There's Something About Tokenizing Corporate Stock...
Corporate stock is already digitized, but seldomly tokenized on decentralized ledgers. Even though it seems an obvious use case, in this post we examine why blockchains aren't tracking stock yet.
There’s something about corporate stock tokenization. For some reason, it hasn't really happened yet.
Maybe it is because it’s easier to tokenize native digital assets, so real-world assets are lagging as a use case.
Property title registries for instance were heralded as a godsend for blockchains, but that hasn’t really happened yet either, and real-estate itself is still largely securitized the old way.
In this context, tokenizing corporate stock is best thought of as a “meta” use case, since real-world assets, including real estate, are typically held via corporate vehicles.
In other words, if you manage to tokenize the stock of such holding vehicles, you abstract the ownership of the underlying: Instead of funny cartoon pics or tokens-out-of-thin-air, tokenized corporate stock - a subset of what’s known as Asset Rights Tokens (ARTs) - represent and track ownership of real-world assets on blockchain.
This post asks what it is about tokenized corporate stock. We probe the reasons why corporate stock is still offchain, examine the benefits of putting corporate stock onchain, size its opportunity and propose a possible implementation.
A tens of trillions dollar use case
Let’s start with market size.
According to numbers we ran in-house, an estimated 68% of all value in the world (land, buildings, airplanes, car fleets, drilling platforms, patents, enterprises, domain names, etc.) is held in private companies. The remainder is held either in personal title or via publicly listed shares on the world’s stock exchanges.
If we apply this 68% to a global GDP of an estimated 88 trillion dollars, this means that close to 60 TRILLION dollars worth of assets are held via private company stock (or other titles such as partnership interests).
Any VC who sees an “addressable market” of this size should drool and beg you to accept their check. Yet we haven’t really seen that much action in this corner of the blockchain space.
So there must be other reasons why nobody seems to work on tokenizing corporate stock. In what follows, we list what we believe are the main reasons the potentially biggest promise for blockchains remains unfulfilled.
1. A cynical reason
Let’s start again with size. Perhaps because of the size of this market, so many layers of intermediaries feast on it that they’ll never allow somebody else to eat their lunch.
This is especially true for listed stock, which has wedding cake layers of middlemen, from the exchanges themselves to their member brokers and banks, to transfer agents, clearing houses, proxy voting firms, and at there very top of the cake, the Depository Trust Company (DTC) which custodies most public stock in the U.S. and maintains a ledger of ownership for banks and brokerages.
Despite the clear advantages of “T+0” settlement, putting public stock on blockchains has been a graveyard for many permissioned blockchain projects.
At the time of blockchain’s first ascent (late 2010s), when no tradfin could be seen without an in-house distributed ledger project, clearing and settlement was the Holy Grail of a crop of permissioned chains such as R3. Most projects have died a quiet (and some less quiet) death.
Arguably, banks tore themselves apart by having their internal blockchain projects bite the very arm that fed them. This revenue cannibalization is one of the reasons why innovation within big organizations is so hard.
2. The SWIFT syndrome
What about public ledgers?
They would need to provide a unique selling point (USP) for the whole legacy system of public stock trading, which many perceive sort of works, to move away from the cascade of intermediaries to a peer-to-peer record of ownership with finalization of trades based on distributed computing power.
Why replace the system we’ve got used to with uncertain technology based on “crypto”, which participants only read bad things about? “Who is the sysadmin in all this?” they ask.
It is the SWIFT argument: if it ain’t broken, why fix it? It is for this reason that the majority of payments still run on SWIFT, despite its operating hours and archaic messaging system.
In the same way, publicly listed stock is to a large extent already digitized, and ownership of private company stock can legally be recorded without issuing actual stock certificates by using a book-entry system.
We will get to the USP for blockchains later and make the case why distributed ledger technology can provide clear advantages over the legacy system, especially for private company stock, but for now speed isn’t part of the USP: presently, for transactions to finalize at speed, either security or decentralization would need to be sacrificed.
But speed issues are being addressed in Layer 1 chains such as Ethereum and Layer 2 further removes speed bumps.
3. Regulatory straightjacket
Some may see the regulatory restrictions as an extension of the cynical argument: regulators have been captured by legacy players and have a vested interest in maintaining a symbiotic status quo.
We believe this argument is largely true. When it comes to asset rights, be it real estate (title registrars), public stock trading (DTC) or private company stock (lawyers!), it often appears as if an entire legacy stack is being maintained for the self-perpetuation of intermediaries and regulators.
This stack, at least in the U.S., historically divides the universe of corporate stock between bearer (now largely outlawed) and registered stock, and within registered stock, certificated and non-certificated stock.
Title moves and is finalized in different ways for certificated and non-certificated stock, in the same way that very different regimes apply to publicly traded stock, which list on exchanges, vs. private company shares, which are typically offered under private placement rules. In all of this, intermediaries galore.
