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The last year has manifested significant development in the sphere of blockchain and Distributed Ledger Technology (DLT) across the world. Emerging countries like China are remarkably boosting blockchain implementation by experimenting and developing Central Bank Digital Currencies, whereas developed countries such as Germany are introducing game-changing regulations to ensure wider institutional adoption of blockchain and digital assets in their financial systems.
Consequently, new financial instruments such as tokenized securities are becoming more popular and desired, especially in a world that is demonstrating a stronger need for digitization, taking into consideration the current circumstances with the COVID-19, where daily practices are being undertaken online and remotely (e.g working from home or applying for a residency permit online).
After successfully completing the first-ever security token offering (STO) in Europe, with a prospectus approved by the German Financial Authority BaFin, Bitbond issued its tokenized security in July 2019: the token, dubbed “BB1”, is a tokenized bond. Bitbond initially used the funds raised to expand its SME lending portfolio before further focussing on the development of its bank-grade technology for the issuance, settlement and custody of tokenized securities. The Bitbond Tokenization Platform runs on the Stellar protocol, an open network for storing and moving assets.
Based on our experiences gained in the field, this article will provide insights into the features tokenized securities and as well as their implication for securitization in general. It will outline critical improvements that tokenization brings to the traditional and lengthy securitization process. Finally, the spotlight will be directed towards the importance and necessity of tokenized securities to revolutionize financial instruments. Bitbond’s ongoing projects will be used as examples to help you acquire a practical understanding of the solutions this technology offers.
To develop a better understanding of tokenized securities, we need to first outline what securities are in general. In its core meaning, a security is a fungible and tradable financial instrument that holds a monetary value, typically used to raise capital publicly or privately. However, the legal definition of a security can differ through accross jurisdictions. According to the German Securities Law (WpHG Wertpapierhandelsgesetz), securities (or Wertpapiere), “(...) whether or not represented by a certificate, mean all categories of transferable securities with the exception of instruments of payment that are by their nature negotiable on the financial markets, in particular:
To simplify it, securities are any form of tradable financial assets broadly categorized into debt, equity, and derivative securities. Listed on a stock exchange, they can be traded publicly in order to ensure liquidity by having issuers seek security listings and attract investors in a regulated market.
Alternatively, the sale of securities can take place privately between institutions through private placements. This is considered as an over-the-counter (OTC) trade, where securities are often traded among investors by the use of informal electronic trading systems (e.g. on the phone or online). Following a security offering, newly issued securities can be made available on the so-called secondary market where they are transferred from one investor to another in exchange for cash or other assets.
The set-up described above is highly centralized and time-consuming as it relies on many parties during the whole process of issuance, settlement, and custody of securities in general. The central players that usually take part in this process are:
This method is very time consuming as the whole process requires communication and confirmation within all parties involved. It makes the process highly inefficient and can put these players at significant risk. These risks will be stated further on throughout this article. The process of issuing a security can take up to several months in some countries depending on the bureaucratic/legal process required. The good news is that tokenized securities are here to drastically improve this traditional process of securitization.
Tokenized securities are end-to-end fully digital securities issued on the blockchain or so-called DLT. However, tokenized securities are different from traditional digital securities that we are familiar with. The latter ongo highly complex processes as described above. Tokenized securities use encrypted end-to-end communication to conduct these processes (settlement or defining ownership) automatically. Therefore, bringing significant improvements to securitization overall.
Let’s assume that, in the traditional set up, the ownership of a security is still represented by a paper certificate (which in fact is currently still the case in Germany, these certificates are usually stored in some highly secure vault managed by the institution in charge). The process of tokenization de-materializes securities, meaning that the proof of ownership is now represented by a digital token instead of a paper certificate.
This enables issuers to reach a wider group of investors. Access to global audiences becomes significantly cheaper with tokenized security since it is all digital and its storage becomes “paperless”. With tokenized securities, the transaction fee is dramatically reduced due to the ability to carry out a direct relationship with a global audience without the need for third parties which are replaced by DLT. Represented by a token (e.g BB1) , tokenized securities are held in a wallet.
In the field of capital markets, tokenized securities offer substantial efficiency gains in the issuance process: digital end-to-end investment flow, fewer intermediaries, lower costs, reduced complexities, global transferability and instant settlement of tokens. These are made available thanks to features offered by blockchain technology, such as automatically verifying and recording ownership on a distributed ledger publicly accessible. The image below provides a comparison between both forms of securities offerings.
Blockchain based tokens are radically fungible through the use of public and permissionless distributed ledger. Their independence from third parties offers global and instant settlement at minimal transaction fees.
