The Three Innovations that Tokenized Securities Will Bring (Part #1)
I. All About Security Token Offerings (STOs)
1. What is an STO?
An STO, short for security token offering, refers to the issuance of digital securities utilizing distributed ledger technology in the capital market. To gain a deeper understanding of STOs, it’s crucial to grasp the fundamentals of the three main components for STOs: S (Security — the nature of securities), T (Token — tokenized securities), and O (Offering — the process of issuance).
1) S for Security
In the context of STOs, ‘S’ signifies securities as defined by capital market regulations. Securities encompass contracts governing rights and responsibilities concerning assets. Specifically, these include debt securities, like bonds entailing payment claims, equity securities involving investments in capital such as stocks, securities deposit certificates (e.g., DRs) where custodial institutions manage ownership and exercise shareholder rights on behalf of investors, derivative-linked securities combining derivative financial products (e.g., ELS), and income securities entitling profit reception when entrusted with management, like funds. Additionally, there’s a growing focus on investment contract securities, which grant specific investors the right to invest funds or assets in collaborations and claim profits or losses based on outcomes.
According to Korea’s capital market laws, In STO, S represents primarily income securities or investment contract securities. However, typical projects mentioned in the crypto market related to security tokens are unrelated to Korea’s security tokens. As the “s” in STO denotes securities according to Korean capital market laws, projects conducted by crypto companies not subject to capital market regulations cannot be recognized as STs under current Korean laws.
Figure 1. Type of Securities
The regulatory direction of token securities overseas differs from that of Korea. In the United States, as early as April 2017, the first tokenized security (Blockchain Capital, BCAP) was issued, and tokenized security issuance is possible within regulatory boundaries through the existing Regulation D (private offering rules). Europe faces a similar situation where tokenized securities can be issued without a security filing for up to 8 million euros.
While overseas jurisdictions are adopting a direction to issue tokenized securities within existing laws, Korea is clearly identifying them as securities subject to the Capital Market Act, aiming to form the market through separate guidelines (such as Token Securities Guidelines, Fractional Investment Guidelines). Due to this difference, phenomena like ST issuance in the crypto industry, such as KKR’s ST fund or MakerDAO’s tokenization of U.S. Treasury bonds, and RWA (Real World Asset) tokenization, are not happening in Korea.
Figure 2. Number of STOs in the United States
Figure 3. RWA Token Holders
2) T for Token
Securities can exist in various forms. Paper-based securities are physical securities, while those recorded on servers (centralized ledgers) are electronic securities. In September 2019, the Korean government introduced the electronic securities system, prohibiting physical securities of listed companies and enabling the issuance and distribution of securities like stocks and bonds through electronic securities.
On the other hand, token securities refer to securities recorded on a distributed ledger. While electronic securities are processed on centralized ledger servers, token securities imply processing on a distributed ledger within a blockchain network. According to the Financial Services Commission’s analogy, physical securities, electronic securities, and token securities are like containers capable of holding various securities such as debt securities, equity securities, investment contract securities, and more.
The government aims to include relatively recent unstructured securities like income securities and investment contract securities within the token securities category. Of course, other securities can be included within token securities, and it’s also possible to include income securities or investment contract securities within electronic securities.
Figure 4. Samsung Electronics’ Physical Securities
Figure 5. Implementation of the Electronic Securities System in Korea
Figure 6. Issuance Forms for Different Types of Securities (Korea)
3) O for Offering
Offering refers to issuance. Issuance involves registering securities on an institution or blockchain network to enable their trading or sale. Though issuance methods vary, stocks, token securities, coins, among others, can all be issued.
Firstly, an IPO (initial public offering) is when an unlisted company sells its stocks to the general public on the KOSPI or KOSDAQ and discloses financial information to get listed. It involves rigorous scrutiny by investors, ensures investor rights, and mandates information disclosure as per legal requirements.
An ICO (initial coin offering) is when a business issues blockchain-based coins and sells them to investors to raise funds. If this occurs on an exchange, it’s called an IEO (initial exchange offering); if on a decentralized platform, it’s an IDO (initial DEX offering). Simply creating tokens without an offering on any exchange is referred to as a TGE (token generation event). As it’s based on a distributed ledger, it allows 24-hour trading, decentralized ownership, and a simplified issuance process, but compliance and regulatory standards may vary in comparison to IPOs.
STO refers to issuing tokenized securities. Because it’s based on a distributed ledger, it allows decentralized ownership and can encompass newer forms of contracts compared to traditional securities. While it faces lower regulations compared to IPOs, it comes with a certain level of investor protection and information disclosure obligations.
In Korea, numerous fraudulent activities have occurred through ICOs. Therefore, the government is expected to bring various business ideas and investment opportunities previously issued as coins through ICOs into the framework of regulations, allowing them to be issued in the form of tokenized securities via STOs.
Figure 7. Comparing ICO, STO, IPO
2. Examples of Tokenized Securities
The most significant advantage of issuing tokenized securities is its potential to enhance the efficiency of investor capital. The traditional IPO model involves investors investing in a company engaged in various businesses. For instance, if an investor buys shares of multinational entertainment company, Hybe Corporation (352820 KRX), it’s akin to investing in all artists owned by Hybe Corporation. An investor may buy shares of Hybe Corporation because they want to invest in the growth potential of a newly debuted K-pop group like NewJeans. But in actuality, a higher proportion of his or her investment may go into Hive’s subsidiaries like BTS or SEVENTEEN.
On the other hand, utilizing STOs enables investors to make more direct investments into specific areas of their choice, such as allotting 30% of their investment into NewJeans’ future revenue over the next five years or specific album sales profits. Moreover, rather than diluting the company’s overall stake for funding, the company can create tokenized securities representing specific rights for a particular project to raise capital.
Reevaluating the capital efficiency of tokenized securities could invigorate the financial market. Currently, there exists a 20–80% discount rate for subsidiaries in the Korean financial market. Even if a listed parent company holds a subsidiary worth 10 billion KRW (approximately 7.5 million USD), the subsidiary’s value for investors is assessed between 2 billion to 8 billion KRW (approximately 1.5 to 6 million USD). The more complex the governance structure, the higher the discount rate tends to be. Tokenized securities can help alleviate such discount rates.
Figure 8. Raising Funds Through IPOs
Figure 9. Raising Funds Through STOs
Another advantage of tokenized securities issuance is the ability to list and liquidate various assets (such as parking lots, intellectual property, etc.) that previously had no conventional way of being listed. If diverse assets in the world are liquidated, prices could form based on trading among market participants, potentially stimulating our capital market. This could also prompt illiquid assets that have long remained dormant to emerge in the market. For instance, if a parking lot in front of a famous tourist spot is tokenized and its value becomes known worldwide, more parking lot owners might want to tokenize their properties.
Furthermore, there are distinctive differences from various existing investment methods. It’s worth noting that while Korea grants permission for a few companies in the ‘Financial Regulatory Sandbox’ for fractional investments, with the establishment of a tokenized securities platform, every company might be able to issue various tokenized securities through brokerage firms.
Figure 10. Comparison of STs, Real Estate Fractional Investment, REITs, and Real Estate Funds
