Public vs. Private Markets: The Beneficial Ownership Challenge & Case for Lookthrough
Public market operators suffer from lack of information about their shareholders. There’s a better way to handle beneficial ownership, and private markets have an opportunity to lead the charge.
As people who work at a transfer agent and data management company, we are laser focused on data. Shareholder data, equities & stock records, primary issuance, estate transfers, change of ownership due to gift or private purchase, secondary trades, the source of data, the owner of the data, who makes use of the data, you name it.
Private markets suffer from a severe data problem: information asymmetry, no transparency, and no ability to share data seamlessly across multiple parties. There has been an enormous effort to streamline capital markets activity, indeed the world is able to operate financially in a way previous participants never could have thought of. Imagine trying to explain high frequency trading to someone alive in 1950. This is the beauty and wonder of technology. We simultaneously create and solve new challenges as we bring new technology into existence. It’s incredible and we love that we get to experience it.
We’re on the precipice of seeing the complete transformation and emergence of private markets onto the world stage. Admittedly, it will take some time for private markets look like public markets with regards to the volume of liquidity, activity, and secondary trading, but that’s the future the digital asset ecosystem is working to create. Getting not only to watch, but actually participate, in this process has been incredible to say the least.
Being up close and personal has afforded us the privilege to observe the differences between the public and private markets. It’s these core differences we’ll discuss today.
Before we begin, let’s level-set on several definitions that will aid us in our examination of public stock market activity vs. private secondary markets via the alternative trading system, abbreviated to “ATS”.
Registered shareholders are those who’s names are directly registered with the company on their cap table under their name. The most obvious example of this is where public companies issue stock options or RSU’s to employees, upon vesting and exercise, those employees are added directly to the cap table by the transfer agent as shareholders. So John Smith, as an employee of Apple, is given shares as part of his compensation, and Apple instructs ComputerShare, their transfer agent, to increment those shares in John’s name on their cap table once he’s exercised and is a common stock shareholder.
Street Name Ownership
Through street name ownership, we come to the case where the name on the cap table is not the end user who benefits from the financial instrument, but rather a third party, like a bank, custodian, or broker. This introduces the concept of the “beneficial owner” of a security. From Investor.gov we get the following definition:
A beneficial owner holds shares indirectly, through a bank or broker-dealer. Beneficial owners holding their shares at a broker-dealer or bank are sometimes said to be holding shares in “street name.” The majority of U.S investors own their securities this way.
If John Smith was to go to his broker right now and purchase Apple stock, the de facto standard is for those securities to be incremented on a cap table in the name of the broker, say Fidelity, not the individual name of the investor. The “street name” owner is Fidelity, while the “beneficial owner” is John Smith. This will be critical since the differences in trading models and environments between public and private markets equate to a sharp contrast, as well as an interesting opportunity.
To start, let’s review how an investor actually purchases a security in the public markets as a contrast to how private markets work.
Buying a Public Security — An Overview
When buying Apple, here’s what your experience might look like:
- Investor logs into their broker
- Selects the security to purchase, in this case AAPL
- Brokers go to the stock exchange where that security is listed, in this case Nasdaq
- Broker buys the security on behalf of the investor
- Broker informs Transfer Agent that they (the broker) need to increment their total ownership of AAPL shares
- Transfer Agent records the updated purchase on their books in the Street Name owner of the Broker
Note: In reality most large brokers actually cache and store blue chip securities like Apple, and sell them directly to the investor when buy orders come through rather than needing to go to the Nasdaq for the purchase of the security from another broker, but we leave it like this to highlight the more complex case. In the cached example, the broker simply updates their internal ledger to reflect the change in beneficial owner from the broker to the investor, and both Transfer Agent and Issuer still have no conception of who the beneficial end investor is.
The thing to note here is that the transfer agent, and by association, the issuer themselves, has no direct relationship with the beneficial shareholder. The broker maintains control over every part of what the investor experiences, with the transfer agent and issuer kept in the dark about who that end investor is. If the issuer wants to know who is holding shares in the street name of the broker, they have to approach the broker directly and request it.
According to FINRA, there are roughly 3400 brokers in the United States, and while not all of them offer or emphasize NMS public market securities to their customers, many of them do!
Imagine the logistical nightmare of going one broker at a time and trying to gather the list of investors that have purchased and are holding securities in the street name of their brokerage. At any level of scale, you’d need multiple full-time employees to manage that tedious process.
A Singular Trading Venue
An important consideration in public markets is the fact that while there are many different brokers that investors can engage with to purchase securities and financial products, there is only one trading venue — the Nasdaq.
