Crypto assets and distributed ledger technology – relevant for investor relations?

16 Dec 2019

Crypto assets and distributed ledger technology – relevant for investor relations?By Robert Michels and Valeria Hoffmann, Dentons

On 14 November, 2019, the International Securities Services Association (“ISSA″) issued an analysis of how to issue, settle, safekeep and service crypto assets (“Crypto Assets: Moving from Theory to Practice″, in the following referred to as the “ISSA Analysis”).[1]
 
One of the relevant topics discussed in the ISSA Analysis is the servicing functions of crypto assets, including the processing of corporate actions, such as the voting of shares by proxy and other fundamental securities services that investors expect from custodian banks, central securities depositaries and issuers. While the ISSA Analysis discusses the development and possibilities of crypto assets in general, the new distributed ledger technology can also disrupt the existing securities service industry and in particular investor relations.

Furthermore, the German government passed a comprehensive blockchain strategy [2] on 18 September, 2019, which sets out regulatory plans with regard to blockchain (and distributed ledger technology in general). As an overall goal, Germany intends to exploit the potential of blockchain technology while preventing any opportunities for abuse. One of the regulatory changes will be the introduction of electronic securities. A first proposal regarding blockchain-based electronic bonds was envisaged for 2019. Electronic shares and investment units are expected to follow in the near term. A regulation on public offerings of specific crypto tokens was also planned for 2019, which will require the offeror to publish an information document. Although the envisaged timing is quite ambitious, crypto assets and distributed ledger seem to be an issue for the future. 
 

What is distributed ledger technology and why does everyone speak about “blockchain”?

The term "blockchain" does not refer to an independent technology. It is only a subcategory of distributed ledger technology (“DLT”), a type of technology that has a range of technical and administrative structures. Due to the hype about crypto currencies, Bitcoin blockchain is the most famous subcategory of DLT, followed by Etherum blockchain.

In general, DLT systems are collaborative and synchronized digital databases that operate with a consensus algorithm and are stored on multiple “nodes”. Nodes are computers that store a local version of the distributed ledger. The systems function by forming and constantly adding new data blocks, by which means "blockchains" are formed from the data. That way, it is very difficult to modify already stored data without causing a change in the following blocks and thus notifying the whole network of a (possibly unauthorized) change. 

All involved nodes are connected to each other and the data exchange takes place consistently in a peer-to-peer network. This way each participating computer receives and processes the same information. The data fed into the DLT system is thus stored simultaneously on many computers, so that even if one or more computers fail, the data is not lost. Such replication ensures that there is no central point for errors or attacks on the hardware level. The replicated and block-stored data is synchronized by a consensus protocol, which allows the network to agree on a certain status quo of the data composition. There is no central entity that determines such a status quo.
 

Public and private blockchains

DLT systems are usually divided into two categories: "public and permissionless" and "private and permissioned".

With public and freely accessible blockchains, anyone can maintain the so-called node by downloading the corresponding software. Furthermore, no additional permission or access authorization is required. In these systems there are no identity-related restrictions regarding participation. Whereas in the case of private blockchains with access authorization, there is a central administrator (or several administrators) who regulate the access to the network. These private networks are comparable to an intranet. 

Public blockchains are usually universally applicable infrastructures. For example, all participants of the Etherum blockchain can issue their own tokens for pre-defined purposes by using certain programs (so-called smart contracts). In addition, this blockchain can also be used to exchange crypto currencies. Private blockchains, on the other hand, are designed for a specific purpose. These systems are not freely accessible for everyone. A certain person or a group of persons checks and grants the access authorization so that they are aware of the exact identity of the participants. Companies that want to bring certain internal processes onto a blockchain usually operate with such private DLT systems. 


Investor relations and blockchain

Today, issuers and service providers face various challenges with regard to investor relations management. Such challenges include, for example, the low participation rate of small shareholders or the exercise of voting rights by foreign shareholders. The chain of custodians, which usually involves several intermediaries, can cause a loss of information or even loss of exercise of voting rights. Furthermore, it is difficult to check whether intermediaries exercise the voting rights in accordance with the provided instructions. Also, distribution of the documentation for the annual general meeting and the long duration of the vote count are big issues for investor relations departments. 

DLT can be a solution for some of these problems and there are already the first test projects in the market, which offer a positive forecast for the future of DLT and investor relations.

Just naming a few examples, on April 25th, 2018, KAS Bank N.V. (“KAS”) tested a blockchain-based service for shareholder voting at its general shareholders’ meeting (Voteroom App). Voteroom was developed by KAS’s in-house innovation lab to solve shareholder anonymity and complex proxy voting issues, using the Ethereum framework. The aim was to make the voting process more secure, transparent and efficient. Later that year in May 2018, Banco Santander S.A. and Broadridge Financial Solutions Inc. also completed a practical use of blockchain for investor voting at the bank’s annual general meeting. Usual voting took place by traditional methods, but Santander also created a parallel “shadow register” on DLT to show the participating institutional investors the benefits of DLT usage. Already in 2016, Russia’s National Settlement Depository (“NSD”) announced that it has tested an e-proxy voting system running on DLT.[3] This e-proxy voting solution enabled “cascade messaging” through a chain of nominee accounts, from the issuer to the securities holder and back. NSD managed the database and ensured that all voting instructions were properly submitted and accounted for. The submission speed amounted up to 80 voting instructions per second. Nasdaq developed already in 2016 a blockchain-based voting and proxy assignment application already that enables participation and proxy assignment for voting before and during a general meeting.[4]

As well as the proxy voting scenarios, there are also ideas in the market how DLT could be used to avoid the chain of various intermediaries in the long term. Once the technical and legal questions are answered, issuers could use a permissioned blockchain to create a platform for direct communication with the ultimate intermediaries (depositary banks). This would enable direct communication with shareholders and also simplify the accessibility of foreign investors.

With regard to the overall use of DLT in the financial industry, one of the main questions will be the issuance, settlement and distribution of securities with the new technology. According to the ISSA Analysis, over time the existing highly intermediated securities issuance process is likely to be first supplemented and then potentially even supplanted by securities tokens on DLT networks or tokenization platforms. Whereas the legal and technical requirements for direct issuance of securities on DLT are still significant, there are already projects to demonstrate the instant clearing and settlement of securities on blockchain by using so-called “asset-backed” tokens. In May 2018, the Canadian Depositary for Securities and the Bank of Canada used the Corda Blockchain to tokenize securities and money by issuing so called “digital depository receipts”. The project made it possible to settle “simulated” central bank money against “simulated” securities by tokenizing both.

Clearly, DLT has the potential to disrupt the existing environment of the financial industry and in particular investor relations, by allowing issuers, intermediaries and investors to connect and collaborate directly in a network. 


Valeria Hoffmann

Senior Associate Capital Markets, Data Protection

Dentons Europe LLP

Robert Michels

Frankfurt Managing Partner, Co-Head Capital Markets, Europe

Dentons Europe LLP

 

Dentons is the world’s first polycentric global law firm. A top 10 firm on the Acritas 2017 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. With more than 8,800 lawyers working from 159 offices in 67 countries on six continents, Dentons is the largest law firm in the world.

The capital markets team in our Frankfurt office is highly experienced in both traditional and alternative financing. During the last several months they have successfully advised various clients with regard to the development of cryptocurrencies and ICOs. Additionally, Robert and Valeria are constantly involved in the coordination process between the market participants and the regulators at European level.