Crowdfunding

meets Blockchain




Navroop Sahdev

Centre for Blockchain Technologies, University College London, UK
Centre d'conomie de l'Universit Paris-Nord, France

June, 2017

Table of Contents

1. Introduction

2. The Advent of Crowdfunding

3. Market design and Liquidity Considerations for CFE Trading on the
Blockchain
3.1. Liquidity and Price Discovery
3.2. A game of Information
3.3. Asset Servicing and Voting
3.4. Market Making versus Tokenization
3.5. The impact of Transparent Holdings

4. Concluding remarks

5. Endnotes
6. References

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Abstract

Blockchain, the technology behind Bitcoin, promises to be nothing less than Internet 2.0. The
financial services industry, in particular, is preparing for the disruption blockchain/distributed
ledger technology promises to cause. In the current business environment, the majority of
startups and small businesses have to look for alternative sources of funding given that going
public is increasingly expensive. The crowdfunding space has seen tremendous growth as an
alternative way to raise capital by businesses. However, these crowdfunded shares cannot be
traded for 7 - 10 years on average on any given platform in the U.S. currently.

To build a trading platform on the blockchain which is completely P2P, immutable, fully
transparent and low cost presents some key design issues. In particular, the issue of liquidity - and
price discovery - on the blockchain continues to be a puzzle. At the same time, the proposition of
removing middlemen from equities trading is a very attractive one, streamlining the process of
capital formation with higher market efficiency.

The current paper addresses the following key questions: How can a DLT trading platform ensure
adequate liquidity? What would be the process of price discovery? While some recent studies hail
blockchain technology as a boom for market liquidity, it is not immediately clear what the impact
of P2P trading would be on the prices of various stocks. There are no solutions just yet. At the
same time, the lack of regulation around trading on the blockchain creates an environment of
uncertainty for all players.

In particular, the implementation of such a platform can revolutionize capital formation and build
robust markets in both developing and developed countries where crowdfunding has proven to
be a successful model. While my research is targeted at solving a very specific pain point for both
researchers and companies working on distributed ledger technology, ultimately, it would be a
significant step forward towards onboarding underserved communities across the world who
dont have access to financial services.

List of Abbreviations

1. DLT: Distributed Ledger Technology
2. CFE: Crowdfunded Equity
3. EC: Equity Crowdfunding
4. CFP: Crowdfunding Platform
5. ECP: Equity Crowdfunding Platform
6. CETP: Crowdfunded Equity Trading Platform
7. MVP: Minimum Viable Product
8. POC: Proof of Concept
9. P2P: Peer to Peer

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1. Introduction

These days, blockchain inspires a degree of reverence in the fintech industry. Set to become the
defining technology of the current day - Internet 2.0. the industry is aggressively testing POCs
and figuring out which processes should be moved to a blockchain architecture in the short to the
medium term. Of course, revamping the monstrous infrastructure of the financial services industry
is no easy task and unlikely to be undertake overnight. The way forward is to test specific use cases
and find ways to integrate these as well as integrate the new blockchain infrastructure with the
old centralized infrastructure. The shift is expected to be gradual, as is the regulatory catch-up.
And yet, the activity that blockchain along with other vertical technologies has inspired is
unprecedented along with the regulatory participation in co-creating this brave new world.

The story of the blockchain can have many starting points. It can be a technology driven one,
where a foundational technology can potentially provide a more secure and robust digital
infrastructure and with the current days being the early days of the technology. Alternatively, it
can a story of demand driven factors - where small businesses need to find ways of raising capital
along with new opportunities of financial intermediation. Or we can pick an even more interesting
story - that of a crisis driven market - desperately in need of a breakthrough technology, that can
lower costs and provide a more robust digital infrastructure. Indeed, its probably no coincidence
that the Bitcoin blockchain came into existence right after the 2007-08 banking crisis. Or it can be
the familiar story, of an archaic regulatory regime, that piles up regulation designed for securities
trading from a century ago; this is the story of fragmented markets which are an outcome of such
a regulatory structure. With the advent of any new financial activity - crowdfunding, for example
new regulation is introduced, which only seems to add to the existing regulatory burden.