Apple is listed on Nasdaq, and not on the New York Stock Exchange, Boston Stock Exchange, Chicago Mercantile Exchange, or any others. This means that handling trades between brokers, who then turn around and offer those securities to their customers, is relatively straightforward. Nasdaq is the ultimate authority as the nationally registered stock exchange and trading venue for AAPL.
There is a one caveat to what we present here around public securities, and that’s the dual listing. While exceptionally rare, it is possible for companies to list their equities on multiple stock exchanges simultaneously. Dual-listed companies, abbreviated to DLC’s, often use this dual listing mechanism to support trading in multiple jurisdictions, but it can also be done simultaneously on multiple domestic stock exchanges as well. For example, Barrick Gold is a dual-listed company, trading on both the Toronto Stock Exchange in Canada as well as the New York Stock Exchange in the US.
A recent example includes Nasdaq-listed Nutriband performing a dual listing on the Upstream app, underpinned by Horizon Fintex (providing NFT support) and MERJ Exchange, a regulated digital asset securities exchange based in Seychelles.
According to the Corporate Finance Institute, “Any company that is listed on more than one exchange must fully comply with the legal and listing requirements of all the countries and their respective exchanges that it is listed in. Complying with the regulations of only one of the countries or exchanges is not sufficient.” This means added complexity in following different compliance and reporting standards, which seems to be the primary deterrent for even the largest and most profitable of companies. One example was Charles Schwab, who was at one point, listed on both the NYSE and the Nasdaq. They have since delisted from NYSE (in 2005) and now trade exclusively on the Nasdaq.
Whereas proximity used to mean an advantage (you had to physically be on Wall St. to participate in market activity), the vast amount of digital infrastructure and work done in building out the large stock exchanges in the US mean that brokers, custodians, and retail investors have the ability to find and purchase securities despite there being multiple venues for trading. This has effectively rendered domestic dual-listings unnecessary.
Buying a Private Security — An Overview
An investor wishing to purchase ACME shares would experience the following:
- Investor goes to the executing broker dealer
- They place an order to buy ACME shares
- The order is routed to the ATS, the sole ATS of record for Acme
- The match is sent back to the broker
- The broker, if self clearing, allows the securities to move from seller to buyer and cash from buyer to seller
- The purchase and associated information is only sent back to the transfer agent should the investor initiate a withdrawal
- Vertalo as the transfer agent maintains a complete record of the full cap table, including the street name owner of the custodial broker, but has no insight into who holds shares within the omnibus holding listed on the cap table
Note: We’re highlighting how this works in Model #1 of our article, The 4 Unique ATS Models of Trading Secondaries, below. Of course there will be subtle differences should you employ one of the other models, but at a high level this is accurate to how the trading process works for privately held shares trading on an ATS.
The core difference here is that the ATS, the party responsible for handling order matching and trading, is far more ubiquitous than a nationally registered stock exchange. As of this writing there are 68 outstanding ATS licenses in the United States, as compared to 13 national stock exchanges.
If the executing broker is a special purpose broker dealer, they have the ability to take custody of the asset, necessitating a deposit from the transfer agent or issuer directly, into the broker-dealer’s possession. When this occurs, the shares move into the street name of the executing broker, and the identity of any new purchasers remains a mystery to the transfer agent and the issuer.
Now to be fair, if you as an issuer have a BD/ATS that has listed your private security for trading, and the cap table reflects the name of the broker due to the Street Name vs. Beneficial distinction, the trading and maintenance of the security and your investors is relatively straightforward. You would have a “split ledger” scenario where the cap table is divided between the registered shareholders at the transfer agent and the deposited shares held at the BD/ATS, so collecting a comprehensive list of shareholders becomes a gathering exercise, but not one that’s overly exhaustive or complex.
The question to ask here is, what happens if you list an asset on multiple ATS’s simultaneously? What happens the issuer would like to increase liquidity by bringing multiple ATS’s to the table?
Remember — there is only one Nasdaq. Except in the dual listing case, for all public companies there is only one trading venue for their securities, even if there are many unique venues for purchasing those securities. So what could listing on multiple ATS’s mean for issuers?
Multiple Trading Venues
Adding a second ATS into the trading mix introduces new, interesting, and unique challenges. Assuming the model is one whereby the transfer agent maintains the Good Control Location, one challenge includes race conditions, where two competing trading venues might try to simultaneously trade the same security held by one party, effectively leading to the double spend problem.
Consequently, the double spend problem is one of the primary challenges blockchain sought to solve for coming out of the Global Financial Crisis in 2008. It’s poignant that we’re here now, able to use blockchain technology to account for this, but it’s a tricky technical challenge nonetheless, especially where reporting is concerned for failed or rejected trades.
