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Taking on Tokenization

Michelle Morgan - March 08, 2022

Know Your Customer

You can’t avoid it. Everywhere you turn, people are talking about cryptocurrency, investing in cryptocurrency, debating the future of cryptocurrency. You can't walk down the street without hearing the words “Bitcoin,” “Ethereum,“ or “mining.“ And that’s not just while walking down Wall Street—that’s while walking down the residential streets of Oklahoma too.

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 terminology, this can mean a few things:

  • Private funds are letting investors come in with in-kind subscriptions of cryptocurrency.

  • Investment managers are having their private funds issue share classes denominated in cryptocurrency and represented by blockchain tokens.

  • Secondary private 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 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 them to invest and hold tokenized assets.

There are more than a few questions that naturally arise here:

  • How is know your customer (KYC) performed on the token holder?

  • How is ownership substantiated?

  • How is the secondary private market monitored so no anti-money laundering (AML) laws are broken?

  • How is KYC performed on purchasers participating in the secondary private 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 the box. And these “outside 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?

Performing KYC on token holders is possible. In fact, it’s 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 help 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’s not efficient for KYC to be a manual task anymore, especially with all the additional regulatory demands and the volume of transactions expected.

To automate the KYC process around cryptocurrencies, service providers have developed SaaS solutions. For example, 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 verifies the existence and residence of the investor. 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 fund shares or an asset is tokenized, the GRADA Oracle will allow or deny wallet-to-wallet token movements via an external adaptor on the Chainlink blockchain. This ensures that no token can move from one wallet to another unless both buyer and seller are verified and transaction parameters are met. Furthermore, the GRADA Oracle ensures no international sanction programs are violated when a token movement takes place.

For example, if a private fund’s investment parameters include ensuring KYC is complete, excluding U.S. citizens, allowing only “qualified investors,” and having a minimum equivalent to $250,000, then these parameters are written into the contract. When a transaction occurs, the GRADA Oracle assesses the parameters against the data from both the seller and the buyer and returns a result indicating whether the transaction can proceed. If the transaction proceeds, the smart contract writes it to the blockchain. Once confirmed in the blockchain, GRADA pushes the transaction details into the Titan Platform along with any required investor information or related KYC documentation.

WHAT OPPORTUNITIES ARE BEING CREATED?

Although the mention of tokenization has many service providers grinding their teeth and seeing additional risk, we’re excited about the new opportunities created.

We believe the use of tokenized private funds and smart contracts will 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 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's just one example of the various opportunities made possible by smart contracts.

ABOUT ADVANCED ALTERNATIVE INVESTMENT SYSTEMS

The Titan Platform by AdvancedAIS is a leading-edge cloud-based portfolio accounting, partnership accounting, and transfer agency solution. Titan offers its clients security, scalability, and significant ease of use and supports hedge, private equity, and crypto funds.

ABOUT GLOBAL RISK AND DATA AUTHORITY

GRADA provides a full KYC and AML solution for tokenized funds and assets via its GRADA Oracle technology. The GRADA Oracle ensures that all token holders both at the initial tokenization event and on subsequent transfers have proper KYC and AML as required by most regulatory authorities.

This post was originally published by Joot on the Joot Blog.

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