Chances are that by now you’ve probably encountered things like “security tokens”, “tokenized assets”, “digital securities”, “tokenized securities” or similar. Most often these terms are accompanied by spectacular preachings of disintermediation, disruption and revolution, without going into details about the “how exactly”. The kind of marketing first approach has carried over from the mass madness of the Initial Coin Offering bubble, and continues to muddy the waters about the use of Distributed Ledger Technologies (DLT) in improving the efficiency of securities markets, asset tokenization and transfer. The goal of this article is to critically examine some of the boldest claims as to what DLT can help achieve. For the sake of exploration, let's assume long run regulation to be accommodative to DLT applications.
Similarly to Eskimos having around 20 words for snow, the “security token” industry boasts a number not far behind. In the case of Eskimos, there are connotational differences, whereas this doesn’t seem to be the case for “security tokenists”. The terms “digital security”, “tokenized security”, “security token” and others are often used interchangeably so for the sake of simplicity, we shall refer to all of this as “Digital securities” , if they are regulated by securities laws. Otherwise — utility tokens.
SO WHAT IS A DIGITAL SECURITY EXACTLY?
Digital securities can be defined as the ownership of real or financial assets represented on a distributed ledger in a way, as to be regulated by securities laws. In the most vanilla case, digital securities are simply database entries (tokens) on these globally accessible, decentralised and censorship resistant networks (such as the Bitcoin blockchain).
Assume Bob owns an apartment that he has rented out. Bob decides to represent the rights to his apartment on a distributed ledger, in the form of a token. Bob legally enables the token holder to claim the rent payments every month. Bob has created a simple vanilla Digital Security.
Furthermore, existing and established distributed ledgers, such as Ethereum allow for much more complex structures by leveraging smart contract functionality. Put simply — this allows for programmable, highly automated securities. The functionality of a programmable security can be limited only by ingenuity and real world restrictions (read — regulation).
WHY SHOULD YOU CARE?
“Every security shall be but on the blockchain, in fact, real assets can be tokenized and put on the blockchain as well — that will grant access to a global pool of liquidity, 24/7 markets and unquestionable ownership rights. Blockchain will provide full transparency, instant clearing and settlement. The financial intermediaries currently involved in trade execution shall become redundant, as on the blockchain, participants own their assets directly, and trading will take place on decentralised exchanges. Blockchain will enable new asset classes, such as digital securities of decentralised autonomous organisations, tokenized real asset ownership and much more.”
Above is an example of the typical digital security narrative by your fanatic crypto enthusiast. Most of these claims disregard regulatory factors and technological limitations among other realities and more resemble prophecies than constructive roadmaps. Not having learned from the “utility token” madness, companies still focus on the abstract and distant, as opposed to the immediate and practical. As part of doing the latter, it is important to critically examine the feasibility of what DLT can and can not offer. This is best done in two dimensions — under existing regulatory and technological constraints and under reasonable future expectations. So here are 5 of the more prominent claims made by digital security evangelists
- Tokenize any real asset
- Turn illiquid assets liquid
- Global, 24/7 markets
- Automated reporting & compliance
- Increasing investor base
TOKENIZE ANY REAL ASSET
SHORT RUN: Tokenizing any asset means representing rights to this asset in the form of a token on a distributed ledger (a blockchain is a distributed ledger). This becomes desirable, since the core property of most distributed ledgers is censorship resistance and immutability. So if a token can be universally accepted (read: legally binding) as a representation of asset ownership, tokenization can serve as a hedge against events that could undermine currently existing ownership records. Apart from that, distributed ledgers replace segregated ownership records across different record holders with a single, unified ledger.
The technical part of asset tokenization can be executed with relative ease, however, to effectively tokenize an asset, the weak link is the enforceability of the tokenized rights in the real world legal system. Tokenized assets would have to backed by legacy contracts created within legacy legal frameworks. This greatly increases the cost of tokenization, and eliminates the rationale of creating asset backed tokens unless the cost of structuring can be offset by the benefits of tokenization.
LONG RUN: distributed ledgers are legally recognized as repositories of ownership. Inefficient and compartmentalized state and private registries of various assets have been replaced by a universal (or several) immutable and censorship resistant distributed ledgers. After a long trial and error process governments have finally polished legislation that covers all of the elusive corner cases, such as wallet ownership disputes, private key theft and more.
