Real World Asset Tokenization: Fact vs. Fiction Part II
Myths abound when it comes to blockchain technology applied in capital markets transactions. Let's set the record straight.
By Vertalo Team
Every day we see new articles from financial publications touting blockchain technology and its myriad of uses across many different industries. Without fail, when it comes to capital markets, the oft-repeated points, some of them objectively false, are continually restated despite the obvious reality that clearly contradicts what is being said. In an attempt to help the market mature together, we’ve highlighted some of the more interesting and nuanced myths we’ve encountered in our years in this space.
This is a follow-up post to the first one of its kind we did entitled, “Asset Tokenization: Fact vs. Fiction.” If you’ve not read it, we’d recommend you start there before digging into the thoughts here, since some of these points build upon those made in the original post.
In case you haven’t read it, here is the synopsis of the myths covered in that piece:
Security Tokens rely on blockchain technology and require crypto exchanges for their sale and distribution. False, security tokens are securities, and nearly all crypto exchanges don’t carry the regulatory licensing to properly offer securities, of any form. Yes, they’re blockchain-based, but that’s where the similarities end.
Security token offerings are more liquid than public offerings. False, most securities offerings include lockup periods which prevent trading of any kind for a predetermined window, usually for one year. Once through the lockup, trading securities are subject to all sorts of compliance requirements.
Tokenized assets trade 24/7, just like cryptocurrencies. False because of existing laws for reporting on failed trades means that 24/7 trading is not possible for mostly regulatory reasons. There are ways around this, but it involves creativity around tokenized deposits as balance sheet liabilities, and is not readily available to the standard private securities issuer.*
You can trade and settle tokenized assets instantaneously on-chain. Theoretically true but operationally false due to the nature of pseudonymous stablecoins being tricky for ATS’s to handle.
Blockchain and security tokens open up your prospective investor base to global investors. False because blockchain doesn’t enhance your distribution capability in any way, the exemption or registration (these are securities!) is what governs the distribution and reach of your offering.
Blockchain holds the promise of decentralized trading. Entirely false because decentralized/P2P trading of securities is and has been illegal in the US for many years. This would require the deregulation of the entire industry as we know it, which would be awesome, but we’re not holding our breath.
*Figure is the exception here, their Provenance-based ATS can currently support the trading of tokenized assets 24/7, with bilateral direct settlement executed via smart contract. From what we can tell, what Figure is building is pretty incredible.
After first posting Part I, we had several colleagues from the industry reach out with additional thoughts for some of the myths that are often times heard, as well as suggestions for how to dispel them. As we get deeper into the myths and facts, we notice there’s far more nuance than a simple “true/false” dichotomy that you typically see with this sort of analysis. May this serve as a guidepost for those seeking to learn about the subtle distinctions and what is vs. what is not possible or currently legal when applying blockchain to capital markets.
This is Asset Tokenization: Fact vs. Fiction Part II.
Myth: With blockchain-based securities, I’ll accept crypto as payment for my offering.
This actually can be true, but it’s quite complex, so we’ll emphasize the “how” since many misunderstand the fundamental requirements to do this properly where securities are concerned. We should probably dedicate an entire post to this subject; it’s something we so often encounter that’s fraught with misunderstanding and regulatory hazards.
One of the core differences between a cryptocurrency wallet and your bank account is that self-sovereign crypto wallets are typically pseudonymous, whereas bank accounts include your personally identifiable information, including your full legal name, address, tax ID, employer, as well as other information depending on the nature of the account (a tax advantageous 529 college savings account might contain separate information, like the beneficiary, that differs from a run-of-the-mill checking account, for example).
If you’re using a centralized exchange to purchase a cryptoasset, you may have gone through a KYC/AML (Know-Your-Customer & Anti-Money-Laundering) process, and the information is collected because it is required to run checks against databases as part of anti-money laundering provisions. The most common of these include sanctions from the Office of Foreign Assets Control (OFAC) who monitors sanctioned individuals, jurisdictions (you can’t send a wire to North Korea, for example), and other parties suspected of illegal activity, like those on terrorist watch lists or drug cartels.