Whatever the chosen entry point, we are here now.

Contribution and goals of this paper

This paper is aimed at providing a guidepost for academics who are interested in thinking and
writing about cryptoeconomics and how blockchain - along with other vertical technologies - is
driving a technological convergence that can reshape how economic systems are structured and
how agents interact. This may imply the availability of a new foundational/infrastructure
technology. At the same time, the current study is focused on the challenges faced by practitioners
who are thinking about the new business problems concerning technical infrastructure design
decisions and product deployment on the blockchain. My hope is that we see a partnership
between academia and industry to co-create this exciting new space.

The goal of this paper is to shed some light on some of the latest thinking on blockchains impact
and how it changes things as we know it. After all, if we want to build a future that is blockchain
secure, we need to actively build it right now, while molding it along the way depending on our
collective aspirations and the interests of diverse players.

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Furthermore, how do we reconcile the traditional finance literature with the burgeoning field of
cryptoeconomics? Is it something we should do in the first place? Are we too afraid to take a major
leap forward by focusing on finding ways to integrate blockchain into the current systems? Or can
we simply shift? Consequently, one of the contributions of this paper is to provide a bridge
between traditional finance thinking and economic modeling, and the new world of blockchain.

2. The Advent of Crowdfunding

A recent WSJ article1 points out that there are fewer than 3600 stocks in the U.S. public markets
at the moment compared to 7355 in 1997. Most of the stocks that were crowded out were those
of micro-cap and small-cap companies. In terms of the stock-market value, the difference is even
more acute and the trend unmistakable fewer and fewer companies are going public (see figure
below). Several factors explain the shrinking number of stocks, analysts say, including the
regulatory red tape that discourages smaller companies from going and staying public; the flood
of venture-capital funding that enables young companies to stay private longer; and the rise of
private-equity funds, whose buyouts take shares off the public market. (1)

1
Primary reference: Center for Research in Security Prices at the University of Chicagos Booth School of Business.

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Among the host of alternatively sources of capital that are gaining increasing importance, the
crowdfunding space is a particularly interesting case. Unlike the publicly listed companies,
companies raising money on a CFP are not subject to comparable reporting requirements under
the current regulatory regimes2. At the same time, in-depth vetting and rigorous screening
processes undertaken by venture capitalists and venture capitalist firms while investing in private
companies are unavailable. The space relies on appealing to a different set of investor incentives
like social networks, sense of community, patronage for creative industries, political affiliations,
and/or altruism. These motivators are not exclusive to the crowdfunding space, but definitely play
a stronger role in the CF markets compared to other forms of equity markets. (Tasca 2016;
Adiputro 2016)

Looking at the current trend, clearly companies are staying private for longer and longer. Arguably,
some of them may not even want to go public for a variety of reasons ranging from high costs of
IPOs to high reporting requirements (6). On CFPs, investors thus encounter great uncertainly
around returns of their investments. Given that crowdfunded companies are usually subject to
less regulatory compliance and information disclosure, investors need reliable information to
continue holding their shares3.

Demand for liquidity

The demand for liquidity for CFE has been present all along. The JOBS Act in the United States
clearly provisioned for the trading and liquidation of CFE. Arguably, a healthy secondary market
might play a decisive role over whether or not the primary market would exist at the first place
(Gallagher 2014). Yet, in the United States which holds the largest CF market share - there is no
one platform yet where CFE can be traded4 without the current costs and inefficiencies involved.

3. Market design and liquidity considerations for CFE trading on the

blockchain

While the focus of this paper remains on EC, I maintain that there are important lessons to learn
by drawing parallels between different asset classes and how trading occurred for private equity,
for example. Given the availability of a rich literature, an in-depth discussion comparing various
asset classes is beyond the scope of this paper.

