency I just left. I’m hopeful that the new leadership is encouraging critical engagement consistent with the mixed public-private governance model that characterizes U.S. financial regulatory policy. In this vein, the SEC appears to be embarked on a return to first principles enshrined in that agency’s mandate: protect investors and market integrity while promoting capital formation. On each of these goals, new technologies offer a better way forward for both the markets and for the SEC.
1. Protecting investors
A large part of CFTC and SEC and other market regulation is public transaction reporting. In contrast to traditional financial markets that operate across a complex supply chain of blackbox proprietary databases where public transaction data has to be extracted and reported into a separate reporting database, creating reconciliation breaks and creating data integrity risk, open blockchains record all transactions publicly in real-time. This means investors and data providers have lower barriers to access public data and the data is more accurate. This transparency could be leveraged and is a good reason for policymakers to encourage onchain finance.
Finally, with the introduction of language learning models (LLMs), one can imagine such models translating complex and lengthy qualitative disclosures required for various types of securities for the appropriate level of consumption for lay investors, e.g., under SEC Regulation S-K or quantitative ones under Regulation S-X or prospectuses required under other securities laws. Such LLMs can enhance the efficacy of federal securities laws given that these disclosure rules are designed to level the playing field by requiring issuers to provide all investors with reliable, timely, and material information about investments.
2. Ensure market integrity
Illicit actors are easier to identify and to trace onchain. Many government investigations of illicit activity in traditional markets move slowly because of the need to pierce through a complex chain of financial and corporate records. Often, by the time the bad actor is identified, they have vanished along with their ill-gotten gains. In the case of onchain illicit activity, the illicit proceeds can be traced in real-time. Illicit on-chain activity ($24.2–34 billion in 2023) is a small fraction of total crypto volume, and its share (0.34–0.63%) is lower than the estimated 2–5% of fiat transactions linked to illicit activity. Moreover, seizure rates, an indication of the effectiveness of law enforcement in different contexts, are much higher in an onchain environment (approximately 27% according to my former colleagues at Chainalysis) than in the broader economy where estimates are below 0.1% (using illicit drug trade as a proxy). This enhanced ability to trace illicit activity is another good reason to encourage onchain finance to ensure market integrity.
3. Promote capital formation
While the most privileged parts of the developed world have benefited greatly from the wide availability of financial capital, its scarcity of financial capital in underdeveloped communities is a major impediment to the development of human capital. Open blockchains enable anyone with internet access and a compatible wallet to invest, expanding the investor pool beyond traditional markets to include retail investors and those in underserved regions. Perhaps even more importantly, open blockchains also enable entrepreneurs globally to access capital from these global investors. At the current moment where unprecedented trade barriers are being erected at national borders, the value of open blockchains to enable frictionless flows of capital cannot be overstated.
The benefits of global pools of onchain capital are enhanced by the fact that tokenizing assets, in essence, packing financial assets for global distribution pose trivial launch and distribution costs. Regulation can increase costs. However, if regulations are proportionate to the underlying risks, issuing onchain RWAs will boost capital formation more than the current system while yielding better outcomes from an investor protection and market integrity perspective.
The decline of the initial public offering in the U.S. should be a focus of any SEC. IPOs are down 20% when comparing 2022-2024 to 2002-2005, for example. Blockchain smart contracts can standardize and verify data inputs, such as financial statements and legal disclosures, required by SEC regulations like S-K and S-X. This can minimize errors and accelerate filings. To the extent underwriting fees are a function of costs, an Accenture report found that the use of blockchain technology could reduce such costs by 30%. A 2023 study from the Hong Kong Monetary Authority found significant cost reductions (0.78% lower cost of borrowing) and liquidity benefits (10.8% lower bid-ask spreads) from tokenizing bond issuances.
In addition to efficiency benefits from tokenizing IPOs, LLMs can further reduce their cost. Goldman Sachs CEO David Solomon believes LLMs can produce 95% of an SEC Form S-1 required to register public securities. This reduces workload for lawyers, accountants, consultants, and underwriters. Moreover, LLMs can also reduce the cost of due diligence and audits, further lowering the cost of IPOs and public company compliance. Driving more capital formation into public markets, with better disclosure, should also be a goal of the SEC even though private market capitalization is now many times larger than public market capitalization even though the two markets were roughly the same size in 2004.
Among the most categories of securities that would benefit the most from tokenization is what I call “mini project finance.” Raising capital in existing capital markets for such a product might not be feasible. However, open blockchains offer new distribution channels and lower tokenization costs. This enables new capital formation and unlocks previously unavailable opportunities. It can place a license to its data as a core asset for a special purpose vehicle wrapper that can then raise equity capital against the value of a non-core data product. Obtaining sufficient capital to build such a product might not be worth it but with new distribution pathways enabled by open blockchains and reduced costs to tokenize such equity interests enables new forms of capital formation that can unlock opportunities unavailable before this technology.
I’ve written at a high level here about the potential of open blockchains to serve a public purpose. I’m encouraged by recent shifts among policymakers, in the U.S. and that tone has been bipartisan. Technology itself is never partisan, only the details of the public-private governance system we have can change based on partisan priorities, e.g., one regulatory philosophy can weigh investor protection more heavily vs. capital formation for example.
I argue that achieving these public purposes is a win/win proposition for both public servants and entrepreneurs who share a common interest in unlocking opportunity. In coming months and years, I and my colleagues at Plume will relentlessly present a vision for capital markets that puts the public purpose of open blockchain finance into close focus. We are excited at this prospect and hope you will join us for this journey.