Equity Tokenisation
Most readers are likely already acquainted with the concept of crowdfunding for equity. Since April 2012, when the JOBS Act was implemented, it has become possible for companies to fundraise from individual investors in a financially sustainable way without an intermediary. Both larger firms and startups now have more options for raising funds other than applying for business loans or seeking out angel investors and venture capitalists.
Equity tokenisation can be done utilising numerous blockchains. Using Ethereum as an example, this piece looks at the strengths and weaknesses of tokenising equity.
Ethereum allows smart contracts to be created — applications capable of generating digital assets. Smart contracts are controlled by lines of code and execute arbitrary rules. Technically, it is possible to issue and trade currency, debt, equity and other tangible assets which could be represented digitally with the help of smart contracts.
Equity tokenisation has strengths and weaknesses:
Strengths
Reduced trading costs Reducing the need for intermediaries eliminates the associated fees that make issuance more costly and trade less profitable. Intermediaries such as registrars, custodians and clearinghouses are replaced by smart contracts and the Ethereum blockchain. Smart contracts have the potential to ease legal representation by cutting down on administration and bureaucracy at the same time.
Quicker settlement Carrying out a trade (trade execution) involves formalising the buyer-seller agreement, where both parties document the asset quantity to be traded and the predetermined price. In contrast, trade settlement entails finalising the ownership transfer of the relevant assets and the associated payment. Trades on Ethereum are settled considerably faster than conventional security trades, sometimes in several minutes, and involve far fewer middlemen. Compared to standard security transactions, these are significant advantages for investors. While blockchain encompasses more rapid rates of settlement when it comes to securities, it also includes some complications. Margin trading and short selling are less simple, and drawing a parallel with cryptocurrencies won’t suffice here.
Regulatory compliance The value of tokenising securities mostly depends on how far trade barriers can be reduced, and one of the most notable barriers is regulatory compliance. Two key reasons for this are:
- Regulations are complex and affect numerous aspects of a trade. Jurisdictions of issuer, buyer and seller, nature of assets being traded, and types of investors involved should be considered. Each of these parameters entails a range of regulatory considerations, and for each, there may also be several regulatory bodies overseeing a single trade.
- Compliance and ownership are legally recognised once multiple ledgers are reconciled, and each ledger is under the administration of a different body. As such, regulatory compliance can be costly, result in market segmentation, and compromise liquidity. As each ledger may be constructed by a different agency, such as those responsible for secondary market trade or issuance, ensuring compliance can reduce the overall ease of trading.
Because security tokens can be programmed, it is possible to hardwire their architecture with contracting environment features. Tokenising securities allows for the automation of compliance and, in this way, a lot of the trade barriers involved can be reduced, if not eliminated.
Integrating contractual features into security tokens Advancements in design have made it feasible to integrate contractual features into security tokens in a way that wasn’t possible before. This makes the once unviable idea of a complete contract much more attainable. Complete contracts as an economic notion involve bilateral or multilateral specification of each party’s obligations and rights for an infinite number of future real-world scenarios. This is financially untenable in reality, however, as the costs involved would be prohibitive — for this reason, contracts are in most cases not complete.
Weaknesses
Over-optimism about demand Simply tokenising an asset will not automatically generate market demand for it, so equity tokenisation can engender investor overconfidence.
Over-reliance on stock prices Investor confidence can fluctuate significantly depending on the most recent performance of a company’s traded shares. At the same time, rapid appreciation or depreciation of a firm’s stock can be unpredictable and beyond the control of even the most experienced management. This can encourage blinkered, short-term thinking designed to appease investors on a quarterly basis.
Given that equity tokenisation is in its infancy, investor confidence is mostly tentative. Some early adopters are testing the water, gauging the depth of the market and its potential liquidity. If, however, issuers made the move to issue tokens that are not tradeable in the short-term, this could negatively impact investor confidence.
In spite of the aforementioned weaknesses of equity tokenisation, security tokens offer a host of benefits over conventional financial products because they eliminate the need for several intermediaries. Vesting intervals, dividend payouts, voting, and distributions are now executed by lines of code. Securities become software capable of connecting with outside companies and their own shareholders.
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Related articles:
https://www.nytimes.com/2011/01/15/your-money/stocks-and-bonds/15wealth.html
https://hackernoon.com/security-tokens-will-transform-traditional-finance-31427343d7de
https://medium.com/the-mission/tokenizing-the-world-one-company-at-a-time-60a65c567d09
https://bitcoinexchangeguide.com/equity-token-offering/
https://medium.com/@apompliano/the-official-guide-to-tokenized-securities-44e8342bb24f