Issuing a traditional security requires at least 5 different parties to be involved in the whole process of issuance:
The involvement of a CSD, contributes to a time lag between parties, additional costs and provides an individual entity with central powel. It is the registrar responsible of tracking ownership. Blockchain, or DLT, spare us from such the role played by the CSD. It records ownership automatically alongside enabling instant transfers at very minimal costs. The image below describes the traditional flow of the issuance of a security.
The flow of preparing a transaction and involving all stakeholders for the issuance is remarkably complex and inefficient as it can take up to a couple of months. Bitbond’s token issuance platform enables the onboarding of investors (including KYC and AML checks), the submission and allocation of orders including a book building process, the creation of tokenized securities and their distribution to investors.
Issuing tokenized securities brings radical improvements to the process of securitization for issuers and the investor. All other parties are eliminated in the process. Fewer intermediaries are involved in the process, the CSD is fully replaced by a distributed ledger. Paired with fiat-denominated stable coins, tokenized securities enable settlement payments to be executed in an instant and automated way.
Consequently, unnecessary complexities in the issuance process are eliminated, resulting in faster issuances alongside a drastic reduction of issuance costs. Tokenized securities allow global transferability of tokens which, as mentioned previously, provides access to an international investor base. Instant real-time settlement is a key feature of tokenized securities as they eliminate settlement risk for all parties involved. The advantages of issuing tokenized securities are clear, offering a more efficient and cost-effective procedure.
In the context of tokenized securities, the digital wallet is the application that makes the owner his own custodian. However there are also third party custody services available for investors and institutions, which in Germany require a crypto custody license as of January 2020. More detailed information on custody will follow later on in this blog post.
Custody is an important aspect in securities as it ensures their safekeeping from theft or loss. In the traditional set up, custodian are usually large and reputable financial institutions (e.g. JP Morgan Chase, BNY Mellon) as they often hold assets worth billions of dollars. Other than providing safekeeping of assets, custodians often provide additional services such as transaction settlements, dividend and interest payments, tax support, and foreign exchange. However, these services can come with hefty fees alongside the costly custodial fees.
Defining ownership of funds along with ensuring a secure and fast transfer of assets upon trading via a centralized system requires time. The process involves more or less the same number of players as described previously in this article. We pointed out that tokenization allows for the elimination of CSD as the decentralized ledger replaces the idea of a centrally managed registrar to keep track of ownership. The ledger takes out this function by recording all transactions automatically and irreversibly.
Blockchain technology, as you may know, solves the ownership traceability issue by allowing secure and instant transfer of assets digitally without the need for third party validation. This is completed through the use of a digital wallet which allows sending and receiving digital assets via highly secure encrypted communication. The wallet is the equivalent of an investor’s bank account, where they would deposit their funds.
Handling digital wallets comes with great responsibility. A public key is issued to which you receive funds and a private key gives access to these funds. In case you are not familiar with how a wallet works or what it is, you can find more information here. Just like securities are stored in highly secured vaults managed by banks, tokenized securities are stored in such wallets, therefore respective key management is of high importance. Especially when they store millions and billions worth of funds.
Therefore, demand for third party custody services are on the rise, mainly by big institutions that are getting more and more involved in the cryptocurrency and digital assets space. This article by Dr. Karl-Michael Henneking clearly explains how licensed third party custody services can contribute to greater institutional adoption of crypto assets and tokenized securities.
Bitbond’s digital asset custody platform provides a highly secure custody solution for digital assets including cryptocurrencies, tokenized securities and fiat-denominated stable coins. The platform enables Issuers and Investors to store, transfer and trade these digital assets in a both secure and user-friendly way. Bitbond utilizes key management software replacing private keys with Multi Party Computation (MPC) which is controlled with so-called shares. The representatives of the custodian (“Approvers”) need to co-sign withdrawal transactions of wallet users exceeding certain transaction limits to mitigate theft risks. The shares are stored locally on the devices of Approvers (e.g. laptop or desktop computers, mobile phones) from where Approvers co-sign withdrawal transactions.
Investors can access and use their custody wallet via a web-based interface. The custody wallet can be credited with stable coins to invest in security token offerings conducted via the Platform. After submitting an order to an offering, the stable coins are exchanged with the respective tokenized securities in a delivery vs payment transaction upon issuance of the tokens. Investors also receive coupon payments into their custody wallet which they can either redeem to fiat currency or use to invest in further offerings. Additionally, Investors can transfer and trade their tokenized securities from their wallet.
