In Theory

The transformation of a cap table from analog to digital is, in our opinion, one of the most practical and easily conceptualized applications of blockchain technology within capital markets. The recording of a snapshot of ownership, at a given moment in time, to a blockchain, is extremely useful for proper securities records management. While we don’t have a confirmed source for this, we’ve heard anecdotally that Facebook, now Meta, spent a whopping $100M remediating their cap table prior to their IPO.

That is astonishing. And such a waste.

As far as equity management goes:

• who owned

• what assets

• how much of it they owned

• at what time

• for how long

• when or if they’ve transferred it

• and to whom they transferred it to

…are core & functional problems that blockchain was designed to solve. This was precisely one of the primary reasons Vertalo, Securitize, Tokensoft (who sold their transfer agent / regulated business operations to INX), and now many others, have been formed - to take a state-database snapshot of asset ownership at a given point in time. As changes to the cap table occur, they can be recorded and verified, confirmed through cryptographic key management and proper security protocols for those involved, most notably, the issuer, broker-dealer, transfer agent, or asset custodian.

Contrarily, a privately managed database is subject to changes at the whim of whoever owns or manages the database. Now, making illicit or unapproved cap table changes is a form of securities fraud, and there are plenty of existing methods for adjudication or legal redress should that happen, but one of the foundational pillars underpinning the entire blockchain movement is transparency. Another is the idea that mathematics and cryptography is a method for verifying legitimate transactions while removing the inherent trust found within capital markets applications.

In the preface to “Applied Cryptography”, Bruce Schneier gives us this thought-provoking insight:

Blockchain offers this promise by acting as a database with the unique properties of historicity, transparency (where updates are concerned, specifically the transfer data and which party enacted the transfer), and its immutability. So much has been written on this subject we won’t go into more detail, but the benefits here are obvious. To reduce fraud, confusion, and illicit behavior, as well as increase trust, transparency, and audit-ability, public permissionless blockchains with private permissioned protocols can serve as an outstanding ledger for capital markets transactions.

Balaji S takes this a step further in his excellent thought piece, The Mirrortable. He envisions a future whereby all ownership data could be recorded to the blockchain, secured by the cryptography of the chain, verified and historical due to the chain’s immutability, giving more sovereign ownership over assets to the shareholder and disintermediating unnecessary (see: rent-seeking) third parties that are simply holdovers from a legacy system. While we don’t agree with everything in his piece, particularly how he assumes compliance will be handled in this hybrid system, he comes surprisingly close to the future that most of us imagine, specifically more:

• Transparency

• Accessibility

• Flexibility

• Sovereignty

…over one’s financial assets. All things we 100% support when it comes to the future of finance and how the layperson interacts with financial institutions and products on a daily basis. The idea of a hybrid financial system, that uses blockchain, cryptography, private databases, and regulatory licenses, is incredibly appealing.

While we don’t believe market participants or regulators will ever be comfortable with a fully sovereign financial system in the way that most of the crypto market operates today (think bearer instruments like Bitcoin that are exclusively under the control of the wallet holder, that are therefore sovereign, but also irrecoverable) we do think there are great strides to be made in streamlining legacy processes and reducing friction within private market transactions of all varieties.

In Action

XY Labs’ listing on tZERO was a big moment for the blockchain-based securities industry. It was the largest digitally enhanced dematerialized securities issuance in history, at roughly 24,000 shareholders, due to the successful Reg A+ that XY Labs had conducted back in 2019. They had initially approached tZERO about listing their Common Stock after the completion of their Reg A+ in 2019, but tZERO wanted to see more operating history and better underlying financials before feeling confident in the potential success of a listing, something tZERO refers to as “Direct Trading”.

After several years of operating, with many ups and downs, tZERO and XY Labs both felt ready to move forward with listing their Common Stock for “Direct Trading.”

A brief note on Direct Trading

Those who have read our writing will know we place a high premium on definitions and specificity of language. We freely admit that when speaking, especially if it’s about something we’re fired about or knowledgeable on, we sometimes ignore this and mince words or cross definitions mistakenly, but this is what we love about the written medium. It gives us a chance to revisit, redefine, clarify, or otherwise explain a position that we may hold. Let’s explore the definition of Direct Trading (what we support for XY Labs) vs. a formal Direct Listing.

Direct Listing vs. Direct Trading

A Direct Listing is a form of public offering whereby an issuers shares can be made publicly available for purchase, selling, or trading, but they differ from a traditional IPO in that no new shares are created as part of the offering. Put another way, a Direct Listing does not seek to raise additional capital for the issuer, but simply allows for the issuer’s shares to be freely tradable on exchanges.

Additionally, sometimes in a Direct Listing scenario, the traditional IPO methods, including:

• Working directly with an investment bank to value the shares and company market cap

• Plan for the go-to-market price, including marketing

• A lockup window, preventing existing shareholders from dumping their holdings onto the market on opening day

• The 6-12 month roadshow to garner interest from large institutions, pension funds, and other purchasers who would buy large swathes of shares, and

• The presale of the shares to the investment bank, who then offers them upon listing day to those whom they helped build interest from

…can actually be ignored. Instead, shares are directly listed on a stock exchange on a predetermined date for purchase from the general public, both from retail traders and would-be buyers of large numbers of shares, like pension funds, endowments, or large corporate treasuries.

The Direct Listing process still includes massive commercial marketing efforts to beget buy interest and excitement on opening day, but has the ability to disintermediate the traditional investment banking process that typically accompanies an IPO, as well as the issuance of new shares to be purchased for fundraising purposes.

This is appealing for issuers since the investment banking costs, usually taken as a percentage of the transaction, can get very expensive. Indeed, it’s true that most companies under $1B valuation can’t go public, since the investment banks who would lead that process won’t make their fees on the IPO itself. Conversely, direct trading fees are highly predictable and uncorrelated to the size of the asset onboarding to the trading venue, making this ideal for smaller private companies. Additionally, there are much lower minimums in terms of float and asset value that can pursue liquidity, which again lends itself to smaller private companies.

Some of the more famous Direct Listings include companies such as Slack, Spotify, Palantir, and Coinbase.

A thought on Coinbase - we hold Brian Armstrong and the entire Coinbase executive team in high regard for remaining strong and performing Coinbase’s IPO as a Direct Listing rather than traditional IPO. Undoubtedly their executives had every investment bank on the planet vying for the opportunity to underwrite a traditional IPO, which would have netted the bank anywhere from $30-50M guaranteed, plus additional take based on performance the day trading goes live. But no, instead, Coinbase chose to back into a price per share by getting creative and using an ATS to achieve price discovery. They allowed their employees to list shares on an ATS, Nasdaq Private Market (NPM), and sell those shares within specific trading windows several days per week for four weeks in a row. Employees were only allowed to sell a certain portion of their holdings, and over four weeks of preliminary trading totaling roughly 1200 transactions, they were able to back into the $250 price-per-share on opening day for COIN listed on Nasdaq.

The ability for Coinbase to side step investment banks and offer a direct-to-market option goes to show just how powerful Direct Listings can be. We expect to see more and more companies choosing this alternative public offering route over the traditional IPO, especially as the core tenets of blockchain (disintermediation, transparency, and accessibility) continue to grow widely in the market.

See also: Coinbase 'IPO' Isn't an IPO. Here's Why That's Important

In effect, “Direct Trading” is the private market version of a Direct Listing.

Some in the blockchain-based securities space use the words “Direct Listing” to refer to “Direct Trading,” but that is not, definitionally speaking, accurate. This is why tZERO and others in the industry use the alternative wording of “Direct Trading” to refer to this public-like environment where a class of shares, usually Common Stock, is available on an ATS, but the company is not yet a fully public reporting company in the eyes of the SEC and FINRA.

For our purposes here, we’ll use “Direct Trading” to refer to how we worked with XY Labs & tZERO to support their trading objectives.

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XY Labs’ Vision

To start, let’s examine why XY hired Vertalo in the first place, since their motives were a driving factor in the decision making process. Surely there are many transfer agents out there who would have gladly bid for XY’s business - it was definitely an appealing cap table at north of 24K shareholders. So what were their primary goals? During the initial engagement process, we broke them down together like this:

As you can see, we planned for a phased approach that allowed us to build together in stages (for product purposes we “bucketed” them as labeled here) in order to support what XY Labs needed from us, with a plan to implement new features along the way. We’ve heard this referred to as “land & expand” - you win an account and then continue to deliver value and expand your product offering, allowing your client to realize more value and for you to increase revenue from an existing customer.

XY’s goals required that we stage and plan for the following steps to fully execute against their vision:

• Data Hygiene

  • Extraction and clean-up, especially in supporting XY’s transition away from their legacy transfer agent and to Vertalo as a digital transfer agent

• Data Management

  • Investor account management, including employees with options and shareholders across multiple share classes

• Transformation

  • Fully dematerialized (no paper) & digital support (digitally enhanced) of existing share classes and assets

• Consolidation

  • XY wanted one repository of truth for shareholder information, since they were previously handling multiple “source of truth” (as oxymoronic as that sounds, different classes had different sources of truth based on capabilities from their respective provider)

Transfer Agent Migration

This is typically the most time-consuming part of the process when moving from the analog to the digital world. Vertalo has completed this process many times with all sorts of customers, and this is an example screenshot of the process we run when performing the migration:

This migration includes the following steps:

1. Establish an appointment date. This includes informing the DTCC of the change of transfer agent after a board resolution can be proposed and ratified. We require at least 10 calendar days in lead time from the time of signature to the appointment date, to guarantee we can properly support all compliance requirements for an issuer.

2. Gather necessary client onboarding data & documentation. Clients let Vertalo know the board meeting was held, Vertalo was instated as the transfer agent, and there is a written board resolution as a confirmation thereof. This allows us to commence gathering the shareholder data.