The cornerstone law establishing a framework for anti-money laundering behavior was the Bank Secrecy Act, passed in 1970, also known as the Currency and Foreign Transactions Reporting Act. Later bolstered by a number of money laundering-specific laws, as well as the Patriot Act in the wake of the 9/11 terrorist attacks, this law made it a requirement that banks work with regulators to prevent money laundering, especially by reporting suspicious transactions, including reporting all singular transactions of amounts above $10,000 USD. These reports, called a “suspicious activity report” or “SAR”, are required by all banking institutions domestically situated within the United States. Since the introduction of the BSA, nearly all modern jurisdictions have their own forms of checks to guarantee money laundering doesn’t occur.
These anti-money laundering provisions are even more ardent when accepting cash (or in the case of crypto, monetary instruments like stablecoins or tokenized fiat deposits) for securities. The government seems to care much less if you’re accepting Bitcoin as payment for a t-shirt on a Shopify e-commerce site than if you are using it to accept payment in exchange for an exempt or registered security.
With the growth and adoption of the crypto market as a whole, we saw the return of two significant elements:
The bearer instrument, which had previously been outlawed in 1982 under the Tax Equity and Fiscal Responsibility Act, and
Pseudonymity, through the ability to transact with wallets that were not explicitly connected to your real-world identity. This pseudonymity has only been bolstered by the explosive growth of global decentralized trading and lending markets
In order to accept crypto as payment for securities, here are the things one would need to do:
*please note that this is in no way legal or professional advice. Consult with a seasoned securities attorney or money transmission attorney should you in any way attempt to do what we’re about to explain*
Full KYC check on the individual receiving the asset. This seems obvious, but it’s important to reiterate that know-your-customer provisions are a critical step whenever issuing securities, no matter the form or function of the payment received.
Wallet registration at the time of sign-up. This is another obvious one, but you’ll want your investors to verify that they do in fact own the wallet they’ve brought to the table. This can be done with a simple transaction signing process, followed by a mapping exercise to guarantee you associate John Smith’s wallet with John Smith’s identity.
Source of funds tracking via a blockchain analysis company. Remember - Bitcoin, Ethereum, and many other blockchain-based tokens are pseudonymous, not anonymous, meaning that tracking and analysis can be applied using many different tools; blockchain analysis is a multi-billion dollar industry after all. Source-of-funds tracking allows you to flag concerning transactions for review. For example, companies like Elliptic, Chainalysis, or CipherTrace can help issuers understand where the funds had come from, or more importantly, if they flowed through dark pools used by Russian darknet market Hydra or North Korean hacker group Lazarus. If the funds intended as payment had touched addresses known to be associated with Hydra, Lazarus, or any other sort of illicit or sanctioned party, the chain analysis provider could help you make that determination, allowing you to either reject or further investigate the nature of the crypto paid-in and decide whether moving forward is prudent.
Ongoing wallet monitoring to guarantee investors don’t port wallets to other users by giving them private keys. The scenario here that could land one in hot water, and one of the biggest hangups to blending crypto & digital asset securities is as follows. With the 12-word seed phrase in hand, we could easily:
Register our wallet
Sign a transaction
Verify we are not sanctioned
Then, give the private keys to our friends in living Russia, North Korea, Cuba, or who are part of a drug cartel, or any other entity or jurisdiction disallowed from participating in capital markets activity.
Remember, under current capital markets architecture it is impossible to “port” your bank account over to another user after clearing KYC. In order to prevent this from happening in the pseudonymous crypto world that we’re discussing, you’ll need to employ some of the more rigorous tools offered by blockchain analysis companies. This includes KYT (Know Your Transaction) and KYW (Know Your Wallet) monitoring, and even IP logging, that would allow you to flag if the user is accessing the wallet from an IP address different from the one they used when they first registered the wallet. This isn’t ironclad however, since people get new computers, they move, they travel, they use VPN’s, etc, all of which would dictate a different IP address than the one the user first signed up with. But broadly speaking, a KYC, KYT, KYW, and IP monitoring service would probably be enough to satisfy even the most rigorous of compliance officers where money laundering is concerned.
On a personal level, we believe the pseudonymous nature of cryptocurrencies, especially Bitcoin, is very much a feature, and we fully support the right of individuals to make private purchases outside the purview of the prying eyes of the government, a payment processor, or even an analysis company. That said, we do have anti-money laundering laws that demand our respect, and crypto’s pseudonymous nature means that without taking care we could easily find ourselves on the wrong side of review with a government auditor. And to put it mildly, where money laundering is at stake, auditors are not playing around.