For purposes of our later discussion about a possible decentralized implementation, non-certificated stock - perhaps counter-intuitively - lends itself less easily to tokenization.
4. Entrepreneur’s ennui
Whether or not the current regs are a result of a genuine attempt to protect the investing public or the outcome of regulatory capture, to wish for a greenfield in which new regs could be drawn up from scratch is not realistic.
Entrepreneurs shy away from heavy-regulated areas and typically stay clear of use cases that require a change in the law to work. We believe it helps explain why tokenization of corporate stock hasn’t innovated, especially at the listed stock end of the spectrum.
However, private corporate stock such as the C-Corp in the U.S. is largely contractual in nature, with State law and some element of Federal law (primarily in the sphere of securities regs) superimposed on the sacred freedom to contract.
Any entrepreneur brave enough to tackle tokenization of corporate stock may therefore want to start at the private company end of the spectrum, which is also where we put our focus.
revoluçion piecemeal improvement!
It may seem that, on the face of it, there won’t be a revolution in tokenizing corporate stock. The best we can hope for is piecemeal improvements (in the spirit of Popper).
Nonetheless, we believe there is an implementation that could radically transform how we own and transfer real-world assets and which may eventually change our sovereignty over such assets beyond recognition.
This idea of asset sovereignty is perhaps the main reason why tokenization of corporate stock, and Asset Rights Tokens more broadly, are inevitable: decentralization, a bit like the genie in Aladdin’s lamp, can’t be bottled up again. Once a broader market discovers the benefits of storing and transferring tokenized assets simply by connecting their wallet, there is arguably no way back. The main factor then is timing.
Let’s look at the benefits of holding and transferring corporate stock on blockchains a bit closer to understand this inevitability, and conclude with a sketch of a possible implementation on a full public ledger.
Before we do so, its is important to stress that many of the ailments of corporate stock, for instance the lack of liquidity in private companies (often because of the unwillingness of owners to sell) will not be cured by putting company stock onchain. They are what they are, exogenous of the technology.
However, the USP of putting corporate stock onchain can probably be broken down as follows:
1. Transaction costs
Anybody who still moans about gas costs on Ethereum is now officially a bore. Not only are they significantly lower post-merge, there are L2 solutions that make transaction costs negligible. In many event, gas fees are puny compared to what it costs - after everything is said and done - to move a stock on the legacy layer, whether public or private. So this argument is won.
In private companies, speed is not really relevant: even if it takes 5 minutes to finalize a blockchain transaction moving a tokenized stock certificate from seller Bob to buyer Alice, neither of them would have been able to print out a PDF and sign it within that time.
Listed stock is different, but here too we believe it is just a matter of time (though don’t hold your breath!) before public stock trades and settles quasi-instantly onchain.
The question how private transactions of corporate stock on blockchain are is not so trivial to answer.
It may sound bizarre but in the U.S., listed companies are by law prohibited from knowing the identities of secondary market participants in their stock (at least if the shareholder wants to be treated as what is called an Objecting Beneficial Owner). We envisage that by the time listed stocks trade and settle onchain, privacy-preserving onchain tools such as zkSNARKs will mask transferor and transferee data.
In private companies with certificated stock, perhaps equally bizarre, it is up to the actual transferee to notify the company of their status as beneficial owner of the stock, after which a company is expected to update their stockholder record (making such beneficial owner also a record stockholder).
In many ways this makes sense, since it is impossible for a private company to track who owns its stock if such stock can be transacted contractually.
The situation is different with uncertificated stock, where a book-entry system is the means of recording beneficial ownership: the “ledger of truth” is therefore what the internal ledger says.
For this reason, if we want to tokenize stock in a de minimis setup, all it would take is to tokenize the company’s stock certificates. Such tokenized stock “certs” can then trade more akin to genuine bearer tokens, such as Bitcoin and Ether itself, even though for all the good reason (see below) we do not want them to have full bearer characteristics.
In this context, it helps that certain U.S. States, most prominently Wyoming, include a public wallet address in their definition of shareholder “identity” for purposes of keeping a stockholder record. This means that stock can be transferred peer-to-peer in a secondary market without the need for the company to record the identity of each participant: the daisy chain of wallet addresses would effectively take over this internal record-keeping function.
Such wallets are of course pseudo-anonymous however they offer pretty good privacy compared to the (hackable) central repository of uncertificated stockholder data such as Carta’s.
The trust advantage distributed ledgers have over a central setup is known. It includes not only the absence of centralized (read: hackable) data silos, but also censorship-resistance, the reduced potential for confiscation and (if wallets are managed properly) theft.
“Censorship resistance” is laden with ideology but in the context of tokenized stock, it means that anybody can participate as an economic agent, surely something we should all welcome.
On the subject of theft, people seem to think that if they hold stock in a wallet and the wallet gets hacked or access is otherwise lost, they’ll forever lose their title to the stock.