3. Request shareholder data from previous transfer agent. This effectively kicks off the ETL (extraction, transformation, loading) process, where we start examining the state of the data, particularly the integrity of it, as well as search for discrepancies or plan for how to handle inconsistencies.

4. Import & validate existing shareholder information. The bulk of our work really occurs here, where we extract, transform, and load the data into our system. Once this is completed we have the issuer confirm the accuracy of the data, after which we can invite investors to login and see their positions.

5. Investor communication & platform invitation. This is the final step of the process whereby investors are able to use the Vertalo platform, branded for the issuer via simple whitelabel or full-bore API integration, to log in, view their holdings, or initiate a transfer.

Extraction, Transformation, & Loading Process

After the appointment and necessary documentation and disclosures, we set to work on gathering the existing information for XY’s existing shareholder base. This was an interesting and entertaining exercise, since we were working from not one, but two, sets of data. XY Labs had previously done a migration from a cap table management service provider to one of the largest transfer agents in the world, thinking that this migration would satisfy their needs for their cap table management, including stock option exercise management, multiple share classes, differing conversion rates, and purchase & paid-in-capital records that varied fiercely across their multiple rounds of fundraising. It was quite a process of compilation and diligence.

When we received their official ledger for the bulk of their common and preferred shares, we began the extensive process of parsing data into a formatted cap table we could properly ingest and upload into our system.

Legally, part of transfer agent → transfer agent migrations include the TA being let go offering all cap table data to the new transfer agent, but that doesn't mean they have to be helpful or supportive; they are being fired after all. Thankfully we didn’t hit any speed bumps with their legacy TA being unwilling to help us, instead we found that generally they were very willing to answer questions and help with the transition.

Funny anecdote: The file we received was a fixed-width format file and was very difficult to work with, after some handwringing and attempts to manipulate the file in the way we needed one of our engineers exasperatedly exclaimed,

“What the **** even is this? A data file from 1994?!”

Never a dull moment in technology.

Restricted Accounts

One of the factors of the cap table data that we needed to dissect included restriction codes listed for why investors accounts have been restricted. To give you an idea of how these codes typically work, here is a sample (although not fully exhaustive) list of Vertalo’s active account restriction codes:

If investors trigger flags for any of these reasons, our compliance team can force an account review to examine the flag and take appropriate steps. During the import process, we realized that the legacy transfer agent had over 350 restriction codes! Many of these codes were so similar from one to the next that we couldn’t understand why they would have a separate code for the same restriction. For example, one investor account may have been restricted under code “OFAC Restriction”, but another would say, “Office of Foreign Assets Control - Restricted.” Of course, these are the exact same restriction, just filed under different names, making understanding the state of your cap table, and reporting, quite difficult. We found deciphering the variables or reasons for why restriction codes varied when they seemed to be the same, a challenge to say the least.

At one point we encountered a restriction code that read, and this is a direct quote,

“Go ask Chris”

We’re sorry…but who on earth is Chris?! What are we even supposed to do with that kind of information as a restriction? It was wildly unhelpful and added confusion and uncertainty to our process, from start to finish.

It was at this point that the bulkiness and existing architecture of the legacy transfer agent world became even more clear to us and members of our product and client success teams. If a transfer agent can restrict an investor’s holding on the basis of, “Go ask a random employee why this is restricted!” what else is happening that is similarly restrictive, on an entirely arbitrary basis? Put another way, within transfer agency, what could be made more efficient? Is there any value in having 350 restriction code types, if they could be filed under the same restriction, or that just complexity for complexity’s sake?

To be perfectly clear, our intention in asking this is not to demean or diminish legacy transfer agents, their technology stacks, or even the industry as a whole, but rather to stimulate critical thinking.

Doing things a certain way because “that’s the way it’s always been done” is not always a great reason to continue doing things in that same manner, and while the crypto industry is replete with examples of people pushing the envelope and seeking (and in many cases, failing) to build new products or create new processes in the place of legacy ones, we remain more steadfast and convinced that this industry as a whole is posed for radical and sweeping disruption after having a look at what the legacy players have done with their digital infrastructure and technology.

Not for nothing, but we look forward to the radical transformation that lies ahead.

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Inconsistent File Formats

Another tricky piece of this when performing the ETL process was the fact that there was no clearly defined standard for the file formats from one file to the next. Even within a singular file format, we found inconsistencies in treatment that meant handling the files at scale (there were 24,000 shareholders after all) was very difficult.

Additionally, there was no single master file of all shareholders, but rather disparate pieces of a fractured master that had to be put together like a puzzle. Between the inconsistent formats, no single master, and a restriction code list that we’re not fully convinced wasn’t a practical joke of some sort, we ended up having to parse and assemble the data piece by piece:

Along the way we added tools and automation to our processes, enabling us to do this faster and with less learning for the next customer we encounter that looks similar. As of this writing, we’re proud to say we’ve done several additional large-scale ETL projects like this for other customers, and have continued to develop tools to support the process start to finish. And while the onus of technology development and implementation will remain on us, since we can’t imagine legacy players adopting *good* tech any time soon, that’s a function we’re happy to lead.

Stock Conversion

The final element to note here was the conversion of multiple classes of stock down to a single class of Class A Common Stock at shareholders election that could be freely traded on tZERO. Like many companies, XY Labs had issued different classes of stock with differing shareholder rights, the classes of which are not fungible with each other. Only one class was being opened for trading on tZERO, so shareholders who held other classes with conversion rights elected to convert their holdings in order to trade their positions. Vertalo supported these conversions, which increased the available volume of Class A Common shares for trading.

This conversion and collapse from multiple classes down into a single class allowed us to square the cap table, both from different classes of preferred, as well as from option holders, to support the free trading. In order to produce enough volume, it was prudent to convert any outstanding shares into Class A Common Stock where possible. Of course unvested stock options should remain as unconverted, and are not part of the cap table strictly speaking since they don’t represent issued shares, but the right to purchase the underlying (typically common stock) at a predetermined price. That said, for issued shares that could be converted, especially the previously issued preferred stock, this collapse & consolidation effort helped to drive more shares available for trading on the ATS once the asset went live.

Integration with tZERO Markets

The goal with XY’s listing was a “public-like” environment whereby the Common Stock of XY Labs could be freely traded, with orders matched on the tZERO ATS, that could be accessed by any prospective shareholder willing to create an account. This necessitated integration with their executing broker dealer, tZERO Markets, who stood between our transfer agent and their alternative trading system, tZERO ATS. The nature of our integration, and how we moved data between these three parties, including the asset tokenization itself, we intentionally leave out of this breakdown, as you’ll see below as well, in the vein of “protecting trade secrets” we keep some of the more specific details private.

If you’re interested in learning more about how trading tokenized assets on an ATS works, feel free to dig into this piece where we break down the various factors that influence the process, as well as how those factors change the models themselves.

Chain-Enabled with Collin

The 4 Unique ATS Models of Trading Secondaries

I remember back in January of 2018 when I stumbled across an article about what blockchain technology could do for private assets and capital markets. From asset tokenization, to automated KYC via smart contract, to secondary trading, this article laid out the vision of private markets that many of us had shared for a long time…

Read more

4 years ago · 8 likes · Chain-Enabled with Collin

Biz, UX, Integration, Legal

In order to properly onboard investors, we created a process that would allow us to support the regulatory requirements imposed on tZERO and Vertalo by the SEC and FINRA, pursuant to securities law in the United States. This required connectivity with tZERO Markets, which could then send orders to the tZERO ATS, who would match buy and sell orders, the result of which can then be settled, including cash moving and securities changing hands, by tZERO Markets. This process effectively took XY’s cap table from a stagnant to a dynamic one, with trading live right now available on tZERO.

In order to support this seamlessly, the process we designed had multiple inputs, including:

• Business Considerations

• Investor User Experience

• Technical & Integrative Requirements

• Legal Considerations

We keep exactly how this worked and the processes we created vague, out of respect for Vertalo, tZERO, and XY Labs, but we are immensely proud of what we were able to construct across all of these areas of input to fully support the trading of their asset.

Disclosure Requirements

Direct Trading, like what we did to support XY Labs, is sometimes referred to as “public-like” in terms of liquidity being added to a class of shares that can be purchased by any end investor. And similar to a fully public reporting company, the issuer of the stock has to complete due diligence under securities regulations to qualify to trade freely on an ATS.

tZERO has very specific disclosure requirements to qualify for trading on their platform, including diligence into the company, its officers, revenues and expenses, operating history, float, asset size, and others. The goal with these disclosures is to create some standardization from one issuer to the next, similar to GAAP accounting, allowing investors to make informed decisions, especially where risk is concerned, as they evaluate the pros or cons of buying or selling an issuer’s stock.

A benefit that accrued to XY Labs was that the regulatory requirements coming out of a successfully filed and completed Reg A+ meant that the standard disclosures required under 15c2-11, which is a securities requirement for Broker-Dealers offering quotations (order matching) for assets that trade, were easy to satisfy. 15c2-11 is usually associated with over-the-counter trades, but also encompasses orders handled on an ATS.

Learn more about 17 CFR § 240.15c2-11 - Publication or submission of quotations without specified information here. Additionally, Charles Schwab has a great breakdown of the restricted securities impacted by 15c2-11.

Reg A+ filings are more strict as a threshold and demand more information than are the standard disclosures cited under 15c2-11, which meant that XY Labs possessed plenty of audited information that tZERO simply had to confirm as legitimate, after which trading could commence. This reality can be highly beneficial for issuers that have conducted a Reg A+, since the ATS listing requirements are not as burdensome for a private company if they’ve already provided everything necessary to their shareholders as part of the Reg A+ registration and filing process.

