Regulated exchanges for crypto security tokens could transform equity capital markets


Peter Lee
Published on:

New efforts to execute equity transactions on blockchain are emerging, for now concentrated in private equity, as disruptors seek to build investor and regulatory confidence in security tokens.

On August 15, Swarm, a Palo Alto-based blockchain platform for private equity, which markets itself to private wealth managers and family offices as an open means of access to alternative investments, announced the prefunding of the so-called Robinhood Equity token (Rhet), the first security token of its kind.

Robinhood is one of the new generation of low-commission conventional stock trading apps in the US, which is itself challenging the established brokerage model. The new Rhet initiative allows accredited investors on the Swarm platform to reserve their stake in a fund created for the purpose of holding equity in Robinhood. 

Once the minimum funding goal is reached, a Swarm syndicate manager will form an entity to acquire equity through established relationships with former employees and other equity holders in Robinhood, and convert committed funds into Rhet equity tokens.

Philipp Pieper 160x186

Philipp Pieper,
Swarm Fund

It all looks a little cheeky. Robinhood itself is raising no equity here. It is not even involved. Swarm is hoping to use tokenization to bring secondary market liquidity to stock in a private company, which, ironically enough, is itself in the stock brokerage business.

“Secondary equities transactions and refinancing of legal entities which hold private company equity are not new in the United States,” says Philipp Pieper, chief executive of Swarm Fund. “What’s new here is the tokenization of these assets and the doors opened by this innovation. 

"One of the key innovations of tokenization is that token owners can participate in the value creation of the very network they are part of. Swarm is bringing this paradigm shift to companies that are key players within this movement but have yet to permit the network to participate.”

Rhet is the first of many tokens representing equity in private companies that Swarm expects to launch on the platform. At the end of August, Swarm unveiled its so-called market access protocol (MAP) for tokenized security trading, an effort to bring self-regulation to an emerging market infrastructure. 

For a transaction to be considered compliant on Swarm, parties must confirm the existence of valid credentials for each participant, and also ensure adherence to token requirements and restrictions.

Swarm’s MAP contains a graph of protected data that can instantly surface whether or not a particular wallet is compliant with the requirements for any security token transfer and show whether a wallet has been validated against a set of qualifications – including KYC/AML, accredited investor, and geographically-based rules – as well as who provided that validation.

The hope is that this will help the security token market, including centralized and decentralized exchange models, to grow faster.

"One of the key innovations of tokenization is that token owners can participate in the value creation of the very network they are part of."
Philipp Pieper, Swarm Fund

In June, KPMG surveyed the interplay between cryptocurrency, blockchain platforms and regulation of conventional financial markets, noting that while the lack of identifying information throughout a digital transaction is an obvious obstacle to anti-money laundering (AML) surveillance and enforcement, in fact identifying parties and a record of the transaction can exist in the world of cryptocurrency. 

For example, South Korea’s Financial Services Commission has banned anonymous trading accounts and implemented a new requirement for exchange platforms to perform real-name verifications. Anonymous or pseudo-named wallets are no longer permitted in South Korea.

Indeed, distributed ledger technology inherently has much greater potential to reduce AML risks than fiat currencies, KPMG argues. Blockchains maintained via an online public ledger mean each transaction can be supervised, validated and recorded in a complete history. Cryptocurrency is almost impossible to forge. 

In addition, it is technically feasible to revise the blockchain protocol to limit transactions to know your customer (KYC)–verified wallets.

Matthew Unger 160x186

Matthew Unger,

Just one day after the announcement of the Robinhood equity token, iComply, a leading global RegTech platform for digital finance and cryptocurrencies, announced the launch of its public beta following the closure of a seven-figure seed funding round.

“Tokenization of securities and other financial instruments holds incredible potential; however, security token platforms and initial coin offerings being used in practice are still riddled with issues,” says Matthew Unger, chief executive of iComply

“With no mechanism to ensure compliance, tokens on the secondary market become prime vehicles for sanctioned individuals, criminals and known terrorists to launder millions. The recent Mueller indictments demonstrate how bitcoin was used to fund the attack on the US election.”

iComply’s patent-pending software combines robust KYC, AML, blockchain forensics, source of funds reporting, secondary trade management (currently only deployed for Ethereum) and even registrar functions for equity tokens.

“We developed this software so that security and utility tokens can monitor and document compliance, governance and risk procedures while trading in real time,” says Unger. “This can solve one of the last major barriers between cryptocurrencies and institutional investors – in particular, the ability for a token to prevent itself from going into the wallet of an unverified or illegal actor, such as sanctioned individuals or terrorists.”

On August 21, Global Blockchain Technologies Corp (Bloc) announced an investment by its Hyperion crypto exchange division in the Delaware Board of Trade, which will enable Bloc to take advantage of DBOT’s SEC-registered Alternative Trading System (ATS) for trading tokenized securities.

"Security token platforms and initial coin offerings being used in practice are still riddled with issues."
- Matthew Unger, iComply

Hyperion is a security token exchange that performs the same functions as a stock exchange but uses blockchain technology to automate processes otherwise performed by third parties such as clearing houses, thus improving speeds and lowering costs. Bloc owns 12.82% of Hyperion. Hyperion’s strategic investment in DBOT enables it to become part of DBOT’s SEC-registered Alternative Trading System, which should provide investors with the protections of federal securities law and regulatory oversight.

The SEC emphasized the importance of this in its public message released in March about potentially unlawful online digital asset trading platforms, all of which lack SEC registration.

“Blockchain technology has been the answer to questions that people were asking for decades in high finance,” says Richard Schaeffer, an adviser to Bloc and former NYMEX chairman. “Between speeding up transactions, cutting out middlemen and enabling assets to be traded virtually without borders, I see tremendous promise in so many of Bloc’s projects, especially Hyperion. 

"Every serious investor in the United States knows the importance of SEC compliance, and attaining this will enable Hyperion to compete on the same playing field as traditional exchanges, which will set new standards in the world of finance.”