Fact: As long as you employ the proper tools to verify the holder of the crypto, the source of funds, and the individual themselves are who they say they are and are not sanctioned, crypto payment for securities is straightforward. The buildout and necessary infrastructure is simply complex to architect and support.
Myth: The price of my tokenized asset will be affected by the price of the utility token for the chain it was tokenized on.
False. The example case here might be Ethereum and it’s ETH token against the price of a tokenized security that was tokenized on the Ethereum blockchain. The price of ETH should have practically no bearing on the price of your asset, since one is a utility for the Ethereum network, and the other a securitized financial instrument using the underlying blockchain as a database and ledger of record.
The analogy we like to provide here is that it’s akin to asking what happens to your tech company that’s built on AWS if Amazon’s stock price dips?
They’re unrelated.
Your company valuation and equity price should not be impacted by Amazon’s stock price moving up or down, aside from high correlation at the macroeconomic level, like when we see large bull or bear runs that impact the business landscape and global financial markets as a whole.
Unless AWS, or the chain, experiences a complete and total meltdown that’s irrecoverable, the underlying blockchain is simply being used as a database for your equities-related information.
Admittedly, complete blockchain meltdowns are perfectly possible, just look at Terra Luna, or earlier, NEM, or even others; LBRY lost their case against the SEC, which could more or less render their blockchain useless and untouchable. But even the case whereby a chain is rendered unusable can be remediated and fixed provided you keep accurate shareholder records of your equities. This is one benefit to the Digitally Enhanced Dematerialized Digital Asset distinction that many who are tokenizing assets are using, as long as you maintain an offchain record alongside the onchain one, changing the blockchain it was recorded to through the “enhancement” is relatively painless.
Just as your customers shouldn’t have any problem with you migrating from AWS to Google Cloud, if a blockchain was unusable for whatever reason, a simple Chain Swap from one blockchain to another should remediate your problem easily provided you have properly kept the ledger of record for who owns what.
Fact: The price of the native utility token of the blockchain you’re using should not impact the value of your equity, but should there be some related impact, you can always perform a Chain Swap function off of an existing chain onto a new one.
Disclaimer: We are not attorneys, broker-dealers, investment advisors, or wealth advisors. Nothing presented herein is nor should it be considered as legal, professional, business, investment, or any other kind of advice. The information presented here is done so for educational, informational, and entertainment purposes only. Always consult a licensed professional before taking professional, investment, or legal action.
Myth: The use of blockchain makes security tokens more available for fractional ownership, including partial shares.
False. This is one that we consistently see repeated over and over again, that applying blockchain means that now an issuer can fractionalize a share, and our suspicion is that the fractional token standards of 18-decimal places on Ethereum, Tezos, and other chains is the principal driver behind this myth. The reality is that fractional ownership and fractional share offerings have no formal requirement to utilize blockchain, have existed for decades, and are entirely possible outside the use of blockchain where private assets are concerned.
There are some limitations here, but they are typically only economic or technical in nature. The economic limitations usually come into play with share minimums that more readily facilitate a lower cost of capital. For example, in order to properly qualify an investor buying your asset, you need to perform and/or record the following:
Investor Suitability
KYC/AML Checks
Data Management (recording their share purchase & issuance information)
All of these incur expenses, so if your minimum investment amount is low, your cost of capital will end up being much higher on a per investor basis. Typically this is scalable, since there are unit-based costs for each (you must perform KYC on every individual for example) but the Suitability and Data Management can usually be priced in a tiered manner, allowing you to reduce expense on a per-investor basis as you add more and more investors within any given tier. The cost breakdown might look something like this:
$3.00 / investor at 1,000 investors in total
$2.00 / investor at 5,000 investors in total
$1.00 / investor at anything above 10,000 investors in total
The technical limitation here is a shallow hurdle from what we’ve encountered, but we have seen certain products that, per their design and system architecture, cannot accommodate fractional share issuance. This is a simple fix in theory, since any digital system should be able to, or be modifiable to be able to, accept partial shares, but the limitation overall is one to be informed of, since we continue to see the myth of blockchain as the only option for fractional share ownership promoted in literature, blogposts, and online forums.