From XY Labs COO Markus Levin,

“Working with Vertalo on the digital transformation of our cap table was a fantastic exercise, all things considered, especially since it was the second migration of its kind that XY had to complete. We were pleased with Vertalo’s willingness to work with the varying and incomplete data sets to guarantee our cap table was whole and could support the trading of our Common stock on an ATS to provide liquidity to our shareholders all while navigating a unique tri-party engagement.”

Conclusion

This process was so instructive for our team, as well as for our partners as worked through the many elements that made it possible to transform XY’s cap table from a traditional ledger into a full digitally enhanced non-certificated securities with a blockchain representation. The extraction, transformation, and loading of their cap table was quite an exercise, made more difficult because of outdated formatting, inconsistencies in data integrity, and a lack of clarity across different files that supposedly were pulled from the same master data set.

The integration with tZERO was especially illuminating for us as we worked with one of the approved and regulated models for trading private assets compliantly. tZERO was an excellent partner for Vertalo throughout the integration, with each party performing their respective duties, in an automated fashion, to support the liquidity of XY Lab’s Class A Common Stock.

Till next time.

Questions about tZERO, Direct Trading, and how to support liquidity for private assets? Feel free to reach out to Solomon Tesfaye, tZERO’s Head of Business Development & Capital Markets, or reach out directly to sales@tzero.com.

We can be found here on LinkedIn or Twitter.

If you’d like to speak with Markus Levin about XY Labs and their experience as an issuer listing on tZERO for Direct Trading, feel free to reach out to him on LinkedIn.

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.

Glossary of Restriction Definitions:

Writ of Execution - A court order served by a US Marshal that freezes a defendant’s property so that it can be transferred to the plaintiff to repay a debt or fine.

Escheated - Abandoned/unclaimed property that is turned over to the state.

Treasury - Shares held in treasury are not outstanding (owned by an investor.) They are reserve shares.

Rule 701 - Stock issued in an employee benefit plan that have a one year holding period and are subject to the other terms of Rule 144.

Rule 144 - Allows the public resale of unregistered securities under a few conditions: holding period, current public information, trading volume formula (for affiliates,) ordinary brokerage transactions, and form 144 filing with the SEC. https://www.sec.gov/reportspubs/investor-publications/investorpubsrule144htm.html

Transfer subject to reporting requirements - Specifically for control persons who need to declare their intended sale to the SEC before trading.

Holder is under blackout period for sale - Under a period of time when certain people—either executives, employees, or both—are prohibited from buying or selling shares in their company or making changes to their pension plan investments. With company stock, a blackout period usually comes before earnings announcements.

Holder has tendered shares, do not transfer - An issuer makes a tender offer to buy back their shares from shareholders, and a particular investor takes them up on the offer and pledges their shares, so their shares are restricted from being sold to another entity.

IRS lien - If someone is delinquent on paying their taxes, the IRS can impose a lien freezing their assets contingent on collection of back-taxes.

OFAC block - An investor is on the “naughty list” set by the Office of Foreign Assets Control (OFAC), a division of the US Treasury Department. This usually means the investor is related or somehow associated to sanctioned parties, especially countries or jurisdictions found in non-compliance, terrorist organizations, drug cartels, money laundering operations, or other illicit activities or illegal operations.

If we’re being honest, this probably should have been something we put together as the very first post of this newsletter, since the background, history, and details around securities, and what form they take, all really matter. That said, hopefully this will be useful for those of us in this space, since there is a lot of opinion about how digital securities behave, and what the necessary treatment of them looks like, whether you’re a Transfer Agent, custodian, bank, or broker.

In this piece, we’ll take a look at the different classifications of securities and explore what that means for their treatment and what operators in this market need to be aware of with securities offerings and management.

Before we dig in to the definitions, we offer a brief background and history of securities to set the stage for the definitions. If you’d prefer to - jump directly to the definitions here.

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 herein is done so for educational, informational, and entertainment purposes only. Always consult a licensed professional before taking professional, investment, or legal action.

A brief background on the history of securities

While there are many examples of individuals owning “secured interest” in private companies dating back thousands of years, the earliest examples we have of formally certificated ownership of private entities dates back roughly 400-500 years.

The reality of finding the first company to issue shares is really one of definition. Most agree that the first example of a joint-stock company was a french company called Société des Moulins du Bazacle sometime around the year 1350. There were 96 shares representing ownership in this company that could be bought or sold depending on the market value of the watermills owned by the company.

Skipping over several companies in the 1500’s that had shares that could be bought or sold, the Dutch East India Company is typically considered the first company to formally issue equities to the public, effectively conducting the world’s first initial public offering. Formed in 1602, they united a number of smaller trading companies in a consolidation effort, after which they formed their joint-stock company. The paper certificates for the Dutch East India Company could be bought and sold in open-air secondary markets, dealing face to face with those holding the paper certificates themselves. These face to face dealings with those selling securities would later form the basis for practically all stock exchanges around the globe.

In this early period of company formation & shareholder creation, these newly formed companies were more transient than the everlasting corporations we think of today; companies would be formed for an express purpose, then dissolved once that purpose was accomplished. In the case of trading companies whose businesses consisted of importing and exporting goods, the company would be formed prior to the voyage casting off, then immediately dissolved upon its return.

The process of granting ownership via equity in private companies flourished in markets all over the world, particularly in large cities, through the late 1800’s and early 1900’s, allowing entrepreneurs to access new capital, but also permitting bad actors to defraud unknowing or uninformed investors. This led to support for legislation and structure in the world of finance, banking, and securities.

With the Great Depression - and the severe financial losses felt by middle class America - as a formidable backdrop, the United States created the Securities Exchange Commission in 1934 under the Securities Exchange Act of 1934. This came immediately on the heels of the Securities Act of 1933, which brought with it two express objectives:

1. Requirements that investors receive financial and other significant information concerning securities being offered for public sale; and

2. Prohibitions against deceit, misrepresentations, and other fraud in the sale of securities.

The SEC was formed to both create standards for, and oversee the enforcement of, the objectives of both ‘33 and ‘34 Acts. These standards included many elements, such as corporate reporting, proxy solicitations, tender offers, insider trading, the registration of exchanges, associations, and others, through to the definitions for what is a security and enacting enforcement. Additionally the SEC created standards around how to treat these securities, including the establishment of a Good Control Location over the securities themselves.

Now, we’ve written previously about how the “Good Control Location” provision requires that brokers, custodians, or transfer agents, maintain an actual location of control over the asset - think paper certificates in physical vaults. This effectively means that securities must be overseen, leading us to coin a phrase we use often with customers and partners: “Securities are not sovereign.”

This also means that in theory it should not be possible for securities to get lost. With a blockchain or digital database implementation, this is an observable reality since critical shareholder & equities records can’t be mutated, destroyed, or otherwise changed without express permission, for example, being the broker or transfer agent of record.

That said, one rarely-considered side effect to the horrific attacks on September 11th, 2001, was the destruction of physical paper certificates held at the World Trade Center. Here you can see the National Museum of American History’s efforts in reconstructing damaged physical certificates in the wake of the attack. A digital approach to securities and shareholder data management means that attempts to destroy records should rightfully fail.

This is critical to our examination here, since the Good Control Location requirement, expressly required of brokers, custodians, or transfer agents, applies no matter what form the securities take. As we’ve said before, a strong observation of mine is that the fear from regulators with regards to the application of blockchain technology for securities centers around investor protections, which is the driving force behind the Good Control Location provision with regards to digital assets.

As we continue to migrate from an analog to a digital world, it’s important we remember and appreciate the regulations (even though we sometimes have a visceral disdain for them and how they function in reality vs. the purpose for which they were passed) and to work to create new frameworks for operating that maintain this awareness. Regulation is coming whether we’d like it to or not; it’s better to work with regulators to create approaches that make sense and provide stability than bury our heads in the sand and write off any attempt at regulation as nonsensical or unneeded.

With that background firmly in place, we can move on to our examination of the different forms securities can take.

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Securities & the forms they take

There are four basic classifications of securities in capital markets:

1. Certificated Securities

   1. Book Entry/DRS (if non-certificated)

2. Dematerialized Non-certificated Securities

3. Digitally Enhanced Non-certificated Securities

4. Digital Asset Securities

There has been a lot written about the types of securities out there and how to treat them, this is a chance to set the record straight based on our understanding of the different types that exist and how they should be conceptualized.

Certificated Securities

Many securities, especially legacy securities or products, fit this definition. Certificated securities are those that have physical, paper-based certificates. For these assets, including public market securities or NMS securities, there are paper certificates that are generated, held, or maintained either by a transfer agent, broker, or custodian.

For shareholders on the cap table that do not have printed physical certificates, the shares are still maintained on the shareholder ledger, in what is known as “book entry” form.

Originally, physical stock certificates were not able to have any sort of digital representation, first because we didn’t have the technology, and then because it hadn’t been implemented in a systematic way, but that changed through the creation of the “Direct Registration System” from the DTCC, which was launched in August of 2006. This allowed for investors to “dematerialize” their shares into a digital format, otherwise known as “book entry” shares. The Direct Registration System allows for more efficient capital markets activity through providing unique identifiers and a singular clearing and settling entity. One reason for the fragmentation in private markets is precisely because there’s no nationally available party to handle this routing, clearing, and settling function.

In fact, under the Wikipedia entry for “Book Entry” there’s a subsection entitled Private Companies that says this: “Adoption of book-entry systems among private companies has lagged adoption among public companies, public company transfer agents, and broker-dealers. This may be due to a number of misunderstandings and challenges unique to private company security issuance but, regardless, data suggest adoption of book-entry systems among private companies is growing rapidly.”

