Many crypto enthusiasts imagine a world where everyone holds securities DRS (direct registration of securities) which have been issued/delivered in the form of tokens on a blockchain and trade them on exchanges. That's not going to happen.
Make no mistake, I'm a huge fan of tokenizing securities. I'll explain how, when and...most important...why.
Last week I spoke with the CEO of a large REIT. He'd spent over a million dollars on tokenization initiatives for his securities and, close to going live, he spoke with some of his investors (funds, insurance companies, cities and other institutional investors) and was stunned to learn they absolutely didn't care. So he shelved the project and continued issuing securities just as he always had. He asked me "why would anyone do this?"
Good question. Lets deconstruct the answer...
The problem that almost all real estate firms have, as well as private companies regardless of size, is that there is no secondary market for their securities. The costs of going/being public and trading on NASDAQ or OTC Markets are crushingly high, so that's not an option. Enter a new generation of Alternative Trading Systems ("ATS"), exchanges that are poised to fundamentally disrupt and transform capital markets as we know them. The promise is that real estate interests and private companies (and personal lending, but that's a topic for a future blog) will have liquidity as markets can exist at dramatically lower cost.
These ATS' don't necessarily care what form the securities are issued, be it physical certificate, book-entry, or tokens. Their job is to provide data and match sellers with buyers. And to do so in compliance with SEC and FINRA rules and regulations, as well as BSA obligations.
Traditional clearing firms, the ones that an ATS might typically link up with, are effectively sidelined from providing services due to structural and regulatory issues...
- Structurally, public securities trade and settle via long established infrastructure (aka "plumbing") of DTC, NSCC, registered transfer agents and other entities that are all networked together. If an investor sells 100 shares of Apple at Etrade to a buyer at Raymond James then the plumbing safely moves cash and securities between the counterparties and ownership changes are reflected by the RTA. Private securities & real estate interests have no such mechanisms.
- If an investor holds those shares of Apple DRS as a paper certificate instead of in electronic form at a custodian (brokerage firm), then to trade them they need to DWAC (Deposit Without A Custodian) to a brokerage firm to effect the transaction. That's a massive headache, expensive, time consuming, and risky from both a regulatory and tort perspective. Verifying ownership of the stock certificate and getting it back into the plumbing in order to effect and settle a transaction is something most brokerage firms won't accommodate.
- Regulatory rules strictly govern how a clearing broker holds custody of investors securities. This affects net capital requirements, there are daily customer reserve calculations to be performed, cash cannot be released from customer accounts except first out of the clearing brokers own corporate operating cash (yes, really), securities have to be marked to market, and many other requirements. These are impractical to the point of impossible-at-scale for any traditional clearing firm. They simply cannot hold custody of non-public securities.
Securities issued on a blockchain in theory could solve that. If people were to avoid custodians and hold everything directly then these transactions could be confirmed via blockchain. However, ATS' are broker-dealers and as such are subject to a wide variety of securities regulations and BSA obligations. They generally cannot directly hold cash or securities (regardless of form of issuance) and as such have no way to ensure a transaction is safely settled between counterparties, thus creating liability. They also face sever penalties if they can't properly KYC/AML buyers and sellers.
On top of this, the ideal of everyone holding assets directly just isn't realistic. For starters, all SEC-reporting entities (RIA's, hedge funds, etc) are required to have all assets held by a qualified custodian (trust company, bank or clearing firm). And individual investors cannot effectively hold assets directly for risk of theft or loss, as has historically been seen with Bitcoin wallets, cash under the mattress, and bearer bonds. The world uses custodians to hold assets - be that a bank for their cash, a brokerage firm for their securities, or a crypto exchange for their Bitcoin.
Thus these next-gen ATS' are all tying into custodians like Prime Trust where investors will hold cash and securities, and who will take responsibility for KYC/AML and will safely & securely settle transactions that counterparties have effected on the ATS.
Custodians, though, don't care what form the assets are in. We hold everything in omnibus and settle transactions between counterparties on our books and records. Cash and securities don't literally move anywhere. So, then, why bother with tokenizing?
The answer is "plumbing". Just as with the public markets, in these new private markets the participating custodians need a mechanism to safely settle transactions between ourselves. If we are holding securities in paper/physical form, then to get them to a transfer agent and forwarded to a counter-custodian is going to be expensive, time intensive, and potentially risky. Blockchain solves that for us. It becomes the plumbing that custodians can use to settle transactions between our firms.
This is happening. tZero, Securitize, Abbra, Oasis, ShareNett, Symbridge, StartEngine and many others have ventured into the ATS world. They have a lot of work to do in order to create markets and build a buy-side, and there's still work for us to do as Prime Trust provides the custody and settlement infrastructure for this industry. It won't be overnight, it may take a couple of years. But one day in the near future we will wake up to a very different world for investors, private companies, and real estate firms with liquidity and true democratization of investing. Blockchain will be a big part of what drives this.
Founder & Chief Trust Officer
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These materials are my personal opinions and for informational purposes only and not for the purpose of providing legal or tax advice, nor are they a recommendation or an offer of any securities. I am not advocating, advising or recommending anyone purchase or not-purchase any specific or general investment of any type, ever. The issues discussed above include complicated areas of law and legal advice should only be obtained and relied upon from a securities attorney about your specific circumstances.