The transfer agent solution to the digital securities custody problem

By Vanessa Malone

In a previous blog, we discussed how a transfer agent’s role is of critical importance when it comes to maintaining truly compliant digital securities offerings.

We also introduced CustodyWare, our blockchain solution which enables an issuer’s designated transfer agent to compliantly custody digital securities, manage transfers, and maintain accurate shareholder listings leveraging the Ethereum public blockchain.

Today, we want to explain more about how this works, and why CustodyWare works the way it does to solve for previous industry pitfalls.

Quick recap of why transfer agents are necessary in today’s digital securities landscape

Engaging a transfer agent is mandated by the SEC for issuers conducting S-1 registrations or securities offerings under Regulation A+, unless 12(g) exempt. A section 12(g) exemption is difficult to accomplish as it requires an offering to have less than 500 non-accredited investors, less than 2000 investors of all levels, and for the company conducting the offering to have less than $10M in assets on its balance sheet.

Rule 506(C) of Regulation D

In order for a security issued under Regulation D to trade on a U.S. compliant secondary trading venue after a holding period, it must use a registered transfer agent. As the SEC website states “Because transfer agents stand between issuing companies and security holders, efficient transfer agent operations are critical to the successful completion of secondary trades.”

Good Control Location

Recently, the SEC has hinted that the blockchain is not a recognized source of truth when it comes to share ownership, which is where the use of a transfer agent comes into play in instances that don’t explicitly require the use of a transfer agent. Regulators already recognize transfer agents as good control locations and valid sources of truth when it comes to maintaining the identities and ownership of shares.

Besides being legally required for most digital securities offerings, the use of a transfer agent paired with blockchain technology also works to solve for current custody issues prevalent in both traditional and crypto markets.

The state of custody solutions

  1. They replicated existing custody solutions which in turn replicated the same inefficiencies, slow settlement times, and inaccurate shareholder listings.
  2. The solutions didn’t take full advantage of the transparent infrastructure provided by the blockchain.
  3. Custody solutions that relied solely on custodian features being embedded into smart contracts were limited and constrained by the immutable nature of the blockchain.

How CustodyWare solves for the above

Second, with the blockchain comes unprecedented transparency and accountability which have never before existed in financial systems. All transactions between the investor and transfer agent are signed and these signatures are transparently and immutably stored on the Ethereum blockchain. This protects issuers, investors and transfer agents as anyone can view the public ledger at any time.

Third, sometimes valid changes need to be made to digital securities. If the solution were to only exist using smart contracts, the issuer could be forced to burn, reprogram, and reissue new tokens each time a regulatory change or any of the other intricacies that come with managing securities happens. For example, while smart contracts can be programmed to automatically lift legends, this gets tricky when you’re dealing with multiple holding periods, affiliates, etc. For example, if a shareholder joins the board of the issuer’s company, this would make he or she an affiliate who is restricted from “insider” trading the security. With CustodyWare, the issuer can simply notify the transfer agent and the transfer agent can input the CEO’s KYC’d wallet ID into the CustodyWare portal and apply relevant affiliate status restrictions on the securities in that wallet. This approach also puts control in the hands of properly SEC regulated transfer agents instead of developers or CEOs, thereby adding investor protection.

Overview of how it all works:

  1. Only on instruction from an investor can the transfer agent execute token transfers and releases. The cryptographic assets remain the property of the investor, however appointing a transfer agent allows the investor to securely custody and manage their holdings.
  2. Utilizing a transfer agent sets up an issuer’s digital securities for compliant and efficient secondary trading. After any relevant holding period, digital securities can be seamlessly moved from custody to “street-name” for secondary-trading on a US SEC-regulated ATS.
  3. Using CustodyWare, transfer agents can maintain post-offering custody. From issuance through secondary trading, transfer agents can continue to maintain up-to-date shareholder listings, reports and ultimately perform the same duties they do for traditional securities to make an issuer’s life easier. Again, using a blockchain solution, tasks such as paying out dividends, cash, or other distributions to shareholders, sending out annual reports and sending proxy information for shareholders to vote becomes instantaneous.

Concluding thoughts

What is demonstrated with CustodyWare is the ability for capital market participants to adapt to the evolution of securities for the betterment of everyone involved.

About Horizon

Horizon licenses and operates global securities exchanges.

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