Tokenization of Existing Assets: Compliance Implications

Often, when we talk about digital assets and blockchain technology, we talk about cryptocurrency and innovations related to completely new forms of storing and transferring value. Lost in the shuffle, however, may be one of the most important aspects of the digital financial revolution: the tokenization of existing assets.

Historically, the storage and transfer of stocks and bonds has been the responsibility of custodians and transfer agents, which form the backbone and infrastructure of traditional securities markets. By implementing blockchain technology, these third-party intermediaries could be, at least partially, replaced by individuals who control their own assets through the maintenance of keys to a cryptographically secure digital wallet.

But what would this immediate future mean for the evolution of financial crime compliance? Well, to understand the answer to that question, we must first look back at the days of bearer stocks.

Back to basics

A bearer share is a security that is fully controlled and owned by the person who owns the physical certificate representing the ownership interest (or “bearer” of the instrument).

An equity issuing company does not maintain a register of ownership and does not keep records of asset transfers through any centralized ledger. In fact, these assets can only be moved through the exchange of physical paper and are beyond the control of the issuing body. To receive a dividend payment, the paper coupon must be presented to the issuing company.

This structure presents obvious advantages for equity holders: ease of transfer, privacy and lack of need to trust a third party, to name a few. However, it has often been argued that these advantages are outweighed by major disadvantages when it comes to mitigating financial crimes such as money laundering, terrorist financing and sanctions evasion.

Without any third-party control, it is very difficult to prevent bearer shareholders from transferring physical share certificates to bad actors. They can then use them as collateral for loans, use shell companies and agents to present coupons for dividend payments or otherwise obtain monetary gains that undermine the efforts of law enforcement agencies and regulators globally.

Because of these serious risk factors, bearer shares have been limited or eliminated in most parts of the world. Countries historically known for their strong consumer privacy protections – such as Switzerland – have completely abolished the issuance of bearer shares.

US states similarly known for their favorable corporate environment – ​​such as Delaware – have also banned ongoing bearer stock issuance, in an attempt to curb the proliferation of financial crime and allow companies to better understand those parties who have an ownership interest and serve as stakeholders in their ongoing operations.

Impact on the digital world

How does this affect asset tokenization? In short, many of the same risks present in bearer stocks – namely lack of registration and direct transfers – are the spectrums of risk when it comes to tokenization of assets and their transfer via blockchain technology.

Consider traditional cryptocurrency – if such a thing can be said to exist. Changes in the ownership of digital assets are usually only recorded on the blockchain and can be stored in software, hardware or self-hosted paper wallets, fully controlled by pseudo-anonymous users.

In this context, the centralized issuer may not have control over the dissemination of assets in the wild; although in crypto, this is a feature, not a bug. For obvious reasons, regulators are not too eager to bring these privacy-preserving but still risky features into the world of traditional stocks and bonds.

Stay safe

So what can be done? First of all, the flexibility and modularity of blockchain technology solutions can be used to innovate solutions to some of these financial crime problems.

Taking a page from stablecoin issuers, tokenized assets may be imbued with the possibility of being frozen by a centralized entity, if transferred to a bad actor or a wallet associated with risk beyond the issuer’s appetite.

Digital identity solutions – such as soul-bound identity tokens – can be leveraged to provide regulators and law enforcement agencies with insight into the identity of asset owners.

Whitelists can be applied to allow transfers to be made only to those counterparties who have passed the KYC process through the token issuer or its agent. Integrated blockchain analytics solutions can be used to automatically prevent the transfer of funds to or from any wallet deemed to pose too much risk.

Furthermore, an “auto-burn” feature can be built into the asset so that if the assets end up in the hands of the wrong people, they can be not only frozen, but completely destroyed.

Watch out

It is important to note that different organizations may adopt some or all of these approaches to combat financial crime related to tokenized assets. However, regulatory bodies will be required to issue guidance on the appropriate compliance risk management standards that should prevail in the industry.

Through meaningful public-private partnerships, asset tokenization can present an opportunity for 24/7, 365 markets that operate in a seamless and automated manner, freed from the rent-seeking that middlemen often impose on the industry.

This opportunity for greatly increased efficiency will only be possible if industry participants truly embrace a culture of compliance and work to mitigate financial crime in a meaningful way.