Ohanae is an asset tokenization platform that will disrupt the capital market with automated compliance, improved liquidity, and enhanced ease of trading with fast transaction settlement. Equity tokens or digitized securities may become the more common method of securities ownership and secondary trading in the future, allowing users to leverage smart contracts to automate regulatory compliance for their securities.
Equity tokens and the promise of automated compliance
Technology never exists in a vacuum. That’s especially true at the cutting edge, where new innovations hold the potential to transform the world at a scale difficult to contemplate. The newly released paper by The Thomson Reuters Legal Executive Institute, Digitized Securities and the Promise of Automated Compliance, not only outlines how revolutionary this process could be, but also explains how smart contracts could be used to automate compliance with certain securities laws.
An equity token is a digital representation of a security, such as a stock, which can be programmed to automate certain functions and whose ownership can be traced in real time using a distributed ledger or blockchain. The paper from The Thomson Reuters Legal Executive Institute explains the concept of an equity token aptly:
“The first generation of digitized securities being issued today are effectively traditional securities enveloped in a digital wrapper. That should not suggest that their potential impact is limited, however. As in the shift from “snail mail” to email, the content of the underlying information does not change. However, like email, digitization offers significant advantages over the legacy paper-based system.”
One of the significant advantages that digitized securities can offer is the opportunity to use smart contracts. Certain distributed ledgers, such as Ethereum, allow users to embed computer scripts, or smart contracts, into the ledger, and these scripts will then be executed automatically by the nodes running the ledger if the conditions specified in the script are satisfied. Smart contracts can then become a way for us to automate compliance with certain aspects of securities law.
Using an equity token, an issuer could write certain transfer restrictions directly into the code of the smart contract, effectively enshrining certain key securities law requirements, such as holding periods or shareholder caps, directly into the security itself. Done properly, this could provide both issuers and regulators with assurance that applicable laws were being complied with, while also eliminating certain transactional frictions that make it difficult for investors to trade on secondary markets.
The value of an equity token is that these compliance checks would be enforced automatically upon any transfer, without requiring any post-trade intervention or reconciliation to ensure compliance and track ownership. This is possible because distributed ledgers allow the various entities necessary to effect a securities transaction (e.g., brokers, alternative trading systems, custodians) to all share a common, programmable data layer, overcoming the current lack of infrastructure needed to facilitate legally compliant secondary trading at scale.
In the long term, distributed ledgers may also gain adoption in public capital markets, streamlining not only settlement processes but other heavily intermediated functions like dividend payments and managing shareholder voting. Ultimately, equity tokens may not be the panacea for private market liquidity issues that some advocates claim. However, they can offer real benefits to private market issuers and investors, as the status quo simply remains too inefficient and cumbersome as we move into the digital age of capital markets.
In Digitized Securities and the Promise of Automated Compliance, The Thomas Reuters Legal Executive Institute lists several challenges that slow down the adoption of blockchain for capital markets:
Limited transaction throughput on public blockchains
- Traditional public blockchains sacrifice efficiency and high transaction throughput for decentralization and interoperability. Because the ledger needs to be maintained concurrently by all mining nodes, public blockchains are less efficient from a throughput perspective than permissioned blockchains. As a result, public blockchains are not currently equipped to replace the public capital markets settlement system. As noted, today’s public blockchains are currently better suited for the smaller, private markets where trading volume is significantly lower.
Poor user interface
- Current applications in the digital asset space are not easily accessible and understandable by the average layperson. Beyond hobbyists, most investors will not purchase an equity token simply because it leverages a blockchain as the settlement layer. The application layer of most of the solutions needs to improve to the point that investors are as comfortable using new technology as they are using their browser. Given the relative simplicity of updating deficient interfaces and the payoff it promises in terms of attracting investors to a product, many companies are already expending resources to avoid this problem. There are some new platforms with significantly improved interfaces (e.g., Ohanae) and further improvements in this area are likely.
