Tokenisation of Securities: Real World Applications — Removing the Middlemen
Find a broker and set up a brokerage account. Prepare to pay a whole host of different broker fees e.g. trading fees, withdrawal fees, maybe even data fees or inactivity fees. Identify the stock you wish to invest in and have your broker get in touch with a market maker. Receive a price offer on your desired stock from the market maker (via your broker). Decide whether you want to buy at that price. Enter the trade.
That is all it takes to invest in securities.
Alternatively, if you wish to buy into an investment fund — effectively buying units in a managed portfolio of investments — via an investment company, you need to add in fund managers and some more fees (e.g. investment management fees, admin fees, platform fees, entry and exit fees, trading costs, even performance fees) to the mix.
It is a fairly convoluted and potentially expensive process as you speculate on what securities might give you a good return on your investment. Most critically, there is a significant number of intermediaries to go through before an investment is even made. Intermediaries who you are paying to play with your money.
Security tokens offer a new proposition — one without numerous middlemen and without multiple friction points. Tokenise aims to provide a platform to enable these swift, frictionless and disintermediated transactions, all built on the blockchain. Simon Telfer, Tokenise’s COO, explains how this would work in practice:
“Tokenise intends to set up, where there is no direct access to the marketplace, a third-party dealer/broker. This will be part of the same ecosystem and therefore will allow access through our own in-house broker. It should create a seamless transaction straight to the exchange.”
The Ledger
Shares in publicly listed companies are typically not held, sold and distributed by the companies themselves. They are held centrally by a third-party custodian, who in turn maintains and updates a ledger or a register of shareholders. So, even if you buy a share in a company, you do not physically own it — much in the same way as the phrase on a banknote ‘I promise to pay the bearer on demand the sum of…’ was effectively an IOU when banknotes represented deposits of gold. The share certificate remains in custody. The only thing that changes to acknowledge your ownership of the share, is the register, with your name on it.
Brokers do not share their ledgers with other brokers, nor with the company issuing the security. Each party has its own ledger. They then trust third-party clearing and settlement services to handle the confirmation and delivery of transactions. This is problematic.
Constantine Milias, Investment Analyst at Tokenise, explains the difficulties faced in the UK market and how Tokenise plans to establish real ownership of shares represented by security tokens:
“The Companies Act makes tokenisation of equities very difficult. However, while creating tokenised equity may not be the route, for now, it is feasible to achieve a ‘synthetic equity token’ which will involve a nominee and a custodian. If tokens (digital certificates) are lost or stolen, it is possible to see who the registered beneficial owner is. In addition, we will initially use enhanced ERC20 as a protocol, therefore only people who are within our ‘walled garden’ and have been approved can register or own the shares.”
Why does this complex system exist? It is the only way the markets have managed to work at scale. But with Distributed Ledger Technology (DLT) this could all soon change.
The Distributed Ledger
Previously we have explored how Distributed Ledger Technology (DLT) has the potential to improve ownership and trading by increasing efficiencies in trading, record-keeping, and paving the way for improvements in governance. DLT can remove many of the friction points experienced in the traditional financial markets. Simon Telfer summarises the key benefits:
“There are several benefits, the main ones being cost and time savings. It also enables individuals to take more control of their investment portfolios and manage their own risk.”
Making all transactions using smart contracts on a blockchain not only creates an immutable record of every transaction, along with proof of ownership, but it also eliminates the need for a trusted third-party to manage a master ledger. There will no longer be the need for a centralised custodian to look after everyone’s shares. The securities will become digital certificates of ownership enabling direct ownership. DLT promises speed in the verification of transactions and transparency in their execution, at scale. Which is more than has ever been attainable to date.
Does Tokenisation Remove the Middlemen?
Potentially, yes. There will always be space for advisors, people with in-depth market knowledge, and increasingly, technical knowledge. But will these be entirely necessary? Not for the sophisticated investor. The future of tokenised securities could mean that investors, and security token issuers, can effectively reduce the need for middlemen, making for frictionless transactions, wallet to wallet, using smart contracts as part of a new financial system built on blockchain technology. Constantine summarises the potential impact and benefits of security tokens quite succinctly:
“The biggest benefit of tokenisation of securities is that it enables leveraging current regulatory and legal safeguards while lowering both cost and complexity. Blockchain technology offers the opportunity to simplify the structure, reduce the number of parties and quantity of documentation, and automate many of the processes; saving time and cost.”
However, Simon points out that there are still potential risks to be aware of and that there is still a place for some middlemen within the investment process:
“People should only make investments on their own if they know and understand the risks involved. We are not advocating that people do not take advice, we are simply stating that if they are able to make their own decisions, they should be afforded that capability. Naturally, a good financial advisor will assist in the process and, where there is any doubt, a financial advisor should be sought and consulted before any investment decisions are made.”
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