2
Note that reporting requirements depend on the size of the company.
3
Adiputro (2016) finds evidence concerning signaling about non-traditional factors (social networks and human
capital) has played a critical role in the success of European CFPs compared to well established indicators like
intellectual property and financial information.
4
Some European startups, however, do offer such an option. Couple of ways this can be accomplished is either by
trading the shares within the investor pool via the ECPs tokens (see for example https://markets.funderbeam.com/)
or by selling the shares to outside investors. The latter is a more uphill battle.

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 3.1. Liquidity and Price Discovery

I will first revisit the notion of liquidity in capital markets as a starting point for the discussion on
liquidity on blockchain that follows. Consequently, I will focus on the EC market.

Liquidity is the ease with which an asset can be converted into cash and vice versa without
drastically affecting its price. Take, for example, stocks of a publically traded company like Apple
Inc. are extremely liquid. Although there is huge heterogeneity between the various stocks listed
on the public markets, in general, publically listed stocks are highly liquid because of the high
numbers of buyers and sellers that are present in the market5. At the same time. market makers
play a role in pumping liquidity into the market.

Given that blockchain based trading is completely P2P, whether or not the market would be liquid
enough i.e. whether or not there would be enough buyers and sellers in the market such that the
market can discover the 'true' price of the asset, is an open question. Furthermore, should DLT
platforms engage market makers to provide greater liquidity to the market? Section 3.4. develops
this point further. For EC, given the limited number of the company shares that are crowdfunded,
even lower levels of liquidity can be reasonably expected. In other words, there would simply be
way less buyers and sellers in the market.

3.2. A game of Information

On a more theoretical level, the body of literature that explores why trading occurs at the first
place particularly the enormous volumes witnessed in the public markets - relies on the
conceptual framework of information asymmetries. After all, if information was perfectly
distributed, there would be no incentive for those who spend resources to collect information to
do so and as a result, there would be no trading6. This is the so-called efficient markets
hypothesis: impossible as argued by Grossman and Stiglitz (1980). (12) Hence, it is no secret that
most of the trading in the current markets is done on information asymmetries.

Keeping that in mind, a host of studies argue that moving to a DLT trading regime would address
some of these information asymmetries and make the markets more transparent and fair. This is
complemented by lower costs, better recordkeeping and transparency of ownership.
Subsequently, is there a trade-off between addressing information asymmetries and trading
volumes? Given that some of these information asymmetries stem from the companys
management holding better information about the firm compared to outside investors, Yermack
(2017) argues that this may not necessarily be the case. If the greater transparency of blockchains
deterred insider trading by managers, outside investors and analysts would have greater

5
It's important to remember that "liquidity" of an asset is an abstract notion (despite the variety of metrics that are
available to measure liquidity) and is usually understood in comparison to the relative liquidity of another asset.
6
Some degree of trading can be reasonably expected due to demand for liquidity triggered by reasons other than
asymmetric information. Investors seek liquidity for many reasons, typically due to the "Four D's": Death, Divorce,
Debt and Done (Waiting). (Reference)

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incentives to invest in acquiring information about the firm. This could rearrange the overall
distribution of information in the economy and potentially lead to greater allocative efficiency of
outside investment. (13)

By inference, while there would invariably be some losers in a DLT environment those who hold
superior information about the company and are benefitting under the current centralized system.
By contrast, as is being widely argued in the industry, the majority of the investors would be
winners thanks to the greater allocative efficiency that blockchain can afford by addressing
information asymmetries.

3.3. Asset Servicing and Voting

With regard to the back-office work on clearing and settlements, there is little ambiguity that
blockchain infrastructure holds tremendous potential to integrate systems, facilitate automatic
bookkeeping without the need for a third party and lead to billions of dollars in savings. As a
common example, compare the T3 or three-day settlement period involved in the US public
markets to the Bitcoin blockchain, where transactions are verified every 10 minutes with the
formation of a new block. In other words, the trade itself is the settlement. At the same time,
the process of shareholder voting can be streamlined on the blockchain. Creating consensus online
- in real time - in a direct and unambiguous manner drastically enhances the very purpose of voting
rights. Think of the way voting occurs now - commonly through a proxy and by mailing in
responses! This has led to a plethora of problems like incorrect voter lists and counting of votes.
(Kahan and Rock, 2008)

Blockchain can be a game changer for how voting rights are exercised for shareholders. In a
blockchain election, eligible voters would receive tokens (sometimes called votecoins) that they
could transmit to addresses on the blockchain to register their preferences. (13) Wright and
DeFilippi (2015) extrapolate the utility of current voting rights to how the efficiencies gained by
blockchain based corporate voting may motivate shareholders to participate to demand voting
rights on an expanded set of decisions. Currently, a few startups are even exploring anonymous
voting on the blockchain.