Vertalo’s mission is to connect and enable the digital asset securities ecosystem. This means that integrating the various players within private capital markets is core to our focus, from primary capital formation, to mid-life cycle securities data management, through to secondary liquidity and collateralized lending. Our mission is exactly why we’ve architected in a fully digital manner, with both digital dematerialized shares, as well as blockchain enhancements that add additional security and functionality.

Dematerialized Non-Certificated Securities

Vertalo, as a digital Transfer Agent, distinguishes itself as a non-certificated Transfer Agent. This means that we don’t, nor will we ever, send out paper certificates or portfolio statements through the mail, but instead we keep a digital copy that is dematerialized (not in paper form) that can be accessed through an online portal. Our ability and offerings via white-label and/or API make this particularly appealing for private asset issuers.

So why break out dematerialized non-certificated securities from book entry shares when they’re so similar? The reason we draw this distinction is that while many public transfer agents do and are able to deal with physical certificates, any non-certificated transfer agent would have to formally dematerialize paper certificates upon becoming the transfer agent of record, transmuting the records of the shares from paper to an internal digital ledger.

The process of dematerialization and digitization is something we’ve become quite skilled at, as many of our customers have come to us seeking to modern their equity stack and offer investors a portal for login, as well as Secondary Liquidity.

We will detail this extensively in an upcoming post, as part of a series we’re planning around the applications of blockchain technology in private markets, but when Vertalo engaged with XY Labs to support their existing shareholder base of 24,000 individuals, we had to work with ridiculously outdated data formats - formats plural, it wasn’t even standardized from one set to another - to import and properly digitize their cap table. The nuances and behavior of these data files took our team, who is extremely proficient at the ETL process, a number of weeks to process through. As companies seek to modernize their equity stacks, this familiarity and ability to work with data - management, manipulation, extraction, reporting - are all things operators should consider.

Statistically speaking, nearly all securities today exist in either book entry or dematerialized digital format.

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Digitally Enhanced Dematerialized Securities

This is where it gets interesting, since we introduced the blockchain to the mix, but in an interim fashion rather than a full fledged firesale and replacement of existing infrastructure. The digitally enhanced distinction is one whereby the dematerialized digital copy still exists, and is, in the eyes of regulators, the security itself. The “enhancement” however, is simply that of a mirror copy, a courtesy of sorts, that allows investors to view something tangible (like a token on a blockchain). For all intents and purposes, the security IS the digital copy stored on the internal database, like that which a broker or transfer agent might use. The blockchain copy is a mirror copy for convenience or added functionality, like secondary trading, for example.

When issuers or investors talk about blockchain-based securities, the predominant method for adding blockchain features to a security is through this method of “digital enhancement.” The security itself is still maintained in a digital and dematerialized state in a database. This was also a driver for why Vertalo chose to bifurcate the issuance and tokenization process, something we write about here:

How to Tokenize: The Realities of Asset Tokenization

By separating the process of issuance and tokenization, you open up many different possibilities for issuers, investors, and brokers. One of the biggest benefits one can realize here is a partial cap table tokenization. For issuers, if you have investors who are interested in your offering but hesitant to invest in products built on blockchain technology, this process of separating issuance and tokenization allows you to have the best of both worlds. There can exist digital dematerialized securities in a digital ledger database, as well as the digitally enhanced blockchain-based tokens for those more savvy users, but blockchain in this case is a capability, not a constraint.

Here is some legal language (intentionally kept obscure for privacy purposes, although this does appear on the SEC’s EDGAR filing site, and is therefore public) from a partner of ours, “Digital securities are conventional uncertificated securities where the issuer arranges for a digital "courtesy carbon copy" of the transfer agent's share registry to be viewable on the blockchain to enhance the trading experience and may also be referred to as ‘digitally-enhanced securities’.”

If there are two copies of the security, one in a ledger and one on-chain, it begs the question, why use blockchain to enhance the security at all? What enhancements does it bring to the table? Valid question, and from where we sit blockchain can still provides operators with many benefits, including:

• Transparency

• Programmability

• Audit Trail Capability

• A shared ledger between two unrelated parties

• Cryptography and/or hashing for security and pseudonymity

• Liquidity via an ATS

• Decentralized finance applications - including collateralized lending against tokenized assets

• The ability for an investor to see the copy of their security, both in their wallet as well as on-chain

…among many others. As we move towards more application of blockchain for capital markets, this interim state between digital database and blockchain has seen tremendous support from regulators since it’s both assuaged their concerns around investor protections, but also allowed operators in this space to experiment with the technology and it’s countless applications.

Digital Asset Securities

Finally, we arrive at what most believe they’re talking about when they discuss blockchain-based securities. Digital Asset Securities are those assets that are fully chain-native, where the blockchain not only holds the ledger, but also serves as the source of truth for the shares themselves. Under this definition, the security token IS the security and there is no additional copy stored elsewhere like in the “enhanced” distinction.

With the hesitation of regulators globally, there are very few tokenized issuances that fit this definition. Even if the media and asset issuers themselves refer to these shares as “digital asset securities,” most of them actually fall under the previously defined “digitally enhanced dematerialized shares” interpretation.

Fully chain-native securities bring with it some interesting promises (and challenges!) but we’re far from seeing this sort of activity yet in the real world. One of the biggest benefits for a chain-native securities approach is intraday settlement, but as we wrote in our piece on fiction vs. fact (see below), the vast majority of securities transactions still are not settling on chain, mostly due to Anti-Money Laundering provisions that require the issuer to know, and continually check for sanctions against, their shareholders.

Chain-Enabled with Collin

Asset Tokenization: Fact vs. Fiction

I recently came across an article online about how tokenization would revolutionize the securities industry by applying crypto principles and processes. The vision was outstanding - more accessibility, broader audiences, faster settlement times, expanded trading windows, all of the talking points you’d expect to see for blockchain-based assets that have…

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3 years ago · 4 likes · 2 comments · Chain-Enabled with Collin

To be clear, the on-chain settlement is a perfectly solvable challenge, just one that requires a considerable amount of technical support from third parties, along with legal opinion on just how detailed you want to get in confirming, then reaffirming, the identity and ownership of the wallet you want to send funds to. The pseudonymous nature of blockchain wallets is the big concern, since wallets can be ported through private seed phrases, whereas bank accounts cannot. Two companies that are already working on this in real-time are Figure and Oasis Pro Markets.

A brief note on smart contracts for digital asset securities

This is one of the areas where we see many people theorizing, but not too many people applying the theory or seeking to understand the nuances of how smart contracts might be implemented in the space to deliver on the promise of disintermediation and efficiency.

Alexandra Damsker, coined a phrase several years ago on Clubhouse as many people sought to understand the impact that blockchain might have on capital markets, financial institutions, and the every day user. As an attorney and experienced operator in this space, she continually hammered this point home:

We jokingly tell people it’s a heavy misnomer since both words, standalone or together, do not accurately deliver the meaning of what smart contracts are or can do. Smart contracts derive their value by being triggers that can be pre-determined and agreed upon, after which they can be written to the blockchain. The chain’s immutability then gives both parties the confidence to transact, as well as the knowledge that a trusted third party won’t be necessary, since the rules have been set, then written to a public database (the chain) that can’t be hacked, altered, or otherwise mutated.

While we love the idea of using smart contracts to cut out middlemen and unnecessary third parties - and indeed we see many applications for this in private markets currently - in securities there is a bevy of regulatory considerations that almost always require some form of licensed third party (brokers, custodians, transfer agents, RIA’s, chartered banks, etc.) to facilitate or complete a transaction. We’re not opposed to efficiency, quite the opposite, just accepting the reality of the current legislative world we live in.

The existing regulations and requirements mean that the smart contract architecture needs to be kept flexible to account for a changing regulatory and technical environment. But immediately this starts to hamper the benefit of smart contracts - their rigidity due to blockchains being immutable. How institutions adopt and apply smart contract frameworks is still something that is not clear, since there will almost always be some form of third party involved in the transaction. Rather than all third parties being removed, we foresee a reduction, but not elimination, in intermediaries through the application of blockchain in capital markets. To what extent this reduction occurs is yet to be determined.

The area where we see the most value and application in smart contracts and on-chain functionality with regards to securities will be through the collateralized lending against real world assets. This requires some deep critical thinking, since custody, lending terms, due diligence, loan origination, cash disbursal, term violation penalties, etc. all necessitate third parties and/or heavily technical & legal support. But broadly speaking, a tokenized security could directly interact with a lending contract, possibly from MakerDAO or Aave, in order to produce loans against pledged assets.

Conclusion

We produced this piece because we want to be sure our industry has a shared lexicon and understanding of what we’re talking about when we use the terms we’ve defined above, including digital securities, digital asset securities, or digitally enhanced dematerialized securities. The first time we heard the term “digitally enhanced dematerialized securities” several years ago it instantly planted a red flag in our mind - we didn’t know what a digitally enhanced security was, but was determined to learn.

One of our good friends and coworkers is Vertalo’s VP of Integrations, Kyle Brown, and since he first arrived he has always been laser focused on something known as domain-driven design, a concept first popularized by Eric Evans in his book by the same name.

Part of domain-driven design includes the idea of a ubiquitous and shared language, defined as follows: “Ubiquitous Language is modeled within a Limited context, where the terms and concepts of the business domain are identified, and there should be no ambiguity.” This means that within a given industry or domain, whether across teams or from a business to a customer, a term has a specific meaning no matter where you use it.

As an industry, let’s use specific and clear language, and remove ambiguity or confusion, when referring to these assets and the forms they take. This specificity should only move us forward in our communication, especially with those new to this space.

As the legendary Peter Drucker put it, “Communication is what is understood.”

