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Ulyana Shtybel, Chief Capital Officer, HighCastleInvestors are used to the fact that investing in private companies is manual, complicated, and illiquid, and these are among the main reasons that private companies are considered a more risky type of investment.
"Issuance of private securities electronically on the blockchain (known as “Tokenization”) is transforming the capital market, and it is expected to stimulate investments in private businesses and lower the cost of capital"
This was never the case for public companies as their securities are dematerialized, meaning issued electronically. Electronic issuance of securities allows them to be easily transferable and as a consequence, more liquid.
For decades, issuance of securities in digital, known as book-entry or electronic form has been available only to public companies because of the high cost of issuance and settlement dictated by the Central Securities Depositories (CSDs). Central Securities Depositories use a different type of the Electronic Securities Systems (or securities dematerialization system), which can be defined as a system (or database) where the securities and the holder of securities accounts can be administered by book-entry (electronically) without involving physical certificates.
While CSDs are operating the electronic securities systems, the corporate law of the majority of countries requires private companies to maintain the company records (inter alia a share register) at its registered office or at any other place in the country designated by the directors. It allows registers to be entered or recorded by any system of mechanical or electronic data processing or any other information storage device that is capable of reproducing any required information in intelligible written form within a reasonable time.
Even the companies themselves are responsible for maintaining the list of shareholders, but, in practice, the majority of public companies frequently outsource this task to a third-party entity. The entity that is in charge, on behalf of the company, of keeping a register, can generally be referred to as registrar.
In more than half of European markets, the CSD combines the role of acting as primary registrar and settlement system, but in the other half, including the UK, the registrar role is taken on by third parties, such as Computershare, Capita, Equiniti.
Where securities accounts are maintained at the CSD, the register tends to be a direct reflection of CSD accounts, which means that the register is updated on a daily (or even intraday) basis to reflect the changes in CSD records following a securities transfer between accounts at the CSD. In other markets, the register is maintained separately from CSD accounts and may only be updated on an ad hoc basis, typically at the request of the issuer.
The majority of securities accounts at a CSD are owned by brokers, and therefore when an investor buys a share in a public company, using a nominee account, the share register shows the name of the nominee or broker company, rather than the investor’s name. In most cases, this does not affect the investors’ legal rights to ownership but limits investors’ ability to own and transfer securities directly.
Such a complex infrastructure of capital market players involving the dematerialization process was never affordable and accessible for private companies, and as a consequence, transferability of securities was limited and overwhelmed by the paper and legal workflows.
Now, after the breakout of Distributed Ledger Technology (DLT), private companies can utilize permission distributed networks for self-issuance of securities in book-entry form. They also can maintain the blockchain-enabled share register, which captures every single electronic movement of ownership while providing an easy way to passively meet compliance obligations: real-time maintenance of company records, shareholders management, transfers of the titles of the ownership.
Advantages of digital securities over paper-form securities include the following (Figure 1):
1) Decentralization: ownership is recorded on the distributed ledger which doesn’t have a single point of failure.
2) Security: securities are held in cryptographically secured and easy to use digital wallets; all money transactions processing (DvP) is decentralized.
3) Fast settlement: settlement of trades and transfers is executed on the distributed ledger in near real-time.
4) Transparency: company records (shareholders register) are blockchain-based and not based on excel spreadsheets anymore. Blockchain-enabled registers reflect the actual securities accounts balance on the distributed ledger and are not changeable by the issuer, nor by other parties.
5) Voting and Proxy voting: voting and corporate actions can be automated for holders of digital securities.
6) Transferability and Liquidity: digital transfers enhance the liquidity of private securities and provide 24/7 access to the market.
7) Automated compliance: investors’ eligibility and securities transferability is automated and traceable to avoid unauthorized transactions.
8) Programmable dividends payments: book-entry issuance of securities allows dividends and interest to be paid automatically as triggered by specific conditions.
Even though there are still not many blockchain-enabled registrars on the market providing the technological infrastructure, there are few, such as Daura (Switzerland), myStake (Australia), HighCastle (UK), which already provide private companies with registry services for securities issued at permissionless blockchains (eg. Ethereum) or permissioned blockchains (eg. PrimeNet). Permissioned (also known as private) blockchains, unlike permissionless (also known as public), are more suitable for securities issuance from the perspective of network security, privacy and identity protection, as well as the limitation of access to the network to avoid unauthorized and unverified issuance of securities.
Issuance of private securities electronically on the blockchain (known as “Tokenization”) is transforming the capital market, and it is expected to stimulate investments in private businesses and lower the cost of capital. The emergence of the blockchain-based electronic securities systems and blockchain-enabled share registrars will enable the zdigitization of $18.1 trillion worth of private equity and debt. Unless CSDs extend their monopoly to the private securities market, which is an unlikely scenario from a legal perspective, ztokenization opens up enormous opportunities for investors, ultimately simplifying private securities transfers to be as easy as they have been for decades for publicly listed securities and even simpler. As easy as transfer 1$ between two PayPal accounts using a smartphone.
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