It is very important to understand that having payments completed on-chain is also necessary. On-chain payments allow for instant delivery vs payment transactions, the asset and the coin are directly exchanged within the protocol. This eliminates counterparty risk. To simplify it, completing payments on the ledger is indispensable as it ensures delivery of the tokenized security upon investment. Not only does this save a tremendous amount of time and reduces costs imposed by intermediaries, it also provides the asset seller (issuer) with the benefits of reducing risk of not receiving the funds invested to almost 0 and vice versa.
Investing in securities requires handling money transactions for the settlement process and any other form of payments that need to take place, such as coupon / interest payouts. In Europe, the common settlement period for most securities is 2 business days after the day of a transaction (T+2). This means that the issuer must deliver the security’s certificate in exchange for the investor’s payment within that settlement period. Historically, this process was paper based where the investor would hand in the security’s certificate in exchange for cash or a check. Nowadays, it is completed through electronic fund transfer (EFT). An EFT is basically a transfer of money from one bank account to another electronically. Tokenization now paves the road for so-called stable coins to be introduced. Stable coins are e-money that are backed by assets or fiat currency, they are “Tokenized funds” (...) backed by funds (i.e. commercial money, e-money or central bank money) which an issuer or custodian holds for safekeeping; this implies that there is a commitment to ensuring that tokenized funds can be redeemed in full. If you are familiar with Bitbond’s previous lending product, you may be aware of the stable coins used to handle transactions between lenders and borrowers on the platform. This was achieved thanks to the issuance of euro tokens (EURT) backed by fiat euro. 1 EURT = 1 EUR. The use of stable coins allows instant automatic settlement of investments and payments globally.
Bitbond’s stable coin issuance platform allows for the issuance of fiat-backed e-money used for on-chain payments, including primary investments, coupon payments, trading and bond repayments. In secondary trades, on-chain payments allow for instant Delivery vs. Payment (DvP) , thereby eliminating settlement risk of transactions.
Issuers receive the funds raised from their offering in the form of stable coin payments into their wallet. Coupon payments are debited from their wallets and paid out to Investor wallets automatically. A fiat-backed stable coin (i.e. e-money or digital cash) is used within the platform for the following process steps:
Bitbond was the first issuer to receive BaFin prospect approval for its tokenized bond offering in Europe. This set a remarkable milestone in Bitbond’s approach towards their technology and the industry in general. Such an approach was groundbreaking as it contributed to the approval from a blockchain skeptical governing body at the time. Ever since, Germany and Europe in general have been more welcoming of this new approach to issuing securities. For instance, the German Federal Government published its Blockchain strategy in September 2019, which places a focus on the application of blockchain in the financial sector:
Additionally, since January 1st, 2020 the provision of digital asset custody has been added to the German Banking Act (KWG) as a regulated financial service. To obtain a crypto custody license, custody providers need to maintain a minimum core capital of EUR 125k and must have two executives competent in digital asset custody. The service can be provided from within an existing legal entity, therefore banks and custodians can add digital asset custody to their existing product lines
Bitbond has been a key player in the development of compliant technology solutions to drive wider adoption of tokenized securities in capital markets. We deliver our battle-tested bank grade technology and enable access to:
Examples of Bitbond ongoing projects in tokenized securities
This project consists of the development of a peer-to-peer tokenization platform including investor onboarding for debt financing of real estate projects. It is a fully digital real estate investment platform for the European market. KlickOwn launched its STO for its historical building in Lüneburg powered by the Bitbond tokenization platform. More information provided in this article.
One of the oldest German banks, Bankhaus von de Heydt, partnered with Bitbond to develop an end-to-end tokenization platform to connect issuers, institutional investors and providing clients with digital asset custody. It consists of:
Tokenized securities are rising in popularity. They bring significant efficiencies to the traditional securitization approach through the use and development of compliant new technologies. Fintech companies like Bitbond develop innovative solutions to revolutionize the way securities are issued, stored, serviced and traded, thereby overhauling a trillion dollar industry controlled by a small number of powerful intermediaries for decades. In this article, we learned about tokenized securities as a new financial instrument. We discussed three aspects where tokenized securities provide significant improvements. Followingly, we shed a light on the latest actions of governments and financial watchdogs to enable wider institutional adoption of blockchain technology and new instruments like tokenized securities. Finally, two examples of Bitbond’s ongoing projects were highlighted to provide a more concrete understanding of the tech solutions we provide as a pioneer in tokenizing capital markets. We at Bitbond expect all newly issued securities to be tokenized by 2025. What do you think? Make sure to reach out and let us know your thoughts.
Are you looking to tokenize your securities? Check out Bitbond and request a demo of our solutions!
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