Skip to Content
Stocks

Investors and Innovators

These entrepreneurs are making the potential of blockchain technology a reality.

By Lawrence Johnson

The blockchain space is flush with white papers, proofs of concept, use cases, and technologies looking for problems to solve. At a Morningstar Fintech Forum on Dec. 15, we hosted representatives of two companies that have built actual businesses around blockchain. Ashish Gadnis is founder and CEO of BanQu, which enables people without access to the traditional financial system to build an economic identity and enter the global economy. Vincent Molinari, CEO and chairman of Liquid Markets Group, is co-founder of Templum, which created a platform for the primary issuance and secondary trading of tokenized asset offerings—that is, initial coin offerings, or ICOs, that are securitized. Templum links investors with innovators such as BanQu.

Equity analyst Jim Sinegal, who follows blockchain technology while covering banks and the payments industry for Morningstar, led the discussion. The participants' views are their own and not necessarily those of the organizations they represent. The conversation has been edited for length and clarity. Jim Sinegal: How about if each of you starts off with an elevator pitch?

Ashish Gadnis: The best way to explain BanQu is to go back to 2014, when I was volunteering in eastern Congo. I was working with women farmers, and one of the women had made a little bit of money on a harvest and wanted to open a bank account. The local bank refused to open an account for her. We got into an argument, and the guy kept saying, "I can't bank her, but I'll bank you." That's where the name BanQu comes from.

It’s the best elevator pitch I can give you because it’s about that mother in eastern Congo. Even though she had land, she had a harvest, she had three different microloans, and she had lived through 50 years of conflict, she didn’t exist because there was no way for her to prove those critical elements of her life. That’s when I realized the value of blockchain: It is a ledger that can store her information in an economic passport, if you will. That’s what BanQu does. We allow people who live in extreme poverty to own, access, and monetize their data, and that allows them to improve their situations.

Vincent Molinari: Liquid Markets Group's wholly owned subsidiary Liquid M Capital is an alternative trading system, a quotation bureau, and qualified matching service. Our affiliate Templum is a fintech company focused upon blockchain and smart contracts. Templum Markets executes its securities through Liquid M Capital, which is focused on digital assets and distribution and secondary trading of regulated token offerings— to differentiate from ICOs.

We operate at the intersection of the modernization of securities law and innovative technologies, to work with the regulators and create holistic marketplaces that have investor protections, anti-money-laundering provisions, and suitability requirements.

Sinegal: Ashish, why are you using blockchain rather than another type of technology?

Gadnis: The data of that mother in eastern Congo sits in the silos of multiple organizations: the NGOs, the microfinance institutions, the anchor buyers, and so forth. If any of these actors pull out, her data goes with them. That's problem number one. Problem number two: If a war breaks out or a conflict begins, and she shows up in Rwanda, say, as a refugee, all her data is reset. The 2.5 billion people who live in extreme poverty and the 70 million refugees that I represent here today are walking around with a big reset button on their head because anytime something happens, they lose their data.

Blockchain is a distributor ledger that allows that mother to access, own, and monetize her data. It allows all parties in a transaction to have an equal copy of their transaction. If we use blockchain in a trust ledger mechanism in a permission network, that coffee grower in the Congo can now rightfully access every transaction she is involved in. They become part of her identity, and she can build a history. I come from 30 years in traditional software and databases, and they’re one-sided: I capture your data, I own your data, and I can do whatever I want with the data. Whereas in the distributor ledger model, that mother now has equal access to that data in a way that’s secured and portable.

Regulating Tokens Sinegal: Turning to the securities side of the issue, Vincent, can you give us an overview of the difference between a standard ICO and a regulated token offering?

Molinari: Most initial coin offerings are being done in a manner that suggests they are utility tokens. With utility tokens, there's no accountability from the issuer to the token holder, no share ownership, voting rights, or profit participation. There's been no regulatory framework, no governance, no investor protection.

We take a different view. My partner Chris Pallotta, who is the CEO of Templum, and I had a lot of experience prior to the JOBS Act1 and through the JOBS Act with technology and innovation trying to intersect with regulation. We looked at blockchain and felt déjà vu: Technologists were talking about disrupting financial services and didn't really understand the implications. We took the view there is no such thing as a decentralized ledger in financial services. The moment that you're dealing with a security or financial instrument, you need an SRO.2 You have regulated entities, broker-dealers, alternative trading systems, licensed people, so not just anyone can come in and participate when you're dealing with transacting a security and its clearance or settlement.