3.4. Market making versus Tokenization

To what extent blockchain changes the nature of trading remains to be seen. From a research
perspective, how do we reconcile traditional literature on financial markets - issues such as
liquidity, asset pricing, volatility, liquidity risk, liquidity premium, etc. - with the new foundational
infrastructure of blockchain? Many argue that it would not change trading practices per se, even
though it is a fundamentally different architecture that underlines these practices. DLT trading
platforms are coming up with solutions that mimic traditional trading models and practices. For
example, Overstock has developed the so-called short tokens which allow short-selling similar
to in the current public markets in order to attract institutional investors and market makers to
source liquidity to the platform.

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Take for example, the role of market makers in traditional markets. Does a DLT trading platform
where all transactions are completely P2P need market makers? While it may seem perfectly
reasonable to engage market makers for the purposes of risk management and higher liquidity,
the downside of this are the added inefficiencies into the network. Market making is done for
economic rents which reduce the bid-ask spreads leading to lower investor returns. In other
words, it leads to different settling prices than those in a non-intermediated system. This may have
implications such as reducing the overall appeal of a DLT platform. On the contrary, the presence
of market makers may facilitate the onboarding of institutional investors by placing large orders
and trading frequently on the blockchain platform.

Would a CETP be benefitted by the presence of market makers? I maintain that this maybe one
viable solution but should probably be the last resort. As it turns out, other options for sourcing
liquidity to the platform may turn out to be a superior solution. Tokenization of CFE these tokens
can then be traded among the shareholders - is another potential solution. However, this would
mean that equity of one particular company may be tradable with the equity of another company
if the underlining token is the same. One way to think of tokens is as money. For early stage
startups and small businesses the kind of company profiles that are most common on CFPs this
may not be optimal as they might want to ensure steady investors with long-term holdings.

3.5. The impact of transparent holdings

The issue of transparency in holdings on the blockchain has captured the imagination of academics
working on the subject the most, as evident from the limited literature that has developed already.
Arguably, even a little more transparency in transactions may add significantly to investor welfare.
Malinova and Park (2016) present a theoretical model comparing P2P trading with intermediated
markets and find that the most transparent setting yields the highest investor welfare. Similarly,
Yermack (2017) states that better transparency would significantly impact the profit
opportunities available to managers, institutional investors, and shareholder activists, among
others, because the incentives to acquire ownership and to liquidate it could change markedly if
their transactions were observable in real time. (13) In the instance of a maker-taker marketplace
on a DLT platform, there is a probability of reduced risk premiums charged by market makers due
to greater transparency in holdings it may facilitate. However, simply knowing who owns what
doesnt make the market infinitely liquid in itself, although in theory, a platform where all
shareholders can be pinged by a willing buyer or seller is conceivable.

Whether or not a certain market accepts and promotes transparency in holdings is a market design
decision which would be specific to the trading platform and its goals.

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4. Concluding remarks

In the current day, we are witnessing the early days of blockchain deployment. This study is hence,
very much a work in progress. Indeed, the comparison with the early days of the internet comes
up quite frequently. What this effectively means is that the industry is still in the exploratory stage
where the very basic protocols for products and services based on the blockchain are being
iterated upon and MVPs/POCs deployed and tested. This theoretical paper attempts to explore
some basic design considerations along with the currently identifiable challenges for DLT based
equity trading markets, particularly the CF markets. As of now, there are only a few players in the
market that have prototyped equities trading platforms (including CETPs) on the blockchain, most
of which are in the testing stage. It should be noted that there is no trade data available from these
platforms, ruling out the option to undertake empirical work on the subject. However, such an
analysis would be the logical extension of this study. At the same time, this paper is not meant to
be yet another white paper rehashing opportunities and challenges presented by blockchain
technology - I think there are plenty of those out there - instead, the goal is to stir greater academic
interest in the sphere of blockchain research such that structured thought can be dedicated to the
design issues that are inevitable as the global financial industry moves to a new digital
infrastructure technology.