As an example, see Schwab’s breakdown of what they refer to as “Schwab Stock Slices”, which allow investors to purchase as little as $5 of a share of a public company.
Fact: Blockchain is one solution for fractional share ownership and management, but not the only one. Fractional share ownership has existed for many years outside of the creation and growth of blockchain technology for capital markets.
Myth: I will use an auction-bid system to trade my asset after issuance.
Possible in principle, but false in operational reality, and strays into a very grey area that is presently being debated by securities regulators. There are several components to this notion; the first is that, even with exempt or registered offerings, there may be a lockup period that would restrict liquidity (it certainly would prevent an asset freely trading on an ATS, for example), but within lockup periods there still remains the ability for an issuer to allow existing shareholders to buy or sell from one another, creating some semblance of liquidity should an investor have an event that required selling their position.
We’ve seen many products in the “token issuance” space that include the ability for current shareholders to create auctions for their assets, and while issuers can absolutely allow the sale of private shares, statistically speaking most Reg D 506(c) exempt offerings have very few shareholders on the cap tables, so the buyer pool is quite limited, since no net-new investors can participate in an offering after it has closed and is within the seasoning period. The limited buyer pool element is even more pronounced if an SPV structure is stood up whereby the line item entry on the cap table is a single entry, with multiple shareholders inside the SPV itself, creating a dual structure where the SPV is an investor in a product, and an issuer of ownership equity themselves.
Once you’re past the seasoning period, the problem of only selling to shareholders already on the cap table is no longer present, but you still must find a buyer, which is where the auction could prove more powerful, but this leads to the next point that includes the aforementioned regulatory grey area.
One compliant example of auction-based trading is Nasdaq Private Markets, the sister company and private arm of the Nasdaq exchange that operates an ATS. They received an exemption to Rule 102 under Reg M in 2017, allowing them to conduct auctions for registered investments, in particular the fund in question had a dual structure, with both a feeder and master fund. From the SEC letter granting limited exemption, “This order grants a limited exemption from Rule 102 of Regulation M solely to permit Tender Offer Funds to conduct tender offers, during a limited transition period, for their securities during the applicable restricted period even though periodic auctions of their securities also are conducted on the Alternatives Platform [the ATS], subject to certain conditions described below.”1
The second component, and grey area that issuers, custodians, and transfer agents need to be very careful of with regards to auction books for private securities is that typically, where order matching between buyers and sellers is concerned, regulators want to see a broker-dealer and/or ATS involved in the process supporting the order matching, cash settlement, and security transfer steps. The Nasdaq Private Markets example above was only possible because they employed the use of their FINRA-registered alternative trading system.
This means that simply using technology to record the order match, then instructing investors to settle directly with one another, after which the security can change hands from seller to buyer, looks an awful lot like FINRA’s Four Step Process, except that there is no ATS involved. And we know, decentralized or peer-to-peer trading of securities is not legal in the US, nor most modern jurisdictions with capital markets activity. To be fair, there are scenarios of NMS securities that are not sold on an ATS but do require a broker, but since we’re talking about private (non-NMS) assets here, we set that example aside.
This final point is entirely anecdotal since we’ve tried, unsuccessfully, to find the SEC staff statement on this matter, but as we remember it, in spring of 2022 the SEC released comments around the use of technology for creating auction books for private securities, and the position of the Commission was generally negative towards this behavior, since it starts to look like unregulated free trading if order matching is enabled via technology. FINRA’s creation of both the Three & Four Step Processes was done for exactly this purpose: to support the order matching, cash settlement, and movement of securities in a regulated fashion.
Additionally, we’ve had a number of recent conversations with brokers & custodians in the blockchain-based securities space who’ve all confirmed that auction-based order matching is currently being discussed at length in Washington DC among regulators, and we expect we’ll see more concrete statements and firm position regarding the treatment and application of this technology in the coming months.
Fact: Auction or order match systems are a regulatory grey area, and stray close to unregulated securities secondary transactions. A better approach to achieving liquidity for private assets is to formally list with an ATS to support the order matching, trading, and settlement of your security.
Myth: Smart contracts will negate all third parties in capital markets transactions.