Till next time.

If you found this informative or useful feel free to share with your audiences and tag us - especially on LinkedIn and Twitter.

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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 herein is done so for educational, informational, and entertainment purposes only. Always consult a licensed professional before taking professional, investment, or legal action.

Ever since the introduction of blockchain technology for enterprise use-cases, we’ve seen so much interest in the tokenization of real world assets (RWA’s). Particularly, the interest has centered around what blockchain could do for the trading and transference of private assets. Setting aside the trading discussion, for this post we’ll dig into the actual process for how to tokenize a real-world asset to highlight the nuances and subtleties, and requirements issuers must be aware of when performing an asset tokenization.

Note that much of the criticism against existing cryptocurrencies stems from the fact that they are not backed by anything, so their value is entirely driven by market sentiment, hype, and investor activity.

If you have an asset that can back your tokens though, this effectively wipes out that criticism, since we have many different models and methods for asset valuation, based on the class, the nature of the investment, the asset itself, and the operators.

To begin, we first examine the asset itself. Nearly all of the tokenized real world assets that we’re seeing on chain meet the definition of a security, which means they’ll need to be treated according to securities regulations. Most of the assets we’ve tokenized, or intend to tokenize, fit in one of the following categories:

• Equity

• Debt

• Derivatives

• Collectibles*

• Real Estate

• IP Rights

• Litigation Finance

*there’s overlap here; the tokenized collectibles, for example, was preferred equity in an LLC that owned the collectible outright, but it’s important to highlight the various asset classes that we’re seeing garner interest in the market

Once the asset type is determined, this will help you understand how you need to treat the asset, which brings us to the next question - timing.

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Is this an asset you’re raising against currently, or is this an asset that was previously capitalized and simply needs its underlying beneficial ownership reflected on chain?

Both will work fine, and indeed the top tokenization platforms in the world are architected to support the tokenization of an asset at any stage in its life cycle. Let’s examine both cases one at a time to go deeper into the nuances of each.

Security Token Offering

In this case, you intend to raise capital as part of the tokenization. This is a new or recapitalized asset that’s being offered as a primary offering and you’ll need to file an exemption to raise the capital. Most private fundraises are conducted via the Reg D 506(c) private placement. This means that investors must verify that they are in-fact accredited and able to invest in private securities.

Side note - we hold a very strong opinion against telling individuals or institutions how, when, or if they can spend their own money. Sports betting books, casinos, or poker tables have no requirement to check that you can in fact spend the money you want to put down. If banks want to exclude extending credit for risky activities like gambling, that’s fine, and we understand a ban on credit for those sorts of purchases. But your own cash? It’s yours! The minute you want to invest in a private placement, you have to verify your income and/or net worth via asset ownership less outstanding liabilities. We believe the moral thing to do would be to deregulate investor accreditation and open up private markets to all peoples, but we digress.

In order to qualify for securities offerings in the United States, you’ll have to complete the following:

• KYC/KYB & AML

• Accreditation

• Subscription Document Signing

• Funding

If you’re familiar with these processes, feel free to skip to the descriptions of issuance and tokenization down below.

KYC/KYB & AML

Know-Your-Customer or Know-Your-Business (the institutional version of KYC) & Anti-Money Laundering. These checks include making sure the person or investing entity is who they say they are. The Anti-Money Laundering check is to verify the investor or entity is not a terrorist or sanctioned individual prevented from investing. Often times AML checks and companies that provide this as a service have additional verifications, like whether the individual has criminal history. These checks are not something that would automatically preclude you from taking the investors cash, but may factor into the decision. Many of our customers, for example, choose to preclude those with violent criminal pasts or fraud convictions.

Another check that can be included is exposure or access to funds or treasuries, often referred to as a PEP or politically-exposed persons. Federal, state, or local government officials will usually trigger this, but it can also be applied to private individuals and companies as well. For example, Jeff Bezos would trigger a hit for PEP since he most likely has access, either directly or by directing someone who does, to treasuries for Amazon and Blue Origin. It’s not that you wouldn’t want to take investment from him, just a factor for you to be aware of when conducting investor onboarding.

Accreditation

We already commented on our disagreement with this as a practice, but the law currently states that individuals must be accredited to invest in private placements. The threshold for accreditation is defined either through income or net worth. For income, the definition is:

• An individual who has made $200,000 / year for the last two years, with a reasonable expectation for that level of earning to continue

• A married couple filing jointly that has made $300,000 / year for the last two years, with a reasonable expectation for that level of earning to continue

For net worth, the definition is as follows:

• Net worth over $1 million, excluding primary residence (individually or with spouse or partner)

There are also professional distinctions, like securities licenses, that can grant one accreditation status, but since nearly all accreditation occurs via income or net worth, we’ll leave these be. See the SEC’s definitions for more insight.

Subscription Document Signing

All private offerings will include terms in some sort of subscription document or private placement memorandum (PPM). Investors must sign and agree to the terms outlined in this document, which typically includes any preference or conversion in the case of liquidity event (like acquisition or going public), as well as guarantees, anti-dilution terms like ratchets, or other clauses that investors will want to know and understand.

Funding

The accepting of cash for securities is more tightly regulated than accepting money for widgets on Shopify, and this is due to Anti-Money Laundering provisions that require that banks moving capital run their own checks on the individual before allowing money to change hands. This is also a driver for using custodians for escrow purposes - the cash can easily be returned to investors should something be amiss.

It’s important to highlight here that for issuers seeking to create a customized experience, the order in which these steps are completed doesn’t actually matter from a legal standpoint. There’s nothing in the law that says you must KYC before signing a Subscription Document, for example. This means that we’ve seen every order of onboarding flow you might imagine, and the nature of the order of the steps is usually dictated by the asset itself, the investment minimum, and the intended audience. Large minimums and/or more traditional assets will sometimes require payment upfront, after which the KYC and other requisite steps can occur.

Issuance

Once the onboarding steps have been completed, the issuer is then able to issue the security. This is critical, since the establishment of shareholders rights only occurs upon issuance, not before. Not when the subscription document is signed, not when KYC is cleared, not even when cash hits the issuers bank or escrow account. This makes for a favorable scenario for the issuer, since they get to decide who becomes an investor in their asset.

This was the case for Exodus, who raised capital via a Reg A+ offering in May of ‘21. According to their filings with the SEC, as well as from those who were close to the project, Exodus was actually quite oversubscribed to the Tier II Reg A+ limit of $75M, which meant they got to decide who made it on their cap table, giving them some discernment and influence over who became a registered shareholder in their company.

This also reminds us of how, in the venture world, VC’s sign a subscription document but simply never fund their holding, which is unfortunately more common than most might believe. Those subscription documents are not enforceable in a court of law (at least not that we’ve ever seen) and no issuer would seek to enforce the terms of the sub doc anyways, but simply choose to walk away altogether. When dealing with venture: a deal isn’t done till the cold hard cash is sitting in your account, but this cuts both ways. Issuers can choose to exclude anyone from investing for any reason. If capital was collected from someone who was ultimately rejected from being issued shares, it would simply be returned to the investor. While this is not a sentiment that Vertalo, a former partner of ours put it this way, “If an investor is offering me an interest-free loan, I’m taking it! I’ll return the cash later if I have to.”

Finally, the asset must be issued, after which it can be enhanced on-chain through the tokenization. This process is simple, whereby the issuer verifies, either through a Transfer Agent or of their own accord (private offerings do not require TA’s, after all), that the asset has been issued, the date it was issued on, the value, and any other elements they feel necessary to relay.

Issuance vs. Tokenization

Now the distinction between issuance & tokenization is essential. Vertalo made an intentional decision to bifurcate the issuance and tokenization process, based on comments from the SEC and other regulators early on in this space.

Issuance does not not need to mean tokenization. There are several different classifications of digital securities (already preparing a post on this, subscribe so you won’t miss out!) and tokenization does not need to mean issuance. Vertalo has been carefully architected to support both use cases. There are several steps in this process:

1. Issue the security first in a digital dematerialized fashion

2. Deploy smart contracts that are compliant with securities law that govern the security

3. Mint and distribute tokens to shareholders,“enhancing” the reflection of the security to include the token

Because the issuance and tokenization are separate and distinct steps, this opens up interesting options, like a partially tokenized cap table for example, that issuers can make use of. Many investors don’t understand blockchain, public key infrastructure (PKI) or private key management, and even the mentioning of the word “blockchain” is enough to scare them away. They’ve read the horror stories about lost passwords or destroyed private keys and don’t even want to go there.

Even people close to us, who have been subject to our blockchain evangelism for years, were skeptical of buying Bitcoin or other crypto assets until they were comfortable with a custodian who would take the storage risk on for themselves. We know that bearer instruments and securities function very differently, but investors usually aren’t aware of the control provisions required of issuers, making it easy to conflate blockchain with “Bitcoin”, “lost assets”, “risk”, or even, “proceed with caution”.

By separating the issuance and tokenization function, if investors are skittish or antagonistic towards tokenization or blockchain for any reason, the issuer simply has the ability not to tokenize their specific holding. In theory, this could extend beyond the simple delineation of tokenized vs. non-tokenized and into cross-chain functionality across token holders on a singular cap table (e.g. half the cap table tokenized on Ethereum trading on ATS #1, the other half tokenized on Avalanche trading on ATS #2) but we have yet to encounter a solid business case for this sort of behavior. The marketing & sex appeal would be compelling though.

Deploying Smart Contracts

When tokenizing an asset, once it has been issued, you have to deploy smart contracts on chain to govern the token itself. Vertalo uses the Vertalo Securities Protocol, but there are many that will suffice, including ERC 777, ERC 1400, ERC 1404, or the DS Protocol. The thing these protocols all share is that they are restricted token standards, meaning they can solve for the clawback, escheatment, recovery, or reassignment required of all securities.

