We’ll preface this by mentioning our passion and zeal for bitcoin and blockchain technology. After looking at many different blockchains from all over the world, we firmly believe that if you strip out API-based middleware layers (that could serve as central points of failure), the only truly decentralized network on the planet is the bitcoin network.
Bitcoin serves a critical purpose in storing value, disintermediating third parties, and transferring control over assets to the owners of those assets. With this however, there is a trade off — those who hold their own bitcoin in sovereign wallets run the risk that they might lose those assets, never to be recovered.
The trade is sovereignty for security.
With privately managed wallets, you forfeit security in exchange for the right to sovereignly hold your bitcoin. No one is coming to recover lost keys. If you lose the wallet or private keys, your bitcoin is lost to you forever. In the bitcoin case, this is a feature, not a bug. One unique element of modern finance (we may write more on this later) is the power one surrenders to third parties in this case. We’re reminded of the ethos of the original cypherpunks, especially Nick Szabo’s outstanding piece from 1997 entitled The God Protocols. It is as applicable today, if not more so, then when it was originally penned a quarter century ago.
Admittedly, he was talking about banking and cash, not securities as controlled instruments vs. bearer assets, but the primary point is worth noting: when you grant an intermediary supreme control over your assets, THEY OWN YOUR ASSETS. And they can shut you out of them at any time. A dear friend of ours was locked out of his Business PayPal account, that had hundreds of thousands of dollars in it, for no stated reason, and there was basically nothing he could do.
This is why bitcoin is so revolutionary. Your bitcoin are YOURS, and no one can take them away from you.
This assumes proper storage and handling of wallets, private keys, etc. We are very familiar with the long list of fraud (Mt. Gox, Quadriga, NEM, Celsius, Voyager, 3AC, et al) that has occurred in the blockchain space.
Bitcoin was the original bearer asset in the digital asset space, but since then we’ve seen staggering growth, particularly in DeFi, with the ERC20 instrument. Most cryptocurrencies, statistically speaking, are ERC20 tokens. They’re lightweight, dead simple to create, and relatively cheap to move (network/activity fees permitting). For the balance of this piece, please assume when we talk about bearer instruments, we’re referring to the ERC20 token standard, since it’s the most commonly used instrument to represent something (crypto, utility token, securities, etc.) on chain.
Before we make the case against ERC20 tokens for securities, let’s go back to beginning.
Where do bearer assets come from? And where’d they go?
According to Investopedia, Bearer Bonds (a form of bearer asset) “…are government- or corporate-issued debt instruments that differ from traditional bonds in that they’re unregistered as investment securities. Consequently, no records exist that list the owners’ names. As a result, whoever physically holds the paper on which the bond is issued is the presumed owner, giving them a greater measure of anonymity than more common bond offerings present. But since no investor names physically appear on bearer bond papers, it’s nearly impossible to recover such bonds if they’re lost or destroyed.”
Bearer instruments are unique because the logic is completely circular — the owner of bearer asset is defined by the person who owns the bearer asset.
We should key that into excel and record the circular logic error it throws when trying to do that type of calculation.
Bearer assets were outlawed in 1982, particularly since they could be used to evade taxes. The Tax Equity & Fiscal Responsibility Act of 1982 made the issuance of new bearer assets illegal. Previously issued bearer bonds can still be held and used in transactions, but since there are no new bonds being issued, the number of bearer bonds in existence has dwindled, and will most likely be altogether forgotten except to historians and perhaps rare document collectors as time goes on.
After nearly 30 years of no new bearer instruments being issued, we saw bitcoin emerge in 2009. This was amazing for privacy and sovereignty minded individuals who took the time to learn about Public Key Infrastructure & Private Key Management. There was a way to transact pseudonymously, and own your assets end to end. It marked the start of a new period of the internet.
While we’d love to see the world return to privacy with regards to asset ownership, we think that may be a naive desire. The world of securities simply doesn’t operate this way.
Securities are not sovereign.
Haven’t been since 1934. The most broad and sweeping of regulations for the securities industry came through the Securities Exchange Act of 1934, which highlighted a number of requirements for issuers, brokers, and other intermediaries like custodians, around the treatment of these assets. The most important of these center around investor protections. They include things like:
- the ability to restore a security in case of a loss
- an escheatment of a security (stems from prolonged lack of contact with an investor, sometimes due to death, estate transfer, or abandonment)
- the unwinding of an illicit trade or transaction
It also named required standards for the following:
- Corporate Reporting
- Proxy Solicitations & Shareholder Voting
- Tender Offers
- Insider Trading
- Registration of Exchanges, Associations, etc.
If you’re interested, read the entirety of the SEA of ’34 here…
Please note — the investor protection requirements stated above are not possible with ERC20 instruments held in sovereign wallets. That’s the point…they’re sovereign! Holders can do what they please with them, including transferring them, staking them (in the securities case this could look like margin within your brokerage account, although there are fundamental differences), or even burning (destroying) them. As Richard Epstein aptly notes, disposition is an essential characteristic of ownership.
Since the SEA of ’34 we’ve seen massive growth of the regulations in this space, particularly focused on preventing money laundering. You have the Bank Secrecy Act, the Patriot Act, the Anti-Money Laundering Act of 2020, to name a few, but these furthered the notion that issuers, brokers, and custodians, need to know who owns their asset, while still satisfying the restoration, clawback, transfer, or escheatment instances of issued securities.
Now, in the bearer asset case, architecting control over securities is simple: no sovereign wallets.
Custodians, or in some cases, custody technology providers, can custody the assets for you, and the burden of maintaining private keys, wallets, and ledger balances falls to the custodian to manage. This harkens back hundreds of years, to the first goldsmiths who could not only work, shape, and smelt gold, but vault and store it also. Their expertise of gold smithing put them in an extraordinary position of power and control.
