Digitizing ownership stakes using Blockchain
Introduction — Ownership from the virtual world to the financial world
Blockchain or distributed ledger technology (DLT) has the potential to revolutionize the ownership of assets. Beginning less than a decade ago with the introduction of Bitcoin, over $1.5Trillion of assets today have their ownership now recorded on various decentralized ledgers — most of which are virtual assets such as cryptocurrencies. However, real and financial assets are also beginning to use blockchain technology. Atlas One estimates that approximately $1 Billion of securities have been issued using DLT — referred to as Digital Securities Offerings (DSOs). In addition, some $250 million in non-fungible tokens (NFTs) were issued in 2020, representing ownership of mostly art and collectibles. The DSO and NFT market in Canada is relatively small, but growing thanks to firms like Atlas One in DSOs, and DapperLabs for NFTs.
The key operational challenge for real and financial assets is to reflect ownership through the blockchain, which can therefore be sold and transferred. Virtual assets like Bitcoin and Ethereum were born on the blockchain and part of their attractiveness is registry, which is decentralized. Real and financial assets still need to deal with the real world of corporate registries, securities depositories, and title registries. This article deals with the practical ways to link the ownership of assets to the blockchain for the purpose of digitizing ownership with a focus on Canada.
Ideal world — Born on the Blockchain
As virtual assets have shown, the ideal solution would be for real and financial assets to directly register ownership on the blockchain when they are created or transferred. In most jurisdictions, registries, often government managed, are the “source of truth” for ownership. These could be corporate registries for companies, title offices for property, and patent and trademark offices for intellectual property (IP). For public securities, central securities depositories (CSDs) are the main entities that record and note changes of ownership. The challenge with these current bodies is that they are often inefficient and expensive, no doubt due to their monopoly status in managing ownership — either by statute or sheer scale economies.
Moving ownership registration to the blockchain would bring radical improvements in efficiency and opportunity for liquidity in private markets. A company would incorporate and immediately register its shareholders by the simple action of issuing tokens representing shares in the company to investors’ digital wallets (See Exhibit 1).
Property, cars, IP could link a NFT to registration at a title office, again by holding the NFT in a wallet. Changes in ownership can be immediately reflected in blockchain registries as opposed to the weeks it sometimes takes today. This speed and efficiency would enable more active secondary trading of private assets as they would benefit from the same benefit that a CSD brings to public securities — the rapid registration of ownership changes key to facilitating secondary markets. Yet blockchain registries would be able to provide increased access to participants and lower costs than CSDs.
Sounds fanciful? Well jurisdictions such as Dubai, Wyoming, and Delaware already offer the service. Atlas One works with our partner — Otonomos, a blockchain incorporation company — to spin up new entities in Delaware and Wyoming through their Otoco product in a matter of seconds. The Province of British Columbia is piloting its land registry system on blockchain, which could be just the beginning of using blockchain to record and transfer changes in Real property ownership. Jurisdictions around the world are beginning to see the benefits of efficiency and transparency of using blockchain for the ownership of real and financial assets.
There are still challenges to overcome for true blockchain ownership. As Exhibit 1 shows, a variety of services typically performed by corporate secretary firms will still be required, such as identity verification to ensure counter-parties are known, and corporate actions such as annual shareholder meetings and reporting. Some users may still prefer offline transaction validation/notary services, though, one has to remember that issues of fraud already exist in the current system of title transfer — why else would a multi-billion industry in title insurance exist. However, just like the decentralized finance (DeFi) movement, many players will offer their own services to support a blockchain ownership system through the same decentralized application (DAPP) approach we see in DeFi.
Basic Digitization of Ownership
Most jurisdictions are far from the ideal world outlined above. Yet digitization of real and financial assets can still occur using either off-chain legal contracts or intermediate structures common in capital markets. In most jurisdictions, including Canada, private company shareholder registries are maintained by the company itself. Hence, the basis for converting share ownership to digital securities is to legally require the company to update its registry to synchronize with the ownership reflected on the blockchain (See Exhibit 2).
Atlas One does this by inserting legal provisions in our service agreements with the issuer and the subscription agreement for investors to ensure the company maintains its registry and/or its corporate minute book to reflect the ownership created by the issuance of digital securities on the blockchain to investors. As a regulated securities firm, Atlas One also has the responsibility to identify the investors who hold the DSOs in their digital wallet, conduct know your customer (KYC) reviews, and ensure investors are eligible to purchase these securities in the case of Exempt or Accredited investor restrictions. Digital Securities issuance platforms like Securitize and Tokeny provide a similar service.
While this may not seem like an elegant solution, it takes the private capital markets a long way. Investors no longer need to worry about dealing with analogue corporate secretaries or holding paper share certificates, and company issuers can use digital processes to update their capital tables and shareholder registries. Moreover, thanks to the smart contracts embedded in the tokens issued on the blockchain, companies can better control their shareholder base by restricting ownership to, for example, Accredited investors, certain jurisdictions, or to restricted numbers — in Canada, entities above 50 shareholders have heightened reporting requirements. This compliance aspect of digital securities adds security of compliance to the benefits of speed and efficiency.
Hybrid Digitized Ownership Structures
Moving a step beyond basic digitization of ownership are hybrid structures, drawing on experience from public capital markets. As Exhibit 3 shows, we essentially insert an intermediate entity between shareholders and the corporate/title registries and appoint an independent third party to either update the registry or agree with shareholders that the intermediate entity’s own ledger or shareholder registry will be the source of ownership truth.
These intermediate entities could be a trust structure, a special purpose vehicle (SPV), or a nominee company, which are often used by CSDs. Third-party registry managers could be corporate secretary firms, transfer agents, or custodians and fund administrators. In Singapore, the emerging structure is for custodians to hold shares issued from the central corporate registry — ACRA in a nominee company structure, which would then issue digital securities against them. The custodian, fund administrator, or payment agent for bonds would update investor registry. This effectively immobilizes the share ownership in the name of a nominee company, and transfers registry management to the custodian. The custodian, transfer agent, or CSD simply record the registry reflected on the blockchain and that becomes the source of truth.
These hybrid structures are more suited for private companies that expect more frequent transfers of shares and ownership. It also adds extra confidence that an independent third party manages the shareholder registry, which would provide confidence for institutional investors. As a private company eventually moves to increase the liquidity of its digital securities through an exchange listing or creation of other secondary venues, creating a hybrid structure makes more sense.
While ownership born on the blockchain is the ultimate solution to speed the adoption of efficient digital ownership of real and financial assets, the industry is not waiting. Basic and hybrid solutions are gathering pace and one can easily imagine digital securities depositories to emerge in many jurisdictions if traditional registries and industry players fail to keep up. Investors and issuers will drive ownership on the blockchain adoption and digital securities players will play a key role in accelerating that adoption.