The smart contract deployment is a singular action, since once created, the smart contract can be used to mint any number of tokens against any number of shareholders.

Minting & Token Distribution

Once the contract has been deployed, the tokens need to be minted and distributed to investors. If you’re using self-sovereign wallets like MetaMask, you’ll need to have investors register their wallet before transferring tokens. Just like a DeFi participant receiving tokens in an Airdrop, your investors will have to sign a transaction in real-time to verify that they own the wallet where tokens are to be distributed. While this infrastructure is relatively straightforward, it’s a critical step in the process to guarantee tokens are going to the intended recipient, since unlike bank accounts, blockchain wallets are pseudonymous.

This also presents as a unique challenge when trying to use stablecoins in private market transactions like dividend distributions. The pseudonymous nature of blockchain wallets mean enhanced monitoring and verifications, like KYT (Know-Your-Transaction) or KYW (Know-Your-Wallet), become necessary.

If investors are unsure or uncomfortable with blockchain technology, token distribution may present as a challenge, both from a business standpoint (investors simply won’t purchase your asset) but additionally from a user experience standpoint (they may still want to purchase but not know how). This is one area where Vertalo has gone above and beyond through the creation of Keyless Custodial Wallets. We previously wrote about the Transfer Controller function within the securities-compliance in our piece, “The Case Against Bearer Instruments (as Securities)” where we touch on the Transfer Controller function and its ability to maintain compliance with securities laws, but Keyless Wallets are a unique and powerful byproduct of this development.

By creating smart contracts governed by a Transfer Controller function, one can also produce blockchain wallets, on-chain, publicly viewable, that are subject to the Transfer Control method, that do not have private keys. They are literally keyless. They are subject to the Transfer Controller in a hierarchical primary-secondary relationship, and are limitless in number, meaning an operator could create as many wallets as they like to support an issuance with a large number of non-savvy blockchain users. The same way that Coinbase made buying Bitcoin easy with an email and a password (which has allowed them to amass a staggering 100M users globally), Vertalo has made accessing blockchain based securities possible through a simple brokerage environment based on the issuer and/or broker’s relationship to the investor.

No private keys, no wallet infrastructure, no investors being turned away because of blockchain. Investors get access to the benefits of blockchain-based securities without needing to understand the underlying technology.

Imagine if AOL had told its customers, “We have this amazing new technology called the internet, it’s gonna completely change your life! Real quick - watch this 2 minute video on how the command line works to access it!” Draws a smile every we mention it, but that’s what most of the blockchain industry expects of newcomers, and it usually includes explainer videos and walk-through tutorials. The message is always the same - learn about private keys, download MetaMask, and take on risk yourself.

We just don’t see that approach as one that can drive mass adoption. We have to architect for user experience.

Previously Issued Asset

In this case, we assume the asset was already capitalized, all the requisite investor qualifications were completed, and the issuance of the asset was recorded. The timing of when this asset was issued doesn’t matter much, the only time boundary for consideration would be the seasoning of the asset. We’ll assume this asset has fully seasoned.

When the asset has already seasoned, the transformation from analog to digital format, reflected via security token on-chain, is really just a way to change how the asset is reflected. You’re not making any material change to security itself, just the method whereby you record its ownership. These securities are often referred as “digitally enhanced securities” since they have an on-chain reflection of the security itself. We’ll write more on the differences between digital asset securities and digitally enhanced dematerialized securities in another post.

Most shareholder ledgers are maintained digitally today, whether that be with your online broker, a cap table service like Carta, a simple Excel spreadsheet, or a digital Transfer Agent like Vertalo. The tokenization digitizes the ownership to include an on-chain representation of the security.

Staging

To tokenize a previously issued asset, issuers typically go through a staging process whereby their existing cap table and data are brought into an environment that can support blockchain infrastructure. There are only a handful of digitally enabled Transfer Agents worldwide that can support this process, Vertalo being one of them.

The staging process may include a migration and digital transformation as the issuer moves off the traditional Transfer Agent and onto a digitally-enabled one. This typically includes a board resolution where the issuer declares they have hired the new Transfer Agent and fired the previous one. These declarations are filed with the DTCC, and usually bring 30 day termination terms with the existing Transfer Agent. Unfortunately this can make getting the data out of the traditional Transfer Agent difficult, since the entity being fired isn’t always thrilled to support a departing client, but that just means the new Transfer Agent must be prepared to stage unique formats, solve for unknowns with regards to the existing cap table, and handle the ETL (extraction, transforming, loading) process with grace.

Once the data has been staged and imported properly, the tokenization can occur in the two step process highlighted above (Deployment > Minting) to all or part of the cap table as the issuer desires.

If this seems overly simplistic…

…that’s because the process is actually straightforward and relatively uncomplicated. One of the important things we often tell those seeking to tokenize assets is the fact that the tokenization itself is a singular watershed moment, and in some ways it’s almost anti-climactic. The thing you’re tokenizing is really the cap table of ownership.

Having performed hundreds of these tokenizations personally, it’s both satisfying seeing the contract address and minted tokens, but also a bit of a letdown once it’s done, that includes a “Well now what??”, realization. It’s the before & after that truly make the difference.

Ok, so what comes after? Well a non-exhaustive list might look like this:

• Ledger management, including

  • Transfers between shareholders

  • Maintaining the association of identity & pseudonymous token ownership

  • Potential recoverability & transfer of securities if access is lost

• Reporting & compliance (rare for private assets, but not unheard of)

• Investor & equity management, especially where multiple share classes are concerned. You could have options, warrants, preferred, common, etc. All could theoretically be tokenized, but must be treated as securities

The tokenization is truly the easy part. It’s what you do with the asset once tokenized, and how you handle the myriad of use-cases where securities are concerned, that issuers, brokers, banks, and financial institutions need to take care of when approaching asset tokenization. From what we can tell, as far as the SEC is concerned, “Oops, we didn’t know that!” is not a valid excuse for securities violations.

Chain of Choice

The last thing we’ll highlight before signing off is that many come to us with the latest and greatest blockchain asking if we can support tokenization on that chain. Broadly, the answer is yes, if the programming language of that chain is Turing complete, then transfer controls and securities law compliance can be encoded within the smart contracts and that chain could support securities without issue.

But that’s really not the right question to ask - the question here is - what business benefit do you get by tokenizing the asset on this new chain?

In our post, “The 4 Unique ATS Models of Trading Secondaries” we detail one of the critical considerations for how trading blockchain-based securities on an ATS behave with the following:

If the brokers take custody of the asset, and it’s a security token on-chain, they have to have blockchain infrastructure to support the proper custody and ledger management of the asset itself. This has been a huge hindrance to the growth and adoption of the digital asset securities industry, since many large brokerages, like all large companies, struggle to adopt new technology and build with/around it. It is growing though, as companies like Fidelity, NYDIG, Nasdaq, BlackRock, and others, are building digital asset strategies and engaging with the opportunity in this space.

If you intend for your asset to trade on an ATS, and that ATS is custodial under the 15c3-3 customer protection rule, but you opt for the newest and sexiest blockchain to tokenize the asset on without confirming the ATS supports that chain, you’re rolling the dice that the ATS will be able and/or willing to support custody of the securities on that blockchain. As best we can tell, the only blockchains supported by ATS’s domestically in the US are Ethereum, Tezos, Avalanche, and Algorand, although issuers have tokenized securities on other chains like Stellar, Polygon, or Solana.

With regards to the chain - always remember that the assets we’re dealing with are blockchain-based securities, so the talking points you hear in the crypto world about network costs, throughput, transactions per second, decentralization, etc. are all not nearly as applicable.

Network costs - definitely. But the rest? No one is trading blockchain-based securities that could be considered in any way as “high frequency” (nor will they for a long time, lots of building to do before that’s even possible, much less desirable) so the throughput and TPS don’t really matter since settlement happens at the executing broker-dealer.

The decentralization of the chain is also not a necessary consideration, since these are controlled, not sovereign, instruments subject to transfer restrictions, lockup periods, jurisdictional geofencing, and many other controls. If we were dealing with bearer assets designed to trade in a sovereign manner 24/7 globally, we could talk about these and many others points, but we’re not, so that conversation is rendered moot.

Side note - most throw the word “decentralized” around without understanding the nature of middleware-type API layers like Infura or Ankr, who render any element of decentralization obsolete and instead create a distributed ledger environment not dissimilar from AWS. Nothing wrong with that, most of the software world runs on AWS, but we’re not calling it “decentralized” because it’s not, it’s distributed.

Conclusion

Asset tokenization is really pretty straightforward, and the steps in the process only hinge on where you are in the lifecycle of the asset you’re issuing. In its most simple format, one effectively issues tokens against a share ledger which was subject to a securities filing or exemption.

It’s the preparation and staging beforehand, and the data management afterwards, that are the real concern. The nature of blockchain-based securities means much consideration must be taken to maintain compliance, but once those boxes have been checked, issuers can operate with confidence.

Real world asset tokenization brings with it the potential to unlock trillions of dollars worth of assets for greater liquidity and broader capital markets activity.

It just has to be done right.

Disclaimer: None of this information is nor should it be considered as professional, legal, investment, or any other sort of advice or recommendation. The information presented herein is done so for informational, entertainment, & educational purposes only. Please consult an attorney or licensed investment professional before taking any investment, legal, business or professional action.

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We remember back in January of 2018 when we stumbled across an article about what blockchain technology could do for private assets and capital markets. From asset tokenization, to automated KYC via smart contract, to secondary trading, this article laid out the vision of private markets that many of us had shared for a long time.