If an issuer wants to dual-list their shares, why not just tranche it out? Create one tranche or class per ATS, then list each respectively. Wouldn’t that solve the race condition and/or double spend problem?
Perhaps, but it might also bring with it problems around the bid density and depth, as well as equity management. In order to properly tranche out a dual listing, the securities might need to be different classes. This market is still young, so breaking up otherwise concentrated orders would not be the best approach to adding liquidity.
If an issuer was to dual list their securities, FINRA’s Rule 5310, Best Execution and Interpositioning, a detailed rule requiring trading venues to seek the best price for a security, might also come under consideration. Rule 5310 “…requires that, in any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”
This requirement has largely prevented dual listing of securities on ATS’s, as well as market making in the private digital asset securities space, since aggregate data feeds would have to be built to each ATS where the asset is listed. Typically this is handled by a Securities Information Processor, or SIP. To our knowledge, no singular player currently exists to perform this function within private markets.
If you’d like additional information on the role of SIP, Polygon.io has a great breakdown and description of how SIP’s function.
Why run a dual-listing on different ATS’s?
A simple Google search of this question yielded these results:
1. Access to a broader investor audience
One of the reasons a company may resort to dual listing is the opportunity to raise more capital. It provides the company with access to a larger investor base by tapping into the existing customers of multiple BD/ATS partners simultaneously.
2. More overall liquidity
Additionally, dual listing increases the overall liquidity of the traded stock. It allows a larger number of participants to engage in the buying and selling of the stock.
3. Broader trading windows
Furthermore, if a company is listed on an exchange in a different time zone, it provides participants opportunities to trade more often within a given 24-hour period. While there can be restrictions for trading windows of securities, certainly having operational windows that span the continental United States could be useful and unlock liquidity.
A more in-depth answer might be that in order for private markets to attain a healthy amount of liquidity, we’re going to need the market architecture and support necessary to create depth and healthy activity. Everywhere we look we see mention of the fact that private markets lack maturity and depth, and it’s precisely this void that those of us in this space are seeking to fill.
The Case for Lookthrough
We’ve established that private markets are still fragmented, and that a scenario whereby an asset could be listed on multiple ATS’s simultaneously is possible, albeit technically difficult. Now we’ll make the case for lookthrough into holdings held at a special-purpose broker-dealer or custodian.
Lookthrough is defined as the ability to pierce an omnibus holding (the street name owner on the cap table) and break out an omnibus or commingled singular holding into the holdings of each investor respectively. Technically this would simply require an API integration allowing a third party, like a transfer agent, access to see who holds what within the omnibus holding on the cap table.
One of the primary reasons companies who trade their assets on an ATS engage with Vertalo as their Transfer Agent is the fact that Vertalo’s technology can support beneficial ownership lookthrough, via API integration, with the ATS of record for that security. This has been one of the top named reasons existing customers of ours chose to migrate away from their existing transfer agent, in some cases legacy players with many clients, over to Vertalo. Lookthrough, and a consolidated cap table, is of the utmost importance.
But why should an issuer want to know who every beneficial shareholder is?
For this answer we turn briefly to the crypto space. We absolutely love the crypto industry which is what makes it so interesting to watch the passion and zeal with which investors defend their projects.
No where has this been more apparent than the NFT market. Buyers of these NFT’s had the ability, through the purchase and ownership itself, to join a club and participate in an exclusive community. We’ve tried, unsuccessfully, to find this video, but we remember seeing a Bored Ape Yacht Club (BAYC) owner and this was their experience:
- They arrived at some exclusive party in NYC
- While waiting outside the party, they signed a transaction with the wallet that held the BAYC NFT, and
- The door to the party was automatically opened and the NFT holder was allowed access because he proved, cryptographically, that he was a community member and NFT holder
It was straight out of Minority Report!
This cool technical experience aside, as an issuer, we want shareholders to have unique benefits. We want to establish a relationship with them that extends beyond simple ownership. We want them to have a vested stake in our activity as an issuer. In order to do that, we need to know who the end beneficial owner is.
While we don’t have hard data for this opinion, one thing we’ve noticed is that many who hold Apple stock also use Apple products: the iPhone, Macbook, or Apple TV. The same can be said of Tesla, many who drive Tesla cars also own Tesla stock. Of course, not everyone who owns Tesla stock drive Tesla vehicles, certainly the bull run of 2021 led to much speculation around TSLA specifically, but there’s something to be said for the value of your users and your shareholders being one and the same.
As an issuer, we want our shareholders engaged. We want their full buy in. We want them to talk about me to their friends, colleagues, and anyone else who will listen. We want them to feel like they’re a member of an elite community for buying our equity. This requires us to create and maintain a relationship with them.