As a depositor, your gold was co-mingled in the same vault as all the other depositors, and the custodian managed an internal ledger of who was owed what. Side note: this was also closely tied to the introduction of fractional reserve banking, since the custodians realized, through their bookkeeping efforts, that only about 15% of depositors would withdraw their gold at any given time, leaving the other 85% to be lent out in exchange for interest. See Edward Griffin’s work, “The Creature from Jekyll Island” for more on the history of gold as commodity money and the inception of fractional reserve banking.
If one was to use a bearer instrument for securities issuance, and it somehow got out the custody of a registered custodian, the issuer could be faced with a litany of problematic scenarios. A few that come to mind:
- What if the wallet holding the securities is lost, will you re-issue those securities to a new wallet?
- What if that transfer was fraudulent, and the receiver wants to redeem the securities later?
- How would you flag securities as abandoned?
- How would you handle death, divorce, escheatment, clawback, or estate transfer, and maintain compliance with securities laws?
- How would you prevent decentralized trading of these assets? (hint: you can’t)
The risks of using sovereign bearer instruments as securities are severe to say the least.
That said, it stands to reason that custodians would simply treat digital assets the same as cash, gold, or other assets they take custody of. They are the vault and can maintain these assets without issue. Many of the digital custodians today have done exactly this, with multi-party computation and other multi-sig protocols giving the holder the comfort that the bearer instrument won’t be lost.
But as we’ve noted, securities behave very differently from bearer instruments.
This is where blockchain offers an interesting promise. The bearer instrument is only one type of instrument that can be issued as a token; there are many different types. NFT’s for example, while still bearer in nature due to their sovereignty, carry unique characteristics that make them distinct from a fungible bearer token like an ERC20. Most NFT’s on Ethereum are issued under the ERC-721, ERC-722, or ERC-1155 standards, which all differ from ERC20.
When considering the control requirements of securities, the issuing protocol (ERC-777, ERC-1404, ERC1155 etc.) has the ability to encode controls, trade and transfer restrictions, programmatic tendering, and other guardrails as dictated and required by securities law.
Having held many conversations with regulators in support of our clients business efforts, we’re convinced that most of the hesitancy from regulators stemmed initially from a lack of understanding of how blockchain and token protocols work. Having spoken to the SEC, FINRA, and other regulatory bodies, the primary concern underpinning most of their questions seemed to fall around sovereignty and the lack of oversight and control of sovereign, irrecoverable bearer assets.
Just recently , the SEC’s enforcement division released comments on how they are focused on investor protections of digital assets.Additionally, the SEC just set an astounding precedent by naming 9 coins trading on Coinbase as “crypto asset securities” per the Howey Test.
We’ll say it again, securities are not sovereign, but controlled instruments.
Enter the Transfer Controller
In order to properly satisfy regulatory requirements, Vertalo treats tokenized securities as controlled instruments. They are not:
- Sovereign
- Transferable or tradable, without the permission of the issuer
- Losable or otherwise corruptible (paper certificates can decay after all)
- Stake-able, without the permission of the issuer
Within the ERC20 protocol are nine different methods that you can call when interacting with the token. One function includes:
function transfer(address _to, uint256 _value) public returns (bool success)
The transfer:to function allows users to send their tokens from one address to another. This happens every day with ERC20 tokens (and similar tokens on different chains), especially within DeFi. Currently the Ethereum network boasts an impressive 1.2M transactions per day.
Rather than allow blanket transfer and tradability of these assets, which is not legal where securities are concerned (see: Ethereum DEX Uniswap Drops Tokenized Stocks As Regulators Close In) Vertalo created the controlTransfer function; its holder is the “Transfer Controller.”
To reiterate, as an SEC-registered Transfer Agent, Vertalo has the ability to conduct transfers from shareholders, including the cases outlined above where transfers need to happen outside the purview or approval of the investor (escheatment, estate transfer upon death or divorce, restoring a lost security, abandoned property, etc.)
The Transfer Controller function satisfies the legal requirements outlined in the SEA of 1934 surrounding investor protections. This is also where the history is fascinating, since the law doesn’t actually state you need to have a custodian manage the asset.
Rather, it says that brokers and issuers must “establish a good control location” over the security. In 1934, both public and private markets suffered from friction, from information asymmetry, and from a lack of transparency. As part of a way to protect investors, the SEC enacted this provision, which would prevent the loss or destruction of a certificate (all paper-based) by requiring that it’s location be deemed a good control location. Think paper certificates in physical bank vaults.
The Transfer Controller function is a good control location for digital asset securities on chain. It can satisfy all the requirements and remove the risk of loss, theft, or destruction for issuers, brokers, banks, transfer agents, or any other market participant. Further, the Transfer Control function can be delegated to third parties, like custodians, banks, brokers, ATS’s, or other regulated entities. Rather than treating these as sovereign, we should take a more mature approach that stands in line with regulation and established case precedent. Using ERC20 for securities only makes sense if a custodian is involved end-to-end, otherwise it’s a poor choice for securities issuance on chain.
Blockchain, distributed ledgers, and smart contracts have so many real & functional implications (hopefully more on this later) and we are only beginning to see the promise it offers to capital markets and private asset ownership. We have a chance to manage on-chain securities issuance properly, let’s take it.
Disclaimer: None of this information is nor should it be considered as professional, legal, investment, or any other sort of advice or recommendation. The information presented herein is done so for informational, entertainment, & educational purposes only. Please consult an attorney or licensed investment professional before taking any investment or professional action.