Blockchain built for asset tokenization
Building an asset tokenization platform based on distributed ledger technology will help to spur the adoption of equity tokens by streamlining the process for companies looking to launch tokenized assets. To support an enterprise-grade platform aligned with the regulatory and fiduciary responsibilities of its participants, blockchains must be designed around the principle of permissioned and trusted access. However, this is not to say that blockchains must be private; instead, they should be permissioned. They may be open to anyone willing to register and cryptographically validate their identity. Distributed ledgers must also abide by privacy regulations such as GDPR. In most cases, that means any personal data should be kept off-chain based on self-sovereign principles.
Public blockchains with more advanced scripting languages (e.g., Ethereum), as well as permissioned blockchain solutions (e.g., Quorum), will take on a more active role, serving as both the asset registry and the computer that actually executes the transactions.
Since these distributed ledgers all share a common, programmable data layer, this produces an agreed-upon record of who owns a particular security at any moment, updated in real time, regardless of the particular venue or medium through which a transaction occurred. As long as the seller sends the token from her blockchain address to the buyer’s blockchain address, that transfer will alert the equity token’s smart contract (ensuring the trade complies with any transfer restrictions) and will be logged into the blockchain, updating the ownership records instantly.
Blockchain therefore allows for a more direct relationship between the issuer and its securities holders, eliminating the need for any intermediaries, such as transfer agents or custodians. The implementation of this functionality is, however, still in development.
The capital market use case
The Thomas Reuters Executive Legal Institute illuminates the current circumstances of today’s capital markets:
“In the United States public markets, the Depository Trust Company (“DTC”) provides this “asset registry” service, keeping what is effectively the master record of who owns which securities on a daily basis. However, where [blockchain] is automated, programmable, and instantaneous – in trades with a discrete buyer and seller – peer-to-peer, today’s process is manual and heavily intermediated. Most trades today are not settled near-instantaneously […]. This is, in part, due to the fact that, brokerages must affirmatively report all of their clients’ trades to DTC, which in turn must manually update its ledger. Even further complicating the process is the fact that DTC does not track the actual beneficial owners of the securities it processes. […] The brokerages then need to manually reconcile their individual records with each other to ensure their respective ledgers match.”
While this system seems inefficient, it is still superior to the status quo in the private markets, where no such recordation infrastructure exists at all. Suffice it to say, this system is not built to handle legally compliant secondary trading on any significant scale.
Distributed ledgers may offer a way to reduce the transactional frictions that currently occur in the system. Not only can they provide a real-time audit trail of a security’s ownership, but also can they be programmed to automate key functions necessary to facilitate secondary trading, including complying with securities laws.
Specifically, equity tokens can be used for capital markets in the following sequence of events, as described by The Thomas Reuters Executive Legal Institute:
“Using equity tokens, an issuer can create a whitelist of accredited investors who qualified at the time of issuance. They can also outsource the production and ongoing maintenance of the whitelist to a third party, such as a regulated broker-dealer that issues and trades the equity token on an approved alternative trading system and who keeps a master list of all accredited investors on its platform.
The issuer could pull from this master list to increase its total liquidity pool, or it could maintain its own list and add only those investors who request to be added and pass the accreditation check. From a regulatory standpoint, the SEC permits an issuer to rely on a third-party service to verify accreditation status. The accounts associated with the whitelisted investors could then be embedded into the smart contract. If a would-be purchaser’s account is on the whitelist, the purchase will go through; if not, the transfer will be blocked. This creates a liquidity pool in which whitelisted investors can freely trade in the secondary market, with near instant settlement, without incurring the delays and costs currently involved in getting issuer pre-approval or hiring counsel. It also guarantees that the equity token cannot be transferred directly to a non-accredited investor, which is not possible today.”
Automated compliance could not only ease the burden on issuers and their security holders, it could also provide value to regulators and alternative trading systems, providing real-time audit trails and alerts for securities laws violations. Distributed ledgers can therefore add real, near-term value on the private market side, serving as the “smart” settlement system that tracks ownership in real time and automates functions like compliance across trading venues.
Ohanae is an Asset Tokenization Platform for enterprises to tokenize real-world assets. There is no server or software to buy or manage. The platform provides AML/KYC verified identity, stablecoin for payments, password management, secure file sharing, primary issuance and secondary trading.