Note: We’ve tried to find that article, we believe it was Forbes, but it could have been another large financial publication, but we cannot seem to locate it. Another otherwise great piece of content lost to the vast internet. 🤷‍♂️

Assets that could trade between users, middlemen being cut out due to optimization of technology, processes being streamlined, the list was impressive, and probably threatening to many who operate in this space. We’re just now seeing those promises fulfilled, and it’s the reality of how this industry works that we want to highlight here.

The boom of blockchain-enabled securities has really focused on a singular vision: Liquidity.

It’s the challenge for the entire private asset market. The private markets are anywhere from 3-5X larger than the public markets, but are 400-500X less liquid. The private capital markets raise double the amount of capital, and yet are hundreds of times less liquid.

(Source: Harmonization of Securities Offering; Setter Volume Report FY 2018, World Federation of Exchanges database Note: Figures as of 2019).

Private markets are plagued by:

• Systemic friction

• Information asymmetry

• Siloed information (investors don’t know where to look to find interesting deals, if you’re not an insider, you simply don’t hear about it)

• Paper processes that are outdated, unnecessary, and irrelevant (looking at you Medallion Signature Guarantee, or the drawn-out ROFR process)

• Lack of liquidity

• Illiquidity discounts (these instruments stay locked up, so the only buyers that want to buy do so at a large discount, leaving the seller with no option but to take a substantial discount to NAV to unwind their position)

Note: the typical method for secondary liquidity is through secondary market transfers and trading, whereas we believe the future method will be collateralized lending against privately held assets. That brings its own challenges, for this piece we’ll focus exclusively on secondary trading as the fulfillment of the liquidity promise.

Currently, if you want to transfer or trade a privately held asset maintained entirely by the issuer, you’ll be stuck with a papered process that can take weeks, or even months, to complete. Can you imagine getting a notification from Fidelity, Robinhood, or Schwab multiple weeks after the fact that the sell order you posted had been settled?

The Illiquidity Discount

The penalty for private assets that are illiquid. We’ve spoken with real estate operators whose investors suffer from the illiquidity discount if they ever come to unwind their position. In one case, an investor who had bought into an otherwise stable and solid commercial real estate asset ended up with a 38% discount to NAV in order to liquidate his position early. Insane.

Also, companies are staying private for longer

The most straightforward and understood method for liquidity is to go public. But this brings specific challenges too. We know for a fact that Intel’s legal and investor relations teams spent between $3-5 Million dollars per year on filing requirements and public company reporting compliance alone. And that’s perfectly in line with what the research reflects.

Simply put - it’s expensive to be a public company. There are filing requirements, disclosures, investor protection provisions, added personnel to support this compliance, you name it. Due to this, increasingly, we are seeing companies stay private for longer. Commissioner Caroline Crenshaw of the SEC noted that “The number of private companies is growing and they are staying private for longer….” in April 2022 in her remarks at the symposium on private firms.

History side note: With public companies, the Securities Exchange Act of 1934 outlined the requirements and required registration of stock exchanges on a national level. Before this, many cities in America had their own stock exchanges. Even obscure places like Salt Lake City had their own stock exchange known as the Intermountain Stock Exchange. San Francisco similarly had their own Stock & Bond Exchange. Kinda neat.

If we can solve the liquidity problem, it stands to reason that we could eradicate, or at the very least, dramatically reduce, the illiquidity discount that often plagues private markets.

The question here is, how does one attain liquidity for private held assets? They are, after all, securities, and thus must be treated as such. This means that simple blockchain enablement via the ERC20 or similar standard will not work. The upgraded and enhanced treatment of these instruments is required, since they are not widgets you are buying on Shopify, but securities, subject to all securities regulations that have been established. This includes investor protections, anti-money laundering checks, know-your-customer rules, and many others.

We can’t tell you how many conversations we’ve had with operators who are passionate and believe blockchain can solve the liquidity problem for a private asset, like real estate, only to learn that since these are securities, the treatment is completely different from cryptoassets like Bitcoin or Ethereum. Many ask about enabling decentralized trading of these assets, like on a Uniswap or SushiSwap type of exchange, but that isn’t legal in the United States. Indeed, Kim Kardashian’s $1 Million Fine Could Impact Uniswap, SushiSwap And Other Decentralized Exchanges.

A famous example of securities trading outside of a regulated exchange was in 1999 when the SEC filed suit against 3 Individuals for attempting to sell securities on eBay.

eBay is not a registered stock exchange or brokerage firm. By law, you cannot sell securities on their platform just like you can’t sell them on Binance, Coinbase, Uniswap or any other crypto exchange. The matching of buyers and sellers for securities transactions is a highly regulated activity. So the question stands - how can we attain liquidity for private assets without acquisition or IPO?

Enter the alternative trading system (ATS).

We won’t get too detailed into the history of alternative trading systems, although a good friend wrote an outstanding piece on Alternative Trading Systems, feel free to dig into his treatment of them there.

At a high level, ATS operators are registered members of FINRA, they are broker-dealers, and are subject to reporting compliance and standards similar to national stock exchanges, although admittedly the reporting standards are less stringent than stock exchanges like the Nasdaq or NYSE.

At their core, ATS’s have the regulatory ability to match trades of buy and sell orders between investors in an asset. This trading activity is one of the primary ways the digital asset ecosystem is seeking to solve the liquidity challenge. Like a “mini IPO” of sorts, where the issuer can list on an ATS but still remain a private company.

Since the introduction of blockchain-based securities trading on ATS’s, FINRA has released two different models for how to trade and settle tokenized private assets compliantly. These are the 3 Step Process and the 4 Step Process.

We believe the real intent in laying out the 3 vs. the 4 Step processes comes from a desire to separate interests and responsibilities for the various actions that occur within the trading and settlement processes. Indeed Gary Gensler himself has commented on the problematic fact that crypto exchanges are unilaterally performing the following functions:

• Order matching & trading

• Clearing & Settlement

• Collateralized lending

• Account management (largely a brokerage function)

• Cash management & money transfer agency

In the world of securities, these functions are almost all distinct and performed by different entities, which helps to separate and divide the interests of each party involved. Most investors are unaware of this fact, since technology, integration, and a lot of existing infrastructure makes the purchase, sale, lending, margin, trading, clearing, and settlement, of securities seamless and easy. ATS’s operate within the existing FINRA frameworks to divide the interests of these activities and legally trade, settle, and clear securities.

Here is how both processes work.

FINRA 4 Step Process

Step 1. The buyer and seller send their respective orders to the ATS

Step 2. The ATS matches the orders

Step 3. The ATS notifies the buyer and sellers of the matched trade

Step 4. The buyer and seller settle the transaction bilaterally, either directly with each other or by instructing their respective custodians to settle the transaction on their behalf.

In the 4 Step Process, buyer and seller are required to interpose themselves, not only to initiate a trade as you’d expect, but also to confirm that cash should move. They either interact with one another directly for the purposes of moving the cash from buyer to seller, or instruct their custodian(s) to enact the movement of money, after which the securities can move from seller to buyer.

This creates enormous friction and an unpleasant user experience, since it introduces counter-party risk. ATS’s that operate this model typically create rules around the communication of cash settlement, in order to facilitate trades more seamlessly. If buyers and sellers in this process are institutions, brokers, banks, or other large players, this isn’t as much of a problem since there will be an employee (or team) who’s job it is to handle these instructions. It’s the retail case where this model displays its ineptitude. Imagine instructing retail investors to a. send cash to the seller, and b. send the security to the buyer, OR to post a trade, then confirm with their custodian or on their own that it was legitimate and yes, please allow the movement of cash & securities. Not an ideal user experience.

FINRA 3 Step Process

Step 1. The buyer and seller send their respective orders to the ATS

Step 2. The ATS matches the orders

Step 3. The ATS notifies the buyer and seller and their respective custodians of the matched trade and the custodians carry out the conditional instructions

The difference here is that the ATS, not the investor themselves, is able to instruct the custodian to move cash and securities respectively. It’s simpler and produces a far better user experience that is closer to what retail investors have come to expect from public markets. It also reduces the counter-party risk introduced in the 4 Step Process, since instructions are sent to to the custodial partner, who can follow them explicitly thereby reducing the possibility that buyer or seller back out of the trade after it’s been initialized. We expect the lion’s share of the growth in the digital asset securities industry to be through ATS’s using the 3 Step Process and automating the process on behalf of retail investors.

Remember the cardinal rule of user experience - “Don’t make me think.”

Before we dig into the models themselves, there are several critical elements that must be considered when examining how securities are traded and settled, in both the 3 and 4 Step Processes. Those considerations are:

• Good Control Location

• Cash Settlement

• Update Balance Instructions

• Asset Custody

Good Control Location

We’ve written on the Good Control Location (GCL) in a previous post, but this strikes at the heart of the SEC’s goals to protect investors. It includes provisions that protect investors from their securities being lost, destroyed, or otherwise changed without authority. It also includes provision for the ability to unwind an illicit trade, or enact a transfer outside the permission of the investor (like an orderly estate transfer after death, for example). This is what makes digital asset securities so radically different from ERC20 digital bearer instruments on-chain.

The question here is, who maintains the Good Control Location over the securities? It can be:

• a custodial broker

• the transfer agent

• the issuer themselves

• or a registered custodian, wholly separate from the broker

Additionally, if the broker applies a custody model, there may be a “split ledger” situation whereby some of the ledger, and its associated Good Control Location is held by the Transfer Agent, and the GCL over deposited shares at the ATS are maintained by the custodial broker.

