Open innovation has a strong foothold in the tech industry. Big tech companies create application programing interfaces, or APIs, to tap into the knowledge base of outside software developers. By doing this, centralized companies are able to access external pools of knowledge that enhance the value of their own proprietary application. One prominent such example is Facebook’s ‘Like’ button API. Facebook made integrating the ‘Like’ free and easy because it let them tap into apps’ users, giving them access to massive data they didn’t have access to before.
This type of open innovation isn’t unique to Facebook — most all tech companies do it. This isn’t, however, the case for all industries. Tech lies on one end of the open innovation spectrum while the financial sector lies on the other. This is especially true for underwriting services provided by large investment banks like Goldman Sachs. Co-founding Decipher Capital — a VC fund investing in blockchain-enabled projects — coupled with being an investment banker at Goldman gives me a unique perspective into how and why blockchain enabled technologies, specifically asset tokenization protocols, will disrupt investment banking.
This inevitable disruption is best understood by looking at the status quo. Today, Goldman tends to underwrite deals exceeding $100mm. Deal size and limited capacity forces it to be selective with the clients it takes on. Administrative, management, labor, and the other costs related to underwriting a deal don’t change based on deal size — they’re more fixed than variable. As such, Goldman is incentivized to chase larger deals to maximize unit economics. This business model has worked till now because raising capital is expensive and time-consuming, incentivizing companies to minimize the frequency while maximizing the size of capital raises.
That said, it won’t be like this for much longer. Decentralized, open-source smart contract protocols are enabling the tokenization of real-world assets — including equity and debt.
Figure 1: Explanation of Tokenization [1]
Tokenization of equity and debt means that capital raises will be faster and more efficient. This is because blockchain limits inter-party dependency for access to relevant information. Compliance requirements, for example, can now be programmed into tokens via smart contracts, reducing time and money spent on on-going compliance efforts. Given this speed and efficiency, tokenized assets can be further fractionalized, allowing for wider ownership and deepening markets.
Figure 2: Benefits of Tokenization in Investment Banking [2]
The benefits described above mean lower all-in issuance costs for companies. They reduce the time management spends raising capital, lower the fees paid to intermediaries, and minimize losses due to market inefficiencies like deep discounts and high interest rates. Just looking at IPO gross spreads gives us an indication of how costly capital raises are for companies. Given 2016 numbers, the average gross spread for a company raising $1.0bn through an IPO would have been 5.4%, translating to $54mm dollars in underwriting fees alone. Companies will find ways to reduce such costs once viable options are available.
Figure 3: Average underwriter fee in IPO in the United States from 2014 to 2016, by deal size [3]
Therefore, if Goldman wants to be competitive in this new blockchain environment, it needs to use blockchain to enhance its underwriting capabilities. Goldman will need to streamline information flow between syndicate banks and clients, reduce costs associated with on-going securities compliance, and increase market depth for its. If Goldman doesn’t innovate, its underwriting business will suffer from decreased deal flow and margin compression as companies search for the cheapest, viable options.
Goldman hasn’t been sitting on the sidelines. They’ve reacted by actively participating in the blockchain space. Although the press has been focused on Goldman’s short-lived plans to open a bitcoin trading desk [4], its true strategy lies in its investments in blockchain companies. Goldman recently invested in Veem [5], and Tradeshift [6]. Both investments were made through its Principal Strategic Investment Group (PSI). PSI tends to invest in companies that they expect at least one other part of the bank to benefit from a partnership with the portfolio company [7]. These investments increase Goldman’s exposure to blockchain, but the underwriting business is unlikely to be a direct beneficiary of such partnerships. Goldman needs to spend more time integrating blockchain into the day-to-day operations of its underwriting business and not rely on strategic investments by PSI to keep this business competitive.
Final Thoughts and Questions
There is no doubt that tokenization has the ability to reduce capital issuance costs. At minimum, Goldman may want to implement blockchain to reduce the back-end costs of underwriting a capital raise. The question is not a matter of if but of when. How long until capital raised through tokenized assets match that raised through the traditional capital markets? 2 years? 3 years? 5 years max?
Disclaimer. This post is intended for informational purposes only. The views expressed in this post are not, and should not be construed as, investment advice or recommendations. This document is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein. All opinions in this post are my own and do not represent, in any manner, the views of Decipher Capital Partners or affiliated companies.