In this important aspect, tokenized corporate stock is different from pure bearer token-type assets such as BTC and ETH and other crypto currencies or tokens.
In simplified terms, even if access to the wallet that owns the stock tokens could not be technically reconstituted (unless a private key reconstitution mechanism based on e.g. Shamir sharing was devised), a legal restitution of ownership could happen in which the issuer of the token refuses to honor the stolen tokenized stock and issues replacement tokenized certs to the rightful owner.
Even writing this sounds sexy, perhaps because it is!
Paper certs are dumb, and the rights attached to them are embedded in legal documents such as the corporate’s Bylaws in case of a C-Corp, and ancillary agreements such as stock option plans and grant agreements.
The sexiness comes in when actual stock certs are turned into smart contracts, which allow for some key legal clauses to be automated and enforced onchain (e.g. vesting, Right-Of-First-Refusal clause, etc).
Ultimately, each stock cert could have the whole of the corporate’s Bylaws embedded, with a governance protocol in place that determines how the code can be upgraded, similar to how a DAO votes onchain on all decisions.
Such smart contract code could extend into a stock issuer’s ability to mint more onchain stock or burn tokens, always subjects to the company’s chosen governance protocol.
This would move corporate actions and governance onto a whole new level and may - together with the asset sovereignty we mentioned above - form the core of tokenized stock’s USP.
A possible implementation
As indicated above, a de minimis implementation of tokenized stock would be to represent ownership of a corporate stock certificate onchain.
For this to work, a C-Corp would be formed that mints stock certificates for each individual share it issues.
Typically, the number of authorized shares in a C-Corp is 10 million, of which the founders will issue around 70-80% to themselves, keeping 20-30% in reserve for future investors and an Employee Stock Option Plan (ESOP).
So at incorporation, a single founder of a C-Corp would hold say 7MM stock certs in her/his wallet. These tokens could be issued under any token standard as long as they live on a smart contract blockchain such as Ethereum.
In the absence of such governance smart contract functionality, the rights and obligations of each stockholder would still have to be enforced in an analog way, i.e. post factum, with redress for any infringement sought via legal action.
As long as there are no investors, this does not really matter. However, once investors come in, which typically also involves adding an ESOP, the stock token issuance smart contract could be upgraded, for instance to reflect investors’ preference rights, vesting of stock under the ESOP, and key clauses such as the Right-Of-First-Refusal, Tag-Alongs, etc.
Importantly, such clauses could now be enforced a priori, before any infringement takes place.
Say for instance that a founding stockholder, Alice, is prevented under the Bylaws of the company she founded from transferring her founder shares (a typical clause). In an analog setup, nothing prevents Alice to enter into a private agreement transferring her stock outside of her fellow stockholders’ knowledge. However, in an onchain setup, a lock can be programmed on Alice’s stock certs which prevents any transfer unless approved by the majority of all remaining stockholders.
In a more ambitious setup, the whole of the company’s Bylaws could be smart-contractified, with each legal clause a “dApp” that can be bolted on to the corporate’s core governance protocol.
This will not put all lawyers out of work, only those who do not know how to author smart contracts!
This post only scratches the surface of the issues surrounding corporate stock tokenization.
Adoption wise, Asset Rights Tokens, of which corporate stock tokens are a subset, are arguably too early.
One reason is because innovation’s biggest competitor is inertia: the world simply won’t start using wallets to hold real-world assets overnight. Timing is indeed everything.
However there are also legitimate concerns whether blockchains can achieve legal finalization of transfer of title, the same way a heavily lawyered agreement can in the case of private companies or the DTC-stack does for listed company stock.
We believe that, for starters, issuing stock certificates in tokenized format, perhaps initially to blockchain-centric founders, would show the benefits of this new form of stock digitization.
Technically, such issuance is relatively trivial.
Legally, all that’s happening here is a digital representation of a stock cert, basically an extension of the PDF, with the difference that this PDF is hashed on blockchain which, by its nature, acts as a record of beneficial ownership when the PDF changes hands from one wallet to another.
Helpfully, the “identity” on the tokenized cert can legally be a public wallet address, enabling peer-to-peer transfers with the receiving wallet itself as the beneficial owner of the stock. This is very different from how e.g. Carta puts a ledger of uncertificated corporate stock in its centralized cloud and controls who can update the book-entry as proof of beneficial ownership in its master-slave database.
Once tokenized stock certs reach wider adoption, a growing open-source library of smart contract plugins would undoubtedly follow that help automate corporate actions (e.g proxy voting, which would come to resemble DAO delegation), gradually enabling more sophisticated onchain governance of real-world companies.
The end result is blockchains as the ledger and rails on which corporate stock can be recorded and transacted peer-to-peer, as a natural progression of the current digitization of private and listed company stock.
This then would be a piecemeal revolution!
With special thanks to Gabriel Shapiro.
> Reach out to us if you are working or would like to help with the implementation of tokenized stock! Just DM OtoCo on Telegram @OtoCoDAO.