This custodial deposit function highlights the difference between beneficial and street name ownership, and it brings its own challenges of shareholder management and communication, but also additional benefits. The challenge is that there is no centralized ledger of full beneficial ownership but rather a fragmented one, because of how the deposit process and street name ownership works. If an issuer wanted to list your asset on multiple ATS’s for added liquidity and market exposure, the maintaining of your list of beneficial shareholders would become very tedious very quickly.

This is one of the biggest problems that public markets deal with, which we will give adequate treatment to in another post.

Cash Settlement

The second critical element is who handles cash settlement? If the broker is self-clearing, they can handle cash themselves. This eliminates the need for an outside custodial party and can simplify integration efforts between distinct entities, like the Transfer Agent, clearing broker, and ATS. For blockchain-based securities, the SEC does not allow a Broker-Dealer to perform cash settlements, thereby introducing unnecessary inefficiencies into this process.

If the broker is not self-clearing, this responsibility would fall to a custodian that is registered as a Licensed Money Transmitter or Money Service Business (MSB). They would be responsible for the movement of cash from buyer to seller, and relaying that information (purchase amount, date, confirmation of the movement itself) to the broker. This information must be recorded for securities purposes, as well as reporting & compliance. FINRA requires ATS’s to record and report on failed trades, for example.

Update Balance Instructions

The next critical element for consideration and is the core difference between the 3 Step and 4 Step Processes. Where do the instructions come from, which party, and what sort of sign-off or regulatory licenses are needed to certify legitimacy?

The reason this makes the cut as a critical element is that “update balances” is the same as certifying ownership changes - changing the cap table and recording new shareholder ownership. Once a share is owned by an investor, they have special protections and rights, as outlined by the capital stack and defined through the nature of the instrument and/or PPM or offering memorandum (is it profit-sharing, does it carry voting rights, etc.) Beyond these standard measures, shareholders usually have more firm and distinct grounds for legal recourse should they deem that necessary.

Asset Custody

Is the broker-dealer a custodial broker under the customer protection rule, 15c3-3?

Finally, we come to matter of custody. If the brokers take custody of the asset, and it’s a security token on-chain, they have to have blockchain infrastructure to support the proper custody and ledger management of the asset itself. This has been a huge hindrance to the growth and adoption of the digital asset securities industry, since many large brokerages, like all large companies, struggle to adopt new technology and build with/around it. It is growing though, as companies like Fidelity, NYDIG, Nasdaq, BlackRock, and others, are building digital asset strategies and engaging with the opportunity in this space.

Now that we’ve clearly identified the factors for consideration, let’s look at the each of the four models and consider how they work with regards to the required parties involved and the investor experience.

Model 1: Self Clearing Custodial Broker

In this model, we see a unique corporate structuring that allows the same parent company the ability to custody the securities under the Broker-Dealer entity, and then handle trading and order matching through the registered ATS. The parties are separate and distinct, but the Transfer Agent > Broker-Dealer integration, and subsequent end user experience, are much more seamless and pleasant.

In this model, the ATS simply exists to match orders between buyers and sellers, the rest of the process is handled in the Broker-Dealer’s environment.

Investors start either at Vertalo with a request for deposit, or at the broker-dealer themselves. With express permission from the issuer, Vertalo collects the deposit request from the BD on behalf of the investor. There are a number of elements we gather to ensure it is the investor acting themselves (collect signatures, confirm information like address and email address match, the ATS partner uses 2FA upon login, etc.) that allow us to streamline this process.

• Investors request deposit (either at Transfer Agent or from the BD directly)

• Transfer Agent receives the deposit request

• Transfer Agent verifies all information is accurate

• Deposit is submitted, cap table is incremented to reflect Street Name Ownership of the custodial broker

• Investors submit orders on Broker Dealer

• Orders are relayed to ATS

• Order match occurs at the ATS

• Settlement instructions are sent back to the broker-dealer

• Broker settles transaction through moving cash and securities respectively

• Trade is complete

Once deposited, the Broker Dealer holds the securities in Street Name ownership, and can handle the movement of cash and securities once orders are matched on the ATS. Since this is the same parent company, these integrations are easy to maintain, and the investor doesn’t have to log in to multiple locations to initiate the trade or send instructions.

Model 2: Non-Custodial ATS, Custodian Takes Deposit of Securities

In this model, the custodian is the king of the settlement process by handling the custody of securities and movement of cash between buyer & seller in the secondary transaction. The ATS fulfills order matching, and the ledger is kept, but only contains the names of those who are registered shareholders, since the line item entry for all shares held through the custodian are listed in the name of the custodian.

Like Model 1, there is a depository process whereby the investors balances are moved from the Transfer Agent to the Custodian. This allows the ATS to query those balances before a trade is initiated to guarantee that shareholder is, in fact, long the balance they wish to sell. For any investor wishing to purchase, no such query need take place, although there may be restrictions that would necessitate that, such as a pull to see if a shareholder is restricted or otherwise barred from purchase. A common example of this is when employees are not allowed to own more than X% of voting shares of a company.

Here’s what the flow typically looks like in this model:

• Investors deposit shares to the custodial account

• Investors link their custodial account to the account at the ATS

  • this linking can be done asynchronously to the account creation at the ATS

• Investors log in to ATS and submit buy/sell orders

• ATS queries custodian to confirm the selling investor is long the shares they want to sell, receives confirmation or rejection of the request

• Order is matched on the ATS

• ATS instructs custodian to move shares & cash respectively, receives notification that is has been done per the instructions

• Trade is complete

The “Update Balance Instructions” you see from the Custodian to the Transfer Agent is reflective of when investors wish to remove their shares from custody and transfer them back into their name directly. In this case, the investor’s share count is deducted from the omnibus custodial account, and they are added as the Street Name Owner of the security. This is not required, most investors would likely leave their shares in the Street Name Ownership of the custodian, but could still happen if the investor was keen to hold the securities in their name, say for shareholder voting purposes where the investor didn’t want the custodian to cast their vote as a proxy for the investor.

Model 3: Non-Custodial BD, Same Corporate Entity Behind BD & ATS

This model uses the 4 Step Process, requiring investors to settle cash between one another. Otherwise, it’s similar in nature to Model 1, in that a parent company holds both the broker dealer and the ATS, even though they are distinct and separate legal entities.

In this model, the steps are functionally the same as the previous models with regards to order matching, except that rather than query a custodian for long balance information held by investors, the broker queries the Transfer Agent directly, since they are responsible for the maintenance of Good Control Location.

The flow of steps might look like this:

• Buyer submits a buy order, shareholder submits a sell order

  • *buy & sell orders can be asynchronous and unrelated to one another

• The executing broker queries the TA to confirm the seller is long the number of shares they want to sell

• Orders are sent to the ATS for match

• Orders are matched

• Confirmation thereof is sent to the executing broker

• Broker informs buyer and seller for the purpose of cash settlement

• Buyer & seller handle cash settlement between one another directly

• Cash settlement is confirmed to the executing broker

• Broker instructs Transfer Agent to update the cap table with the requisite trade information (buyer information, purchase info, etc.)

• Trade is complete

The critical difference here is that since there is no custodian involved, there is no deposit process, and the Broker can communicate directly with the Transfer Agent for the purposes of maintaining the cap table and shareholder ledger.

The obvious flaw here is that of user experience, since the investors have to deal directly with one another for the movement and settlement of cash. The benefit, however, is that the Transfer Agent is always aware of what the shareholder ledger looks like. This is especially important should an issuer want to list on multiple ATS venues. We’ll write more on this specifically in a future post.

Model 4: Order Match via Order Management System (OMS)

Model 4 looks like Model 3 except for two critical differences:

1. The executing broker has no formal relationship to the ATS, they can be completely separate and distinct companies with no shared parent company.

2. The broker was also the same one involved in the primary issuance of the security, meaning that suitability checks and KYC information has already been collected from each investor.

This model is also unique, because rather than a custodian handling the Good Control of the securities, that responsibility is held by the issuer themselves. Many issuers seek to hire out this role, since it’s so critical, and doing so improperly often bears hefty fines and problems with audit and filing with the SEC.

Here’s what the flow could look like in this model, this assumes the investor account has already been setup and suitability has been handled by the broker:

• Buyers and sellers send their respective orders on the issuer platform

• Issuer relays the orders to the ATS, including the broker ID

• Orders are matched on the ATS

• Order match confirmation is sent to the Broker & Issuer

• Issuer sends cash settlement instructions to the payment processor

• Once cash movement is confirmed, the issuer sends “Update Balance” instructions to the Transfer Agent

• Transfer Agent confirms the share transfer is properly documented, then documents the move of shares from seller to buyer

• Confirmation of the transfer is sent to the issuer

• Trade is complete

We have seen this model often used for issuers seeking to create liquidity and platforms that buy, sell, and trade private assets in context on their own websites. Rally Road is a prime example of where this model functions very well from a regulatory and user experience standpoint. Rally uses North Capital’s PPEX ATS, and has partnered with Dalmore for the Broker Dealer requirements, who was also the broker of record for their Reg A+ filing process. We’re unaware of who Rally uses for payment processing, but this model also necessitates a payment processor (typically a tech-enabled provider like Dwolla) to handle the movement of cash for securities via API integration.

Conclusion

The realities and subtle nuances of each of these models are still being discovered as the operators in the ecosystem grow together, integrate with one another, and bring on new issuers both large and small.

It’s been a real pleasure to have a front seat to exactly how these models behave and the impact it has on issuers and investors. We hope this was valuable for all you readers too. Feel free to subscribe (it’s free!) for more content like this around the digital asset ecosystem, private capital markets, finance, and blockchain.

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Till next time.

Disclaimer: None of this information is nor should it be considered as professional, legal, investment, or any other sort of advice or recommendation. The information presented herein is done so for informational, entertainment, & educational purposes only. Please consult an attorney or licensed investment professional before taking any investment or professional action.