Blockchain, as amazing as it is, has not created a new process. We're still trading, clearing, and settling—maybe in a more efficient way. We believed that you need a centralized location that is transparent and regulated for secondary liquidity of alternative instruments, and we petitioned the SEC to amend Regulation ATS3 for the purpose of unregistered securities. We were approved for that in the summer of 2016. As a quotation bureau, we are able to publish real-time pricing on private, unregistered securities having mark to market. We also have approval as a qualified matching service to transact in nontraded secondary limited partnership interests.

That swath of approvals led us to petition the SEC this past March for another rule change to declare digital assets, in most cases, to be a security. The marketplace was born out of utility tokens, but it is clearly a misperception that these are not securities.

Sinegal: How do regulators define a security?

Molinari: The Howey test comes from a U.S. Supreme Court ruling that said, in short, that any time you're aggregating capital with an expectation of a rate of return, and there's a third-party manager or promoter, that constitutes a security. The SEC said in the DAO report in July that the DAO conducted securities transactions.4 It was a warning shot. SEC chairman [Jay] Clayton recently said very emphatically that he hasn't seen an ICO that was conducted yet that didn't meet the hallmark of a security.

That means that these ICOs were being distributed in a noncompliant way. We are seeing enforcement actions weekly. Secondary trading of utility tokens is happening on loosely defined exchanges. When they’re deemed a security by the SEC, those exchanges can’t transact them anymore, so we’re seeing delisting of tokens across the spectrum.

Now there are tens of thousands, if not hundreds of thousands, of investors who are trapped because they bought into an instrument that cannot transact on those exchanges anymore. It doesn’t meet the compliance or the frameworks of a commodity to be governed by the CFTC [Commodity Futures Trading Commission]. It certainly doesn’t meet the requirements of a security, so folks like ourselves with an alternative trading system can’t transact it. So, we’ve petitioned the SEC for a remediation program where these utility tokens, provided there was not fraud, could ask for a redo. We proposed a 180-day period where these broken ICOs could be repackaged as a security.

This is going to be an ongoing conversation with the CFTC and the SEC in 2018, as these tokens are either commodities or securities. To qualify as a utility token when you’re doing an ICO, your technology and platform actually has to already be built. If you can use that token on that platform, it could very well be a utility token. But when you’re raising the capital to build that platform, that becomes a security. Over the next 10 years, the distribution of securities through tokenized assets will dramatically change.

Sinegal: What rights as an investor do you get with a regulated token offering? Do you get the right to dividends, to cash flows, governance rights?

Molinari: It's up to the issuer. What does the issuer think that the market is going to want? Is it straight equity? Is it debt? The ability within a smart contract to apportion it? Profit participation? A piece of the deal? This is an opportunity to create securities that are in keeping what the marketplace may want, as Ashish is doing now.

It’s a Series A that is a tokenized security. It’s a beautiful mechanism: You can create a distribution system and there’s visibility to secondary trading. Compared with our largely dysfunctional IPO process for smaller companies, a private marketplace is more efficient and has liquidity. This is not just for technology companies. You can tokenize real-estate assets, or any other instrument. It’s a game-changing phenomenon.

Monetizing Blockchain

Sinegal: Ashish, how are you monetizing your technology?

Gadnis: We're a for-profit, for-purpose company. The monetization model is straightforward: We sell BanQu software to large corporations, financial institutions, and banks that are trying to get visibility and transparency into the last mile of emerging markets. The farmer never pays, the refugees never pay.

It’s important to explain the use case. Marginalized producers pay high interest rates on microfinance loans because they don’t exist in the supply chains. That farmer in the Congo brings her bag of coffee to a broker who then brings it to a washing-drying station, and there may be seven or eight intermediaries before it gets to the anchor buyer. That anchor buyer has limited visibility into the supply chain and can’t necessarily say that the coffee qualifies as “fair trade.” The farmer has been tilling that piece of land for 40 years but is invisible and so continues to pay a higher interest rate. In the country of Colombia, for example, there might be 40% interest on a microfinance loan.

This is where BanQu becomes relevant. People call us “blockchain as a service.” We use blockchain in a permissioned software-as-a-service model to create a cloud application where the farmer, via a basic SMS messaging mechanism, connects to a permission blockchain ledger— we use Ethereum. All the intermediaries in that supply chain can connect to the same application layer. We run a mobile site that’s accessible from anywhere in the world. The anchor buyer now, using smart contracts, can see that the farmer brought her 40 kilos and dropped it off at this station, and it’s moving in the supply chain. We’ve used blockchain to connect people, organizations, and assets. We get paid because at the end of the day, these large corporations are realizing the benefits of transparent supply chains.

Sinegal: Are there critics who say you’re really monetizing the data of this poor farmer?

