Crypto Invest Summit — Pt. 3 of 3: The Security Token Mirage; Community As Crypto Without Money
The security token mirage
Let’s look at security tokens through two different lenses. The first is as necessary evil to carry on crypto financing, with the security token the successor to the utility token, which was an interesting experiment in start-up finance that must give way to the realities of (U.S.) regulation. The second is as a way to use the crypto ledger to engage in untold levels of securitization, unlocking liquidity premiums on assets ranging from a newly discovered Picasso to boxes of discarded socks that don’t make the cut on eBay. For crypto nomads with dry throats, security tokens offer the oasis (or yoke?) of U.S. regulatory compliance, and increased liquidity for atomized assets and value streams of sorts both old (e.g., real estate, art) and new (e.g., fees from transfers of digital bearer instruments). These two lenses reveal two quite different markets. Consider first the market for utility token ICOs turned security token offerings (STOs), in particular in the U.S.
From downtown L.A., look not to the Pacific, towards Asia, a redoubt of utility token projects, but turn rather to the desert of the Mojave, and the oasis of securities tokens. The conference featured a separate and well-attended track on security tokens, and discussion of these tokens occasionally spilled into other tracks as well.
For token projects frustrated by the crypto market slowdown, STOs would appear to offer the prospect of tapping non-crypto investors, and tapping them now. Recognize, however, that investors in STOs are usually quite different from investors in utility crypto. First, utility token investors look for “asymmetric” returns, per one panelist — security tokens are structured to substantially eliminate the prospect of such returns. Second, utility token buyers ask different questions about projects, focusing on the need for use of blockchain and its decentralization and the need for tokens and their economics. By contrast, at CIS security token sessions, there was little discussion of these issues, or even of perhaps the more pertinent question of how to sync up the states of off-chain assets and their security token doppelgängers.
As we draw nearer the oasis, the large cool pool of liquidity starts to look more like the dry well of micro-cap stocks. For security token projects touching the U.S. market, a panelist advised having a legal co-founder, who could save hundreds of thousands of dollars in legal fees, as well as a number of sleepless nights. But securities lawyers, whether in-house or outside counsel, are not magicians, and must deal with the same consequences of U.S. securities laws that make the U.S. so unappealing to utility token projects. The U.S. securities laws hinder the ability of crypto projects to leverage the power of tokenization. The primary path to regulated fund raising is Regulation D, whether under section 506(b) or section 506(c). Reg D’s transfer restrictions and holding periods are part of the package, making clear to anyone who is still confused on the point that security tokens are not for usage. In any event, Reg D in practice diverts project tokens away from most potential users to accredited investors, such as angels and early-stage VCs. Regulation CF, for the smaller fry looking for $1 million or so, is little more attractive to security token sellers than it has been to security sellers. Regulation A+, touted to crypto projects for over a year now, has yet to produce a sale of a latter day utility token (please correct me if I’m wrong), and was merely mentioned in passing at the CIS sessions I attended. At the end of the day, even if project STOs begin to surface at scale, they face challenging comparisons to the securities of much larger and more liquid, if more conventional, public companies.
STOs: drunk on liquidity preference?
Let’s come in from the desert. MBA students at the University of Chicago share beverages at regular events called Liquidity Preference Functions. These have nothing on the tipsy fascination with liquidity among securitization, er, security, token fans.
STOs in service of securitization are certainly going after a huge market.Consider, per Elevated Returns, the estimated $240 billion size of the global real estate market, rife with illiquidity and lack of transparency. Real estate is just the tip of the securitization iceberg — huge asset classes from debt to art are also nominated as candidates for tokenized securitization. Alas, attacking large markets can make it difficult for insurgents to establish the competitive moats that drive superior returns, but that’s a critique for another day.
On the other hand, for those with assets to monetize, STOs are a story more for traditional investors than crypto disruptors. You can see this from where the investor demand is coming from for successful STOs. For example, Elevated Returns said that its recently closed $18 million raise came primarily from traditional high net worth and institutional real estate investors. Spice, a fully tokenized VC, originally looked to raise roughly half of its fund from crypto investors. In the event, crypto investors have thus far only contributed roughly 10% of Spice’s raise, with the vast majority coming from traditional family offices, funds of funds, angels, and high net worth individuals.
The STO bar’s specialty cocktail is liquidity, but improvements in liquidity will likely take a lot more than tokenization. Don’t just take my word for it. Listen rather to Barry Silbert, founder and CEO of Digital Currency Group and previously the founder of SecondMarket, which was a pioneer in providing liquidity for private shares of public companies. Silbert(at roughly minute 35 of the linked podcast) turns a skeptical eye to the liquidity promises of tokenization. True, as heard at CIS, tokens could reduce the administrative frictions — and thus delays — of asset transfers. But from the CIS stage, even security token offering bulls said that promised improvements in liquidity are not a near-term prospect. Ultimately, the security token market seems to focus on legal compliance and conventional valuation metrics, catering to traditional investors. This will likely attract a different community than crypto. As skeptical as Bitcoiners may be of smart contracts, it is more difficult to see them adopting en masse the cause of using crypto technology to make the physical world safe for securitization.
Community — crypto without money?
Let’s close with a nod to community, a defining feature of many successful crypto projects. Some at CIS urged a healthy skepticism about quantitative metrics of community engagement, like the number of followers on Telegram or Twitter, which can be gamed. Perhaps, more accurately, crypto projects depend on communities, plural, in that what captures the “hearts and minds” of developers may differ from what captures those of users. Despite the current bear market and an associated slowdown in money flows from token sales, which can invite broader skepticism about the future, the vibe at CIS reflected a crypto community focused on improving the technology, as well as the technology’s appeal to the non-enthusiasts.
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