When bitcoin ignited the cryptocurrency craze back in 2009, most investors and public officials had never heard of the blockchain technology that underlies it, or they knew just enough about it to believe it could soon be the next Internet in terms of its impact. For now, artificial intelligence has displaced the blockchain and “smart cities” as the flavor of the year on Wall Street and in public management, with its potential to enhance operational productivity and even the policymaking process of budget-cutting.
But as blockchain and other forms of advanced financial technology — “fintech” in industry argot — evolve, they are already making inroads into public finance. The challenge is to separate the noise from the signal. More importantly, public officials must also be watchful for those nasty laws of unintended consequences. Technology can be wonderful in driving improvements in public services and financial efficiencies, but its proponents often have a blind eye to unpredictable negative outcomes.
That warrants a closer look at the cutting edge of governmental fintech. It all began on the crypto front, as speculators bid up the prices of numerous cryptocurrencies. This infatuation has blossomed to almost-mania levels. Meanwhile, the allure of stablecoins, tokens, and permanent financial and property ledgers all residing on blockchain systems keeps feeding the imaginations of private investors and various public officials alike.
Last month, the state of Wyoming unveiled its own stablecoin currency, called the Frontier Stable Token. It’s reminiscent of the issuance of private money in various forms by banks and others from the 1800s up to the Great Depression era. The Wyoming commission’s website explains its vision of how its stablecoin, the first issued by a U.S. public entity, will be useful for various transactions, not just within the state but even globally, with all of its tokens to be “fully reserved” by U.S. dollars.
Unlike bitcoin, the Wyoming stablecoin is not intended to become a vehicle for price appreciation and speculation. But time will tell whether it invites dark applications associated with bitcoin, such as tax evasion and hackers’ ransom demands. The stablecoin industry has yet to prove itself immune to a number of shady applications, even though the folks in Wyoming will undoubtedly do what they can to discourage criminal uses while promoting legitimate commercial applications.
Cryptocurrency is just one of many potential applications of blockchain technology. As a presumably permanent ledger of various transactions, any number of potential uses in public finance could eventually benefit from blockchain’s indelible records — assuming that they cannot be cracked sometime in the future by superior technologies like quantum computing. Just a few of these would include the recording and registration of deeds and real estate transactions by county governments; the ownership of municipal bonds and potentially the fractional ownership of munis by smaller retail investors; owning and trading in and out of private equity and real estate funds in public-sector retirement plans; payments to vendors; and even the collection of state and local taxes.
Certainly the concept of a permanent digital ledger would seem well suited to modernize the recording and registration of real estate transactions, title history and tax records. Some companies have ventured into this space, but nobody has yet demonstrated an all-in solution that makes sense commercially. There are several obstacles to clear, including the cost of converting old records including legacy documents — microfiche, PDFs and such — and doing so on sufficient scale with enough users to become the industry standard in a given state, county or region.
Despite the conversion challenges, several local governments have pilot programs underway, including Bergen County, N.J.; Cook County, Ill.; and Riverside County, Calif. Overseas, several smaller countries with historically less-developed land title infrastructure are migrating to blockchain, so there will be lessons there to be learned in coming years. Meanwhile, in an adjacent realm of public records, AI might make it possible to solve the “data transparency” mission of making ordinary financial reports in PDF form machine-readable and analyzable without expensive software conversions.
Applications for Capital Markets
In the capital markets industry, at least two potential applications of blockchain technology could eventually emerge in the world of public finance: the municipal bond market and the alternative investments held in public retirement systems.
In the muni market, most of these securities are “held” in book-entry form at a centralized depository institution that interfaces with the broker-dealer community to facilitate sales and purchases by investors and payments of interest and principal. The system presently requires minimum denominations that discourage ownership of diversified portfolios by small investors.
Whether blockchain technology could someday facilitate fractional or small-denomination ownership of muni bonds is one idea that has been explored by numerous entrepreneurs, but so far they have failed to devise a viable business model that would be cost-effective and marketable. It could work for buy-and-hold nonmarketable bonds, but that’s hardly a commercial gold mine.
The other blockchain use case in capital markets, alternative assets, would be far larger if it could be accompanied by a sufficiently deep aftermarket for trading of the ownership of interests in investment partnerships like private equity, private credit, real estate and hedge funds. Today the investors in such funds are mostly locked in for their duration, until the fund is ultimately liquidated after distributions from individual positions.