Enforceable and effective asset tokenization mechanisms are present, and accessible in a user friendly way, allowing mass adoption of the technology. Trial and error driven progress has driven down the costs of tokenization. Ownership tokenization is now efficient for most tradable assets above a value of $ 3000. Simple transfer of ownership is enabled with few if any intermediaries, depending on the dispute resolution mechanism adopted.
TURN ILLIQUID ASSETS LIQUID
SHORT RUN: there are already assets out there that benefit from being tokenized. That means that having a digital representation of the asset increases the asset’s value by more than the cost of effective tokenization. Digital goods are inherently easier to exchange, since they avoid many real asset problems such as storage, transportation, settlement and others. Even though the ease of transferability is likely to increase liquidity, by no means does it ensure it. In the existing regulatory environment, we again face the problem of right enforcement. There is nothing stopping an owner of a classical work of art from issuing multiple tokens, where in theory, each token represents a fraction of ownership of the painting. However, as discussed above, the value proposition of this token-fractionalization is only as strong as the weakest link, and currently this is the real world enforceability. This nuance aside, rights, as easily transferable, as tokens on a blockchain are a prerequisite for secondary market trading where the transaction costs would otherwise be too high.
And indeed, many token sale projects have attempted to do just that — to tokenize various real assets ranging from diamonds to billboard space. Indeed, the tokens proved easily exchangeable, just as expected, however things became complicated when regulators stepped in to argue that asset tokenization should be classified as unregistered securities. Many in the crypto enthusiasts view regulators as the cause of all evil, however their main objective is investor protection. And to do that, many jurisdictions were forced to over-regulate to ensure a margin of safety due to the once explosive crypto market growth.
Put simply, liquidity is the ease at which something can be bought or sold. Usually, the more participants are able to access the market, the higher the liquidity is likely to be. In summary, DLT is definitely a useful tool to enable liquidity for previously illiquid assets, since several key costs can be reduced to a fraction of what they are currently. However, this is just one of the multiple prerequisites to enable liquidity of currently illiquid assets, and it is likely to require significant regulatory forthcoming via trial and error to achieve the vision of turning illiquid assets liquid.
LONG RUN: in the long run, things are great. Not only has effective regulation enabled tokenization and solved the rights enforcement problem, but the balance of unqualified investor trading freedom and protection has been established. This paves the way for secondary markets of assets previously unimaginable.
It is not unlikely that one day we could see fractionalized real asset secondary markets at a spectacular scale. It is much clearer what needs to be done from a regulatory point of view, than how the end product might look. It would be naive to try and outline how increased asset liquidity, resulting from the growth of mostly unqualified investor/trader base could shape the secondary markets of the future.
GLOBAL, 24/7 MARKETS
SHORT RUN: this is usually the argument that allows to distinguish the truly fanatic crypto enthusiast from the more critical and inquisitive one. It is important to understand that a lot of the cryptocurrency and token madness momentum stems from absence of market regulation. At face value, this enabled unregulated trading of unlicensed securities to non-qualified investors worldwide. Yet, many preach that the 24/7 global token markets have resulted from the advent of DLT.
The technology for 24/7 global trading has been here for a while. It’s the regulation that limits trading to a number of hours per day to keep regulatory oversight manageable.
Only non-security tokens can expect to have 24/7 global markets with few to no restrictions. And as was demonstrated by the utility token market crash, it is not simple to structure a token in a way for it to be both: not a security, and of any value. In the more useful use case of representing actual securities on distributed ledgers, 24/7 global markets are a naive expectation in the present regulatory environment, since there is a never ending list of investor protection and anti-fraud issues to be solved before this visions is brought any closer to reality.
LONG RUN: the crypto trading bubble has demonstrated clearly that the current balance of investor/trader protection and trading freedom is not in equilibrium. In a matter of under 12 months, more than USD 300 billion flooded the crypto market, mostly from unqualified investors. This is hard to interpret differently than the desire of the non-qualified investor to have more investment/trading opportunities available to them.
As a result, we might see a two-fold effect: an increased scope of various tradable non-regulated products and relaxed requirements for the qualified investor threshold. If the former can be structured in a way to offer both tradability and value, then these types of instruments, as they stand today, are likely to remain tradable globally, 24/7.
