You cannot avoid it. Everywhere you turn, people are talking about cryptocurrency, investing in cryptocurrency, debating the future of cryptocurrency. You cannot walk down the street without hearing the words “Bitcoin,” “Ethereum,“ or “mining.“ And that is not just while walking down Wall Street, that is while walking down residential streets of Oklahoma.
Now entire conferences are being held on cryptocurrency and all its opportunities and challenges. Specialists are popping up everywhere. Despite all the grumbling over the last few years about the bitcoin bubble, the use of cryptocurrencies and related blockchain technologies is growing at an incredible pace.
Just when a lot of the industry is finally comfortable with the idea of funds investing in various cryptocurrencies, more curveballs are being thrown, the latest being around tokenization.
More and more investment managers are launching tokenized asset funds. While the industry is still settling on its terminology, this can mean a few things:
- Funds are letting investors come in with in-kind subscriptions of cryptocurrency.
- Investment managers are having their funds issue share classes denominated in cryptocurrency and represented by blockchain tokens.
- Secondary markets are being formed for these tokenized share classes.
What are the issues and what are parties looking for?
Investment managers and investors are leading the charge. Managers want to be able to invest in cryptocurrency or tokenized entities and offer tokenized classes. Many asset managers and family offices that have invested in cryptocurrencies have expressed interest in using their cryptocurrency to invest and to hold tokenized assets.
There are more than a few issues/questions that naturally arise here:
- How is know-your-customer (KYC) performed on the token holder?
- How is ownership substantiated?
- How is the secondary market monitored so no anti-money laundering laws are broken?
- How is KYC performed on purchasers participating in the secondary market?
- Volumes can be high, so how can the industry keep up?
- How is liquidity dealt with?
- How do auditors gain comfort with ownership?
- How do fiduciaries gain comfort with the issues above?
None of these issues are insurmountable but some require thinking outside of the box. And these “out of the box” ideas also need to be offered in an efficient way to keep up with volume and mitigate risk. Adding body count will not suffice. A technology-based solution is required.
How can these issues be solved?
Having KYC performed on token holders is not an impossible task. In fact, it is not very different from regular KYC on an investor. The primary concern is over ownership and control of the wallet used to subscribe to the token. This can be proven by several methods, such as using microtransactions while in communication with the potential investor. A secondary concern is the source of funds that are coming from the wallet. To gain assurance that the source is legitimate, a risk-based approach is used. A combination of wallet behavior analytics with token history tracking can be used to ensure the cryptocurrency being used is not sourced from a previous exchange theft or known illicit source.
From a fund administrator perspective, one of the concerns with a tokenized share class is the potential high volume of investor transactions. To accommodate this, a change in behavior is needed by all parties. It is not efficient for KYC to be a manual task anymore, especially with all the additional regulatory demands and the volume of transactions expected.
GRADA offers a centralized KYC platform whereby the onus is on the would-be investor to complete the KYC as required by the administrator. The GRADA platform then verifies and validates these documents and answers. GRADA electronically validates many documents with the issuer – including passports and certificates of incorporation. GRADA also uses advanced analytics to confirm other aspects of KYC so that administrators can gain comfort in the existence and residence of new investors.
When a fund or asset is tokenized, a special smart contract created by GRADA is used that not only sets parameters that must be met before purchasing (such as a minimum value or being a qualified investor), it also ensures that secondary transfers cannot take place unless these conditions are also met.
The Titan Platform by AdvancedAIS is an all-in-one, cloud-based portfolio accounting, multi-currency (including cryptocurrencies) general ledger, and transfer agency/income allocation platform that has been built from the ground up by seasoned fund administration accountants.
By combining these two SaaS (Software-as-a-Service) platforms, Titan and GRADA can tokenize a share class or asset while ensuring KYC is verified both on the token holder and anyone who purchases the token on a secondary market. The smart contract used for tokenizing the class/asset interfaces with the platforms to confirm that all the requirements to hold that token by an investor are met.
For example, if a fund’s investment parameters include ensuring KYC is complete, excluding U.S. citizens, allowing only “qualified investors” and having a minimum equivalent to US$250,000, then these parameters are written in to the contract. When a transaction occurs, the smart contract calls the GRADA platform. The GRADA platform assesses the parameters against the data from both the seller and buyer and returns a result indicating whether the transaction can proceed or not. If the transaction proceeds, the smart contract writes it to the blockchain. Once confirmed in the blockchain, GRADA pushes the transaction details into Titan along with any required investor information or related KYC documentation.
The required integration of this process is made easier by both platforms sharing the same DNA. The Titan Platform was originally architected by Peter McKiernan, co-founder of AdvancedAIS, 12 years ago. He is both a chartered accountant and software architect and a few years ago, he saw a need in the finance industry for a centralized KYC and risk analytics system. Using a similar architecture to the Titan Platform, he then designed GRADA.
Although the mention of “tokenization” has many service providers grinding their teeth and seeing things in terms of additional risk, we disagree and are excited about the new opportunities created.
We believe the use of tokenized funds and smart contracts is going to open up a whole new world. For example, historically, private equity (PE) managers would go about sourcing funds first, and then look for deals to invest in. With the use of smart contracts, PE managers can market the deal to investors first, noting that they need a certain total of investment before the deal can proceed. This can all be built into a smart contract. In this way, investors are assured that should the total capital raise not be successful, their money will be returned. This will turn the PE deal raising process upside down. And that is just one example of the various opportunities that will arise due to the use of smart contracts.
While gathering feedback about how the industry would feel about working with our platforms on crypto and tokenization, we had a lot of interest from various parties and a ton of idea generation of how to create this ecosystem that would benefit anyone involved in the crypto industry.
For instance, we saw a need for liquidity for token holders and while talking to a market maker out of Chicago, we got them comfortable with how GRADA and Titan would eliminate risk and they offered to provide this liquidity. We were also talking to an exchange in Canada and again, once we explained to them how our technology mitigates risk, they offered to act as a crypto exchange.
It is an exciting and fast-changing industry. Many service providers are just wrapping their heads around understanding it, identifying the associated risks and figuring out where they fit into the landscape. The companies that can get there first are going to do well.