At tZERO, Blockchain Tech Development Turns to Action

Amid continuing debate over the viability of blockchain technology in financial services, online retailer Overstock.com's capital-markets-focused tZERO is pressing ahead. The venture has laid out plans for a variety of blockchain-based digital technologies this year that, if successful, will create a trading ecosystem functioning alongside - and potentially disrupting - legacy financial markets.

Overstock, whose Medici Ventures subsidiary has invested in 19 companies - including majority-owned tZERO - pursuing practical uses for blockchain technology, saw its share price plummet in early 2018 in line with cryptocurrencies such as Bitcoin and Ethereum. Nevertheless, it continued to push tZERO initiatives, refining the trading technology that its Pro Securities trading platform uses to trade its own security tokens and that it anticipates licensing to third-party legacy platforms, including exchanges.

In 2019, tZERO is also aiming to diversify the types of assets it trades, moving beyond security tokens to smart contracts representing rare metals and potentially other commodities.

“2018 was really about getting the platform built, so we focused on that,” said Saum Noursalehi, CEO of tZERO. “We just completed an offsite planning-and-strategy meeting for this year, which will be more about business development and strategic partnerships.”

Broker-Dealer Partner

Earlier this year, tZERO announced a partnership with Dinosaur Financial Group to provide accounts to accredited investors so they can trade tZERO's security tokens. Dinosaur, a New York-based institutional brokerage, is the first of what is expected to be a number of introducing brokers licensing tZERO's digital-token trading technology, broadening investor access to the security tokens.

“We have other interested BDs, and we plan to license our [trading] technology to them,” Noursalehi said, adding that tZERO will file to start its own broker-dealer providing access to retail investors, a process that may be completed this year.

Unlike the more widespread utility tokens that have frequently skirted regulation, security tokens derive value from an external tradable asset - in the vein of traditional equities - and are regulated like traditional securities. tZERO's Pro Securities alternative trading system (ATS) is compliant with regulatory requirements to trade the tZERO digital security tokens, which leverage the Ethereum blockchain.

Noursalehi said other broker-dealers have expressed interest in providing customers with access to the token trading platform. Subject to regulatory compliance, that could happen quickly for those who are already customers of another tZERO subsidiary, SpeedRoute, which provides high-speed connectivity to exchanges and other liquidity sources.

“Through their integration with SpeedRoute, we could enable them pretty quickly, because we already have the [technology] plumbing into their platforms,” Noursalehi said.

How quickly broker-dealers want to give customers access to security tokens remains to be seen. However, they have a significant advantage over traditional securities, at least conceptually.

Back-Office Efficiencies

Stefan Perlebach, co-founder of STOcheck, which tracks security token developments, noted in February on the website Medium that they permit writing ownership and law into the token's smart contract, enabling restrictions on who can buy and sell the token and when. Perlebach also said that the tokenization of securities and recording them on an immutable and transparent blockchain should reduce the size of banks' back offices, decrease errors, simplify accounting and auditing processes, and reduce the complexity and paperwork from managing securities, among other benefits.

In terms of customers, Perlebach says, blockchain provides a uniform method of verifying and tracking data, enabling the fully transparent documentation of securities ownership. It could also allow investors to own small fractions of assets such as real estate and art that otherwise would be out of reach.

“This will make reporting and auditing much easier, which will help to prevent fraud, mispricing, arbitrage, manipulation by financial institutions and corruption,” he says.

These benefits, however, depend on the widespread adoption of tokens representing securities and other assets, and tZERO is joining other token-related initiatives across the globe that are in the early stages of seeking to disseminate the technology.

David Johnston, an early investor in blockchain initiatives and managing director of Yeoman's Capital, said he thinks of tZERO “jurisdictionally.” He views the firm as a “preeminent player in the U.S.” in developing the infrastructure and markets for blockchain tokens, similar to Polymath in Canada and Smart Valor in Switzerland.

“I think what will evolve is that, jurisdiction by jurisdiction, there will be global coverage of platforms to issue and trade security tokens,” said Johnson, who is board chairman of Factom, another Medici investment. “tZERO has been a leader in bringing attention to security tokens and is in a very good position to be that bridge between this technology and legacy trading technology.”