That’s a more complicated problem for the defined contribution industry, such as 401(k) and 457 retirement plans. Investor-participants are accustomed to daily valuation of their stock and bond fund positions, with the ability to transfer from one holding to another on any given day at fair market value, but the existing structure of buy-and-hold alternative investments ownership is ill-suited for this expectation. Thus, there is a dream among some advocates that “tokenization” through a blockchain would facilitate fractional ownership interests that could foster same-day liquidity to employee participants who want to shuffle their portfolios.
Blockchain technology might be feasible for recording such transactions and ownership, but that alone does not solve the problem of properly valuing the fractional ownership interests represented by tokens on a daily basis and replacing the frictionless liquidity of ordinary mutual funds. Fintech by itself does not create deep markets when trades are infrequent, as they will be in the secondary markets for alts and munis.
Sellers need actual — not hypothetical — buyers, not just the scalpers who sit around waiting in thin markets for a desperate owner who will take any price just to get out. Maybe there will someday be legions of otherwise-unemployed wannabe scalpers all lurking on Robinhood and other token platforms to make this work, but don’t count on it. The entire system would need at least a dozen specialist market-making firms commercially engaged in “low-frequency trading” — the operational antithesis of what drives Wall Street liquidity and the major stock exchanges’ efficient pricing today.
Before tokenization becomes allowable for the masses to own private equity holdings directly or indirectly, the participating private companies should be required to file timely current financial reports on a linked blockchain. They should be required to comply with the Sarbanes-Oxley and 1933 Securities Act laws to protect naive small investors from deceptive market practices, scalping, insider trading, pump-and-dumping and other abuses that such a system will almost inevitably invite, particularly in the secondary markets. Otherwise, tokenization for retirement savers is essentially a license to steal.
There’s more: Anybody who’s owned off-the-run munis — or any number of thinly traded securities held in gamier brokerage accounts — can tell you that the third-party pricing spreads used for those valuations in brokerage portfolio reports are wide enough for a proverbial semitruck. Even worse, it’s likely that aftermarket offers for fractional interests in private funds or their component portfolio positions will almost always trade at a discount. Small investors would consistently come out on the short end of the stick whenever they try to sell their dribs and drabs. It’s like the lyrical Hotel California: You can check out any time you like but you can never leave — without paying a dreadful price.
Tokenized Payments
One last concept to mention here is the idea that stablecoins will eventually transform the payments system. Hundreds of business teams are working on this one, because it’s potentially a trillion-dollar industry. The new Wyoming stablecoin token is just one example of the gold rush mentality that has swept the financial industry and the minds of politicians seeking to cash in on the next big thing.
One of the potential use cases involves the ability to settle payments almost instantaneously with blockchain’s presumably indelible proof of the transaction. That idea has any number of potentially useful applications, ranging from the aforementioned real estate transactions to the payment of taxes at various levels of government to facilitating muni bond escrows. All of them carry the potential for the stablecoin to pay “rewards” (not interest, which is unlawful under the new federal GENIUS Act) gleaned from the Treasury bills or other collateral instruments that underlie a properly designed stablecoin.
For those familiar with playing the float on bank disbursement accounts, it’s hard to dispute that the existing payments system has unremunerative spots for cash managers that maybe could be replaced or supplemented by income-producing tokens. But whether that alone is a powerful enough inducement to drive retail consumers and bill-payers onto these unfamiliar platforms is hardly obvious. It seems more likely that the adoption would begin in the banking and investments industries, where the big money resides.
Fans of decentralized finance and AI have dozens of other ideas on their drawing boards. Most of them will never see the light of day for lack of sufficient funding, proof of concept, buyer interest and all of the other hurdles that face startup entrepreneurs. Two places to stay abreast of cutting-edge developments that may someday pan out are Governing’s sister publication, Government Technology, and the Government Finance Officers Association. GFOA is exploring the feasibility of sponsoring an innovation lab with a potential mission to identify, foster and harness applications of new technologies that can advance the practice of local government finance and provide the proving grounds for promising concepts, applications and projects.
Undoubtedly there will be many fintech solutions searching for a problem in the realm of state and local government, most often by people who are clueless about how things actually work in the public sector on at least one of three essential levels: the nitty-gritty technology, the actual operations and pain points that practitioners deal with daily, and the potential adverse consequences and societal externalities.
Bridging those gaps will require more than just naive entrepreneurial hunches followed by wipeouts, which is why the cultivation of a “GovFinTech” community that includes technical and business advisers plus fealty to the public interest will become increasingly important in coming years.
Governing‘s opinion columns reflect the views of their authors and not necessarily those of Governing‘s editors or management. Nothing herein should be construed as investment advice.