This is one of the more egregious misconceptions we still see purported today in news media and from “experts”. Smart contracts are extremely useful, and have much utility in removing rent-seeking third parties that don’t truly add any value, but they are not the end-all be-all of a decentralized utopia like many in the crypto space might believe.
While a trustless system is achievable where a global fungible monetary instrument is concerned (Bitcoin has achieved this in our opinion), there is no such thing as trustlessness when it comes to securities. We emphasized this point at the Digital Assets At Duke panel we were on a few weeks ago:
See the full write-up here:
Put another way, where traditional or private securities are concerned, trust is required element across all transactions, since the very nature of what securities are (securitized interest in a centralized entity) means that you as a holder are placing trust in the issuer, their executive team, board of directors, employees, their customers, and the growth potential of their business and market overall.
When considering the world of securities, let’s remember that not all data required to complete transactions will live on chain, which means that there will need to be not only oracle-tech that can support offchain data feeds into onchain smart contracts, but trust in the source and legitimacy of that data, which will feed into smart contracts for execution. On ChainLink’s website, they give the following simple example:
Let’s assume Alice and Bob want to bet on the outcome of a sports match. Alice bets $20 on team A and Bob bets $20 on team B, with the $40 total held in escrow by a smart contract. When the game ends, how does the smart contract know whether to release the funds to Alice or Bob? The answer is it requires an oracle mechanism to fetch accurate match outcomes off-chain and deliver it to the blockchain in a secure and reliable manner.
In this case, the offchain source feed into the smart contract could be ESPN, BleacherReport, Fox Sports, or CBS, but in all cases you’re placing trust that the sports network will provide accurate data into the smart contracts prior to execution. If Bob had a friend in IT at ESPN, and it was the source feed into the smart contract, he could theoretically have the friend manipulate the input (even for only 1-2 seconds), let the smart contract execute in his favor, ESPN would refresh the score to reflect reality, but it would be too late. Since smart contracts are designed to self-execute upon certain criteria being met, and almost always are sovereign in nature (meaning no clawback or unwind provision for both the transaction, and well as the funds themselves, like USDC or similar stablecoin), Alice would have won the bet, but lost the money.
Vertalo seeks to solve for this natively, with a hybrid onchain/offchain approach that allows for automation and the removal of unnecessary third parties, but still retains flexibility and upgradability where capital markets transactions are concerned. This is especially imperative in a continuously shifting regulatory environment, where the rigidity of smart contracts, or the idea of writing every compliance component into the token itself, could render your token as expired, requiring a burning, re-issuance, and re-minting of the security token.
And if this sounds like something that’s outlandish or not feasible, this has already happened within the digital asset securities world in the United States. The inelasticity of the smart contract architecture involved required a burn and re-mint, which was not cheap to execute. We don’t name those involved, both out of professional courtesy and to respect their privacy, but this is a genuine matter that deserves attention, since the effect of doing it improperly has real-world implications for issuers, investors, brokers, transfer agents, and even regulators.
Fact: Smart contracts will have immense utility, but still require trust from offchain sources in order to execute properly. Additionally, smart contract architecture will need to maintain the necessary flexibility that capital markets participants are used to.
Interested in connecting over the digital asset ecosystem, capital markets, or blockchain-based securities? Reach out to us on LinkedIn or Twitter!
Conclusion
We’ll conclude with a request from those of us here and working in the space - if you hear these or other myths or falsehoods repeated, whether at a conference, on a call, or simply in the course of business, we’d ask that you gently set the record straight and correct their understanding to reflect reality: whether it be technical, legal, operational, or otherwise.
We won’t do those trying to learn any favors by allowing incorrect information to continue to circulate across the industry, rather we should seek to educate the market so we can grow the space in an informed and intelligent way. As we like to say, “A rising tide lifts all boats,” and that is the case here - let’s lift one another.
Till next time.
Disclaimer: We are not attorneys, broker-dealers, investment advisors, or wealth advisors. Nothing presented herein is nor should it be considered as legal, professional, business, investment, or any other kind of advice. The information presented here is done so for educational, informational, and entertainment purposes only. Always consult a licensed professional before taking professional, investment, or legal action.
https://www.sec.gov/rules/exorders/2017/34-80052.pdf