We can already see the job title: Director of Investor Experience.
In a BBC documentary from 2011, neuroscientists noticed that Apple users defended Apple and its products with the same zeal as those who defend their own religious beliefs. That level of user commitment is something issuers could aspire to.
Our ability to succeed as a company very well could hinge on our users and/or shareholders being fully bought in. And we want to create community and engagement like Apple, to spread our products or services via word-of-mouth advertising through our user/shareholders.
How does lookthrough work?
We imagine this breaking down in one of two ways. The first would be the where the transfer agent serves as the central repository of shareholder information, no matter how many ATS’s are trading the issuers asset like such:
Since registered shareholders will already be listed with the transfer agent, a logical place for lookthrough to occur would be at the transfer agent, as depicted in the diagram above. An issuer could list on as many ATS’s as they like, and require the ATS to offer lookthrough to the transfer agent as part of their listing. The transfer agent could then architect lookthrough with the ATS directly, allowing them to see both the Street Name of the custodian or custodial broker, as well as the ultimate prize of who the beneficial shareholders are at any given point. Executed trades and new shareholders coming within the Street name owner could be a simple API call from the ATS instructing the transfer agent that a new shareholder exists.
We refer to this as the “Shareholder table” rather than the cap table, since legally and definitionally, the cap table will be registered shareholders plus street name omnibus shareholders, so referring to the beneficial owners within an omnibus holding as “on the cap table” would not be correct.
Currently, Exodus’s Common Stock, trading on both the tZERO ATS, as well as Securitize Markets, fits this overall model, with the Securitize Transfer Agent sitting in between this process. Jonah Schulman, from Security Token Market, actually performed an arbitrage of a single share of Exodus off tZERO and onto Securitize, where it was trading at a premium (a $6 / share premium in fact) earlier this year. Securitize even has a breakdown of competitive pricing for why their ATS is preferable for investors. When service providers compete, prices come down, quality of service goes up, and that value is returned to the investor/end user.
The second model that could work to support lookthrough would be one whereby a single ATS is able to architect lookthrough themselves, then relaying new shareholder information to the transfer agent upon receiving it.
Why include the transfer agent as holding these records if the Master ATS will already maintain a full ledger? This comes down to the division of responsibilities, since the primary function of an ATS is order matching and trading, whereas the primary responsibility of a transfer agent is bookkeeping and shareholder ledger management.
The primary benefit here would come down to liquidity and the ability for dual (or triple, in the case of the diagram) listings to support market liquidity and depth. This would include order routing and best execution provisions, which would also require a SIP, but at a high level this could play a significant role in the private securities space. Indeed one of the missing elements in private markets is the support from, and technical integration of, market makers, non-technical brokers, and other liquidity providers like what exists in public markets.
Direct ATS → ATS integrations like this could radically enhance liquidity and market activity for every participant and variation thereof (brokers, issuers, banks, custodians, market makers, transfer agents, etc.). As ATS’s specialize, the ability for unique and new audiences to get access to new products could open up new relationships for all parties.
Lookthrough and Privacy
We can hear naysayers winding up — “This is all well and good, but what about privacy? What if shareholders don’t want their information recorded on the cap table, but would rather have their name listed in Street Name ownership only?”
This feels like a solvable operational challenge to me, since the primary benefit for lookthrough comes down to a more formal and individualized relationship with the end user. If that beneficial shareholder doesn’t want any sort of relationship beyond owning the product itself, they could certainly opt out of communications and/or contact from the issuer.
As privacy minded individuals, we personally wouldn’t want to share our securities purchase information either, so we completely respect this position. If we were supremely concerned with a private purchase, a well-designed corporate structure could be deployed to maintain our privacy.
While the private secondary market is growing every day, it still largely suffers from fragmentation, illiquidity, and information asymmetry. Issuers often don’t know who beneficial shareholders are, leaving them only able to use third parties to communicate with shareholders rather than host the communication directly.
There is power in crafting and developing a unique relationship with a shareholder, especially where new products, services, features, or feedback, is concerned.
Lookthrough into custodial accounts is one method to accomplish this. If properly implemented, it could provide issuers with powerful shareholder data, giving them access and key insights into their users and allow them the ability to include those shareholders on their journey. Private markets have an opportunity to create and offer direct relationships between issuers and investors, and we’d love to see what it could mean for participants in the space if we’re able to build it.
Till next time.
Disclaimer: We are not attorneys, broker-dealers, investment advisors, or wealth advisors. Nothing presented herein is nor should it be considered as legal, professional, business, investment, or any other kind of advice. The information presented here is done so for educational, informational, and entertainment purposes only. Always consult a licensed professional before taking professional, investment, or legal action.