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Issuing and Trading digital securities on the Blockchain

Regulatory compliance is key for security tokens. What options do we have on regulation compliant issuing and trading ?

Security tokens and Digital securities are terms that are often used interchangeably. They are not the same. Digital securities are electronic records of shares, bonds, fund units and other financial instruments with centralized securities depositories that are directly supervised by securities regulators in national jurisdictions. For example, in the countries we operate in, the Swiss depository is run by SIS and the Indian depository is run by NSDL and CDSL. Digital securities are often identified by an unique securities identifier such as ISIN and are credited and debited from the brokerage accounts of their investors as they trade securities.

Security tokens, on the other hand, are digital securities recorded on a blockchain. A blockchain is a decentralized, digital ledger that is made tamper proof by a number of validators that have to reach consensus before recording each entry on the ledger. Therefore, although security tokens are digital securities, they are not regulated unless they are specifically approved by regulators. In a handful of countries such as Switzerland, Germany and Japan, security tokens now have regulatory cover. For example, the financial supervisory authority in Switzerland FINMA announced the coming into force of the DLT Act from February 2021 that recognizes securities recorded in decentralized ledgers or blockchains. More recently, in May 2021, the Electronic Securities Act (eWpG) was passed by the German Parliament that recognizes crypto asset registries as an alternative to centralized depositories. Earlier in 2020, the Financial Services Agency (FSA) which is the regulator in Japan introduced ERTRs or Electronically Recorded Transferable Rights that represent security tokens under the Financial Instruments and Exchange Act.

But how does the mere fact of recording securities on blockchains or DLT registers benefit investors ? This is an open question that needs an answer. After all, even if a security token is issued which is recorded on a blockchain, the issuers of such security tokens still need to comply with prospectus guidelines, regulations with respect to distribution and marketing of security tokens, and trading of security tokens. The Swiss regulator FINMA recently announced that DLT trading facilities will function as regulated marketplaces for security tokens in Switzerland. Are DLT securities therefore a solution looking for a problem ? Besides the fact that DLT securities confer legal rights of ownership to security token holders in only a couple of countries.

One key problem our work on the Verified Network has identified is the ability of tokens that represent securities to aid in price discovery of private, unlisted assets and their trade over the counter. The Verified Network is a Layer 2 Ethereum network of financial service providers that enable tokenization of private financial assets, investments in and trading of tokenized assets.

High level architecture of the Verified Network

The Layer 2 network does most of the transaction processing and heavy lifting without incurring Ethereum gas fees and validators on the L2 network stake their share of fee from transactions on the network. Balances of securities and cash in custody are rolled up to the Layer 1 Ethereum main net which reinforces security and the ability to interface with individual users on the main net, in addition to users who interface with digital security token issuing, transfer, trading and settlement related smart contracts directly through L2 using Decentralized applications (Dapps) with built in ERC20 compliant wallets.

Tokens representing securities and cash balances on the Verified Network are utility tokens that aid in price discovery and their over the counter (OTC) trade. Utility tokens have a lower regulatory barrier and are sufficient to address the real problem of lack of liquidity in private, unlisted assets. In this article, we will be referring to utility tokens representing securities as digital security tokens.

Four different alternatives for issuing securities to investors

Businesses wishing to raise capital or letting their investors access liquidity need to register their securities such as shares and bonds with the centralized depositories. This usually requires amendments to the articles of association of a company, passing of board resolutions and appointment of a depository participant such as a paying agent that dematerializes any physical or bearer securities and registers them with the depository. Investors in such businesses with an account on the Verified Network can request issue of digital security tokens. Depository participants on the Verified Network confirm ownership of securities and trigger the issue of digital security tokens and their credit to Verified accounts of investors. Digital security token holders can then offer them for sale on the Verified Network. As described in the previous article, digital security token issuing contracts do not just make their balances available to their holders but also report credit scores and corporate actions.

Decentralized price discovery and proof of ownership on the Verified Network

Just like securities custodians or depository participants trigger issue of digital security tokens on the Verified Network, cash custodians such as banks or payment service providers confirm ownership of cash and trigger the issue of digital cash tokens and their credit to Verified accounts of buyers. Buyers can bid for offers of sale by digital security tokens holders and current implementation supports market, limit and stop loss orders. Once orders are matched on the Verified Network, the system triggers the off chain transfer of securities and cash settlement for securities that is executed by regulated securities and cash custodians.

Therefore, the Verified Network itself does not serve as an exchange or a centralized counter party, and digital security and cash tokens facilitate price discovery and off chain over-the-counter trade settlements. Which brings us to the title of this article — Issuing and Trading of digital securities on the Blockchain- that refers to digital security tokens representing traditional, dematerialized, depository registered securities resolving the problem of lack of liquidity of unlisted securities efficiently and inexpensively, that security tokens or DLT securities as defined by regulators may find more expensive and time consuming to achieve.

Looking back with nostalgia

Digital cash tokens are fully described in a separate article here.

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We share opinions and analysis on topics at the intersection of finance, economics and the emerging economic and technology fabric with digital currencies and blockchains.

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Kallol Borah

Kallol Borah

Entrepreneur, Technologist, Explorer. Tweets@BorahKallol

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