The Colorado Department of Treasury has recommended using blockchain technology and security tokens for state financing following the publication of a report.
Published March 1, the Security Token Offerings State Capital Financing Feasibility Study asked if using blockchain for state securities is feasible and breaks down blockchain technology, current Colorado state capital financing and how financial tech could fit into that process.
Colorado State Treasurer Dave Young in a press release said the department thinks using security tokens and blockchain technology would be feasible. He added those options could be beneficial but “it’s likely the cost of implementing this technology safely and effectively that may be the most significant barrier in implementation at this time.”
The report was prepared by Perkins Coie attorneys partner Joshua Boehm, based out of Arizona, and senior counsel Stephen Keen, based out of Denver. Keen practices corporate law and has extensive experience in money market funds and instrument matters. He said since 2017, he’s worked with and learned from Boehm whose practice focuses on financial technology including blockchain services.
The report was commissioned by SB22-025, passed last year, to look at the feasibility and potential benefits of using emerging fintech for state-issued uncertified securities. According to the bill’s sponsors, the report was needed to explore potential cost reduction for Colorado through secure tokens and blockchain.
“We pay fees right now for the traditional way of debt offering, there’s typically an underwriting fee … we pay a fee to the rating agencies to look at our offerings,” said Sen. Chris Hansen, one of the bill’s primary sponsors, introducing the bill in February 2022 to the Senate Committee on Finance. “I think the promise of securities tokens is that they can lower those fees over time because it reduces transaction costs.”
Hansen added that while blockchain and security token technology has been used in private and municipal bond markets, Colorado is the first state to consider its use for state bonds.
Keen said the report’s primary research question was whether or not it’s feasible to use blockchain and security tokens in state securities. The next question was whether or not that would make sense.
“The big takeaway, I think, is that there are a lot of people that think this could be beneficial to investors and therefore beneficial to the state. But they won’t really know until we try that,” explained Keen. He said if Colorado rolls out these options, there might not be immediate benefits but as more and more people get used to the technology, there could be significant cost reductions. “My chief takeaway is that you won’t really know if it’s going to be helpful until you try, but it shouldn’t be any worse.”
Blockchain and Security Tokens
Modern blockchain technology is often attributed to Satoshi Nakamoto, the pseudonym of the developer of Bitcoin, one of the earliest forms of cryptocurrency. In a 2008 whitepaper, Nakamoto explained how blockchain technology eliminated the need for third parties, such as financial institutions, to be involved to verify online transactions.
While blockchain is often associated with flashy financial tech products like cryptocurrencies or non-fungible tokens, at its core it’s a digital ledger that can’t be retroactively altered.
Blockchains start with a non-centralized network of computers that communicate with one another. All computers have a mutual agreement to keep data in the same format which allows them to verify the consistency of new and existing data. Any new data entered must include a history of older entries and creates a historic record across all network computers. If a data entry is altered, it will alter previous parts of the chain and show a mismatch. For digital assets, the owner of an asset is the only one in the network allowed to alter the data chain. Blockchains use a variety of methods to verify ownership.
Under SB22-025, a security token would be an uncertified municipal security contract verified through blockchain technology.
“These are just [an] uncertificated security. We’ve been dealing [with] uncertificated security since the 70s. So the asset isn’t new, what’s new is how it’s recorded,” explained Keen. “The way that it is recorded allows people to directly trade instead of having to go through an intermediary.”
How Would Blockchain Fit in with State Securities?
Colorado currently sells municipal securities, or the state’s tax-exempt obligations such as notes, bonds or certificates of participation in a lease with annual appropriations.
The report explained the categories of municipal bonds are sold to investors and require hiring a number of third parties to execute the sale and holding such as attorneys, financial institutions and dealers for trading.
State securities are currently sold to The Depository Trust Company that holds securities intermediately. DTC receives a certificate for the full security and is registered as its sole owner. DTC then credits each underwriter for their portion of the securities. The only members of DTC are brokers and banks, meaning individuals cannot directly own a state bond currently.
Security tokens could potentially change that.
“What this opens up is the possibility that you could own directly, that you could establish ownership to your bond through the blockchain records without a broker or dealer,” explained Keen.
Since current law allows for uncertified securities registered in the purchaser’s name, no major changes would be needed to allow direct ownership interest of a security token with an individual investor. But the study noted Colorado or an appointed agent would still need to keep an up-to-date copy of the digital ledger.
The report also said any blockchain technology to replace DTC would need to have built-in compliance features to allow investors to hold and trade tokens.
Keen doesn’t believe security tokens would eliminate the need for brokers or dealers, but would open up a channel for people who are confident and comfortable enough to buy and hold a bond themselves.
Future of Financing
In the five or so years Keen has worked in blockchain technology matters, he’s developed a saying: “Blockchain time is basically ordinary time, times 20.”
“Five years is like 100 years in blockchain time because there’s just so much changing so quickly because it’s open source,” Keen explained.
As part of the study, Keen and Boehm heard from five underwriters about the possibility of using blockchain security tokens. The main takeaway from the underwriters was market acceptance of blockchain securities is needed to drive any adoption.
“One of the big hurdles that the dealers that we spoke to talked about was that people just have to get used to using the technology for this purpose,” said Keen. “There are already corporate issuers of blockchain securities and there are developing alternative trading systems that use blockchain technology for other types of securities. Once you get used to trading securities of any form, then trading municipal securities is just more of the same.”
If the Colorado Department of Treasury adopts security token offerings, Keen thinks market acceptance of the trading could take off quickly. He added that apps to allow the quick and easy purchase of state securities could allow more consumers to purchase bonds without needing to know the detailed technicalities of blockchain or municipal trading.
“If it’s really adopted widely and utilized on a regular basis, the common user won’t think twice about it,” said Keen.
While the possibility of cutting out middlemen through blockchain is an exciting prospect, Keen said the study recommends building in some safety nets to adopt security tokens.
Keen said with potential cybersecurity threats, the Colorado Department of Treasury should keep a blockchain record separate from that created by the network of computers. He added the department might also consider launching a smaller, pilot version of security tokens to assess risk and needs prior to a larger adoption.
“No matter what you do, you should have a plan B,” said Keen. “Maintain your own record off the blockchain so that if something happens to the operation of the blockchain, it doesn’t freeze the asset.”