Patent Obtained

Giving broker-dealers and their customers access to its Pro Securities token trading platform exemplifies how to expand the digital-token ecosystem. An even bigger initiative may arise from a tZERO patent, approved in January, that outlines how to merge digital asset technology with legacy trading systems.

“What surprised me was the breadth of tZERO's patent,” said Tom Forte, managing director and senior research analyst at D.A. Davidson & Co. “Presumably, tZERO could license the technology to a third party, so that party could use tZERO's technology to integrate trading of tokens on its legacy platform.”

CEO Noursalehi confirmed that intention, comparing the model to that of Nasdaq and other market operators that license their trading technology. He added that tZERO's plan is to build out its ecosystem to provide an end-to-end experience for issuers seeking to raise capital as well as primary- and secondary-market investors, while complying with applicable regulatory requirements.

“Building out the [digital token] ecosystem is the main goal, which we plan to do by ramping up our own investor base and issuer pool, and working with other offshore trading platforms in a fully compliant way,” Noursalehi said.

While Pro Securities is an ATS, tZERO is also working closely with the Boston Options Exchange (BOX) to implement its trading-platform technology in an exchange environment. Noursalehi said the technology component is nearly completed, and now BOX is working to get Securities and Exchange Commission approval to trade security tokens. BOX will initially trade security tokens, he said; down the road, other capabilities such as digital options may be incorporated.

Rare Metals

Another aspect of growing the ecosystem will be to broaden the types of digital assets that can be issued and traded. tZERO announced last December that it had signed a contract with Hong Kong-based private equity firm GRS Capital to develop a smart-contract token for the sale of cobalt. They said that the partnership is focused on developing tokenized commodity purchase contracts in Asia to improve the supply-chain process of rare metals, and that the cobalt token is expected to launch this year.

In August 2018, GRS announced plans purchase up to $374.55 million in tZERO and Overstock common equity, and reportedly $30 million in tZERO security tokens from Overstock. In December, however, Overstock said that the investment was delayed until February 28, 2019.

Forte called the cobalt announcement a “kind of silver linking around a dark cloud” resulting from GRS's investment delay, and said that it appears as if tZERO has chosen GRS as a “dance partner. It shows the kinds of opportunities that partnership could open up.”

Noursalehi explained that GSR has investments in the battery sector, and so is heavily involved with both the supply of and demand for rare metals used in that industry.

“They're actually helping us make introductions and build a platform to support those [markets]. We have been working closely with them and have a prototype of the issuance and token design,” Noursalehi said. He added that those smart contracts would trade like security tokens but would have to be compliant with rules governing commodity markets and other regulations. “GSR has a large portfolio of companies, and we're interested in the strategic partnerships they can bring to the table.”

Investor Johnston noted the difficulty in transferring ownership of illiquid assets such commodities, other physical assets such as real estate, and bonds - transactions that can take months to settle.

“Moving securities such as stocks a bit faster is nice, but commodities is an area where this technology really shines,” Johnston said, “because it offers a lot more liquidity, and they can trade much more easily due to quick settlement and transfer of ownership.”

Increased trade in security tokens, commodity smart contracts, and other digital assets could disrupt legacy markets, perhaps prompting some broker-dealers and trading platforms take up the technology sooner rather than later.

Securities Lending

Another area where blockchain technology could significantly impact an established financial market is stock loans. Launched in late 2017, tZERO's digital locate receipts (DLRs), enabling licensees to record immutably in a blockchain when locates are requested and their size, were put on the backburner in 2018.

Overstock CEO Patrick Byrne has long criticized the lack of transparency in the stock-loan market, claiming that prime brokers collect exorbitant fees from institutional investors, an issue DLRs aim to resolve. So far, tZERO has licensed the software only to Stockcross Financial Services, a self-clearing broker-dealer in which tZERO holds a 12% stake. Noursalehi acknowledged that progress on DLRs slowed last year, as the firm focused on developing a trading platform for tokens.

“[DLRs are] a big priority for 2019,” the CEO said. “We're really going to resource the team. It's going to be a marketplace for stock lenders and borrowers.”