Regarding securities trading, there is not much reason to believe that in the absence of a fundamental paradigm shift, securities markets will become global and 24/7. And even if one day (hopefully) the world comes to this, DLT is unlikely to be the underlying cause for such an advancement.
AUTOMATED REPORTING & COMPLIANCE:
SHORT RUN: one of the clear cut value propositions of digital securities is the ease, at which ownership of assets can be transferred from one party to another. Instead of the complex clearing & settlement processes of the current legacy capital markets, digital securities can change hands near instantly, with perfect auditability. This leaves an unambiguous trail of ownership throughout the financial instrument’s life cycle, at absolutely no extra cost. As a positive externality, any wallet owner can export all the transactions going to and from their wallets with ease. This is an unambiguous way how securities transactions can be audited and verified.
This type of transparency and auditability is inherent to most distributed ledgers. And regardless of if or not the asset ownership, represented as an entry on a distributed ledger, is enforceable or not, the entry (token) can be audited from its’ inception to current state. This significantly reduces costs for reporting and compliance.
LONG RUN: in the present, the securities markets do have a well established clearing & settlement mechanism. A multi trillion market is rigid when it comes to architectural changes of such epic scale. However, there is no doubt that DLT provides a clear cut cost reduction and efficiency improvement compared to the existing model. Apart from just the market participants adopting this mechanism, it would also require regulatory accommodation and this is not likely to happen overnight.
INCREASED INVESTOR BASE
SHORT RUN: if one is to look at the set of everything tradable with supposed ownership representation on distributed ledgers (including various utility tokens and the kind), the increase of the size of investor base is hard to argue. To some degree, the regulatory implementation lags have permitted millions of unqualified investors to participate in markets for various tradable and investable products. By now it is becoming apparent that the status quo of 2018 will not be sustained and unqualified investors need a degree of protection.
The most common approach by regulators so far has been to classify everything within their grasp as securities, apart from some of the major cryptocurrencies, such as Bitcoin and Ether. The effect of this has been two dimensional. On one hand, the investor base for the majority of regulated DL tokens is once again reduced to the qualified investors. On the other hand, the demand for increased investment access by ordinary people is as clear as ever. This has lead to the current race of figuring out how to exactly increase the scope of product offering to the unqualified (or less qualified) investor around the world. Most of these attempts indeed attempt to leverage DLT.
However many issuers are trying to find new ways of structuring DL tokens that are not classified as securities, but are also not without intrinsic value. This seems to be an uphill battle, as most regulators are clamping down on any wiggle room due to the utility token crash of epic proportions. In short, in the current state of regulation, the investor base has only increased for unregulated DL non-securities and DL tokens that are classified as cryptocurrencies (such as Bitcoin, Ether, Litecoin and others).
LONG RUN: Jurisdictions are competing for business. The demand for alternative investments, accessible to amateur investors undeniable. Something has got to give. This could be either the level of amateur investor protection, the threshold to qualify as a professional investor or the restrictions on structuring tradable, non-security DL assets. At this point, it would require a thorough legal analysis across jurisdictions worldwide to assess the likelihood of each of these.
The only thing certain is that the cup of water is overflowing, and it’s a matter of time before the spillover happens. And when it does, holders of currently non-tradable digital securities are likely to be rewarded by partially or fully enabled secondary markets, increasing liquidity (and the liquidity premium) of their assets held.
CONCLUDING THOUGHTS
Since early July 2017, blockchain as a technology has generated a tremendous amount of hype and has caught the attention of many. In the early days of DLT based token offerings, the industry was driven forward by techy innovators and pioneers of distributed ledger applications. Things began to turn ugly once marketing became the main domain of competition, and most crypto assets came to be valued based on the marketing hype generated as opposed to technological merit or disruptive potential.
On the bright side of things, for a brief moment, the non-qualified investor had the ability to access investment vehicles with returns usually accessible only to qualified investors and institutions. This did not go unnoticed by large players in the financial service industry.
The race is on to enable liquid investments into early stage companies, and to do it in a regulated and compliant way, while not compromising investor protection. Distributed ledgers appear to be the proper tool in making this a reality.
It is extremely early to predict how the Digital Security industry will develop, and what will be the first current restrictions to give, however it is clear that the value is here to be created, and for the most part now it’s about execution.
