Tokenisation of Equity <-> A Real-World Blockchain Use Case

In this blog I will talk about using blockchain for equity fundraising and management, the benefits of doing so and some operational steps involved in the entire process.

Fundraising with Blockchain - Challenges & Benefits

Traditionally, companies raising equity encounter problems such as the regular maintenance of books and accounting, slow settlement times and the typical nature of issuing and signing stock certificates. There is also higher transaction costs associated in all of these processes, and the shares of companies tend to have lower liquidity as a result. However, tokenisation using blockchain technology can provide several benefits for equity financial instruments. By tokenizing equity, companies can manage their investors and responsibilities from a digital interface, reach a new breed of investors and automate compliance obligations. Digitizing ownership through tokens allows companies to offer fractional ownership to a larger pool of investors, potentially increasing liquidity and reducing transaction costs. Additionally, tokenization can streamline the issuance and trading of equity, enabling faster settlement times and reducing the need for intermediaries. The use of smart contracts can also automate compliance obligations and provide greater transparency for investors.

But you must be wondering how do dividends, bonuses, mergers and acquisitions, and other corporate actions like shareholder voting and follow-on equity sale get handled here? Well, the underlying blockchain infrastructure supports all such necessary activities applicable to the equity world - such is the power of smart contracts!

How Does It Work?

I have come across some companies enabling this in the market like UK-based Globacap, Germany-based Nefund and Luxembourg-based Tokeny to name a few. To deep dive into the operational steps, I will take Tokeny's tech stack as an example. In July 2019 they received funding from Euronext, the leading pan-European exchange in the Eurozone area.

Built on Ethereum, Tokeny and platforms alike follow some pre-built business processes which can be customisable. This includes issuance, allocation, management and servicing of the equity tokens. Components include a compliant issuance solution, which is like a cloud platform used to issue tokenized securities to eligible investors; on-chain transfer solution involving compliant transfer of ownership to white labeled investors; and a securities servicing solution for events throughout the security token lifecycle. Issuance - deals with investor onboarding in a compliant way depending on the jurisdicitions selected. Each jurisdiction (country) has its own legal set of requirements which must be adhered in order to complete investor onboarding successfully. A part of this involves meeting Know-Your-Customer (KYC) and Anti-Money Laundering (AML) provisions covering individual and institutional investors, collating the required data and documents, and issuing a blockchain identity. Transfers - to enable a compliant transfer of securities ownership on the blockchain, Tokeny provides interoperability with wallets, liquidity providers and identity providers​, based on open source and compatible with blockchain standards (including ERC-20)​. The on-chain identity system links proof of KYC and the wallets of the investor, whereby the identities are whitelisted, not the wallets, so that the beneficial owner is always identified. The trade validator system is decentralized, thus eliminating a single point of failure.​

Servicing - to make sure post-issuance ,securities are handled well, going beyond simple reporting and performing corporate actions on the securities. Automation of cap table management, communicating with investors, being able to directly communicat with investors, transactional reporting, news announcements, dividend (and other revenue) distributions. Technical Standards Adopted ERC-1600 & ERC-3643

It should not be surprising that complex business cases like this utilise newer standards, makes perfect sense when you think about the features each standard needs to impose. Just like ERC-721 became a common standard for NFTs, the security token industry also requires common technical standards to benefit from the underlying shared network.

Currently, the common security token standards in the market are ERC-1400 and ERC-3643. They both use a different approach but can enrich each other thanks to the code’s composability. Both of the standards enable the enforcement of compliance rules and the control of transfers to eligible investors. ERC-3643 manages compliance by leveraging the security of the blockchain with an automatic validator system. This system applies the transfer rules related to users (identities) and those related to the offering. The issuer of the securities, or its agent, always keeps control of the tokens and the transfers. ERC-1400 is another approach where each trade must be validated by a specific key generated offchain.

The Future - A Trillion Dollar Industry?

According to projections by HSBC, it is estimated that $1.7 billion per annum is currently spent on Distributed Ledger Technologies (DLT) in financial services globally. The World Economic Forum estimates that tokenised markets could potentially be worth as much as $24 trillion by 2027, with equity constituting a significant part - $8 billion if we include both listed and unlisted equity.

Time will tell how big the market will become, but it's clear that financial market participants, fintechs and infrastructure providers need to collaborate to galvanise change and bring adoption for this emerging Blockchain use case.