With regard to how blockchain transforms our understanding of different architectures and the
current literature on finance, I think there would invariably be comparisons with the traditional
literature. In fact, we can use the traditional literature as an anchor to etch out how DLT platforms
are fundamentally different, or not.

Extrapolating into the future, an iterative process of building this digital infrastructure can be
expected. Ultimately, a range of blockchain offerings with varying degrees of investor anonymity
might compete in the market to attract corporate listings, with companies sorting themselves
among different platforms that appealed to different shareholder clienteles based on their
preferences for ownership transparency. (Yermack 2017)

In conclusion, since the focus of this paper is on crowdfunded equity, it is reasonable to ask if CF
equity need to be highly liquid in comparison to other forms of equity. In particular, companies
looking to get listed on DLT-based CETPs should consider which investor class(es) they are
targeting (institutional investors, accredited investors or retail investors) and what their liquidity
requirements are. Ultimately, the issue of liquidity how much liquidity is enough liquidity - is
driven by investor preferences.

5. Endnotes

v The current paper uses blockchain and distributed ledger technology (DLT) in a
synonymous fashion. While the financial services industry seems to have repackaged
blockchain as DLT for its specific needs, I maintain these are still the early days of

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 blockchain applications and it wouldnt be unsuitable to continue using the terminology as
such.

6. Key References

1. Stock Picking Is Dying Because There Are No More Stocks to Pick
https://blogs.wsj.com/moneybeat/2017/06/23/stockpicking-is-dying-because-there-are-no-
more-stocks-to-pick/?mod=e2fb

2. The Incredible Shrinking Universe of Stocks
https://research-doc.credit-
suisse.com/docView?language=ENG&format=PDF&sourceid=em&document_id=1072753661&s
erialid=h%2b%2fwLdU%2fTIaitAx1rnamfYsPRAuTFRGdTSF4HZIvTkA%3d

3. The Empirical Analysis of Liquidity
https://kelley.iu.edu/cholden/Holden%20Jacobsen%20and%20Subrahmanyam%20(2014).pdf

4. Analysis and outlook of applications of blockchain technology to equity crowdfunding in
China
https://link.springer.com/article/10.1186/s40854-016-0044-7

5. The Need for Greater Secondary Market Liquidity for Small Businesses
https://www.sec.gov/news/statement/need-for-greater-secondary-market-liquidity-for-small-
businesses.html

6. Private share trading takes off as tech companies shun IPOs
https://www.ft.com/content/27e9444c-0879-11e5-85de-00144feabdc0

7. Equity Crowdfunding: Signaling in European Crowdfunding Platforms
http://essay.utwente.nl/71587/1/Adiputro_MA_BMS.pdf

8. Non-Accredited Equity Crowdfunding Investors Need a Path to Liquidity
https://smallbiztrends.com/2015/07/non-accredited-equity-crowdfunding-investors-need-path-
liquidity.html

9. Market Design with Blockchain Technology
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2785626

10. Securities, Intermediation and the Blockchain - An Inevitable Choice between Liquidity and
Legal Certainty?
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2697718

11. Selling Private Company Shares 2.0.

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https://techcrunch.com/2015/10/14/selling-private-company-shares-2-0/

12. Efficient Markets Hypothesis: Impossible
http://www.e-m-h.org/impossible.html

13. Corporate Governance and Blockchains
https://academic.oup.com/rof/article/doi/10.1093/rof/rfw074/2888422/Corporate-Governance-
and-Blockchains#63063809

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