Gadnis: The best part of our technology is that we've created a nondatabase data model. It sounds crazy, but that's part of our patent filings. From a data security and privacy perspective, we've flipped the conversation. Using BanQu, that mother in eastern Congo owns her own data, and that can be connected to her biometrics. She can access and monetize her data; she controls it. There's no way I can see her data.

Because it’s a permission trust network, the data is owned by each of the participants. Technically, there’s no centralized mechanism. A lot of other blockchain companies will have a centralized database mechanism, and they’ll hash it to the chain. In that case, if I get to the database, then you’re compromised.

Sinegal: You’ve also chosen to raise money using blockchain. Why this path?

Gadnis: We believe that people need to know more about the blockchain ecosystem outside of cryptocurrency. BanQu is evolving as a platform, which means point solutions can connect to it. If we went the traditional route to raise funds, investors might pigeonhole us into a particular point solution.

We continue to be the only commercial blockchain-application-as-a-service that’s focused on the unbanked. Raising money with a regulated token offering has allowed us to get the message out to a global audience. There are people all over the world who want to participate not just as an investor, but to contribute to that mother’s life.

Sinegal: What made BanQu interesting as the first offering over Templum’s platform?

Molinari: Our prior business was impact investing, and we had a core premise that profit is not a dirty word. Profit creates sustainability, and that sustainability creates systemic change. We are extraordinarily enthusiastic about what BanQu is doing. To broadcast a story like BanQu to diaspora communities, fan bases, affinity groups is a wonderfully efficient methodology for aggregating capital for good. When you overlay a smart contract, with immutable information and data on the pricing and analytics of the good that's being delivered, you change the perception of return. It's not just financial return but also the social/environmental/cause-related good that's being delivered alongside of it.

Sinegal: Ashish, you’ve done a couple of traditional startups and exits. What is different about a blockchain-based business?

Gadnis: The challenge is to separate ourselves from the cryptocurrency mania. People think that blockchain's application is purely currency. There are a lot of great companies out there for settlement and remittance and mobile money, but people in extreme poverty can't access cryptocurrency. Another challenge has been getting people to realize that the traditional models of microfinance and aid have not worked. Blockchain, in many ways, disrupts the traditional model.

There are also use cases in the U.S. One of the applications that we’re working on is to get homeless people better access to their health records. Imagine an EMT picks you up in an emergency and you are treated by a hospital, and then released. Four days later, you have a seizure and end up at a second hospital that has no idea about the previous incident. BanQu is launching an application that allows homeless people to get a secure copy of their health record, without violating HIPAA regulations. We are also looking at a use case for the unbanked or underbanked in the U.S.

A Tremendous Market

Sinegal: Vincent, are there obstacles remaining on the regulatory side?

Molinari: We thought this was going to be a multiyear process, but just in the last 30 or 60 days, the number of venture capitalists who have come in to us and are now amending their limited partnership agreements to invest in digitized assets is mind-blowing. The challenge now is more education to create awareness of what a digital security can really represent, versus the froth. If you're in the business of aggregating capital and distributing securities, there's a fiduciary responsibility to the investor and from the issuer. If we embrace that and collaborate between the technologist and the securities-market framework, I don't think there's a lot more work left to be done.

Sinegal: What about competitors in the market?

Molinari: This is a tremendous market; it just surpassed $4 billion in issuances as of this morning. What we're largely seeing is the closed crypto community investing and exchanging bitcoin or Ethereum for ICOs. When you can accept fiat currency into the system for first-time purchasers and have a structure that allows ICOs to be transacted through financial-services firms, the market will get dramatically larger.

We think it’s great to have more folks in the issuance market. A lot of apparent competitors are creating software solutions or applications that create compliance, that create a workflow around the process. But they themselves are not regulated entities and can’t do the issuance of those securities. There are one or two others that have alternative trading systems—and more connectivity of these systems speaks to better liquidity and, ultimately, better price discovery. We’re happy about the competition.

1 The Jumpstart Our Business Startups Act was signed into law in 2012 with the aim of easing securities regulations to encourage funding of small businesses.

2 A self-regulatory organization, such as Finra.

3 Regulation ATS is designed to protect investors and resolve any concerns arising from alternative trading systems.

4 The DAO was a digital decentralized autonomous organization that aimed to provide a decentralized business model for organizing both commercial and nonprofit enterprises. It was crowdfunded via a token sale. See: https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings

This article originally appeared in the February/March 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

More on this Topic

10 Undervalued Wide-Moat Stocks
Cheap high-quality names from the Morningstar Wide Moat Focus Index are attractive stocks to buy for long-term investors.

Sponsor Center