Security tokens — stripping volatility out of crypto?

I cannot claim to have been an early adopter of crypto. I conceptualized a product offering similar to M-Pesa back in 2015, floated it past a very astute analyst friend and was told to just consider investing in Bitcoin. ‘Oh and by the way’, he added, ‘check out this project called Ethereum, you should buy some Ether’. Feeling deflated, I went away and did neither. More fool me.

Jump forwards a couple of years to June 2017 and I began developing some ideas into more tangible concepts. Crypto had yet to see the huge price spike we saw take off in September of that year. I went and met my analyst friend again for coffee and his words were thus, ‘2018 will be the year of the blockchain’. And so it is.

With a small team of hungry blockchain enthusiasts, we’ve developed Tokenport as a gateway tool to facilitate established companies, start-ups, funds and projects to create security tokens. Part of the development of this has been to engage companies such as Polymath who are pioneering technological solutions to make this complex process happen.

A big topic of discussion among us here at Tokenport is how security tokens will behave once issued and traded in a secondary market. The thinking is that unlike the ICO of today, largely a bet on a whitepaper, a team and a road map, a security token offers something tangible, a link back to a real world asset. We then have to consider the performance of the underlying asset as the mechanism that will drive the price of the security token.

Let’s take a couple of examples that present likely scenarios.

AttaBoy Coffee Inc have an established chain of coffee shops and are seeking to grow the business. They have a clear road map setting out the growth plan and have accurately costed out the process. They are drawn to the idea of a security token as they are keen to engage their user base to become investors in a business they frequent regularly and share in the upside of the growth they are helping to create. This therefore represents an equity offering. The company would tokenize the entire business into units representing the equivalent of shares. They can then allocate tokens to founders, employees and ultimately the investors as part of their security token offering. In the same way an ICO is launched, there will be lock ups for tokens that have been predetermined when planning the issuance. Investors are thus assured that there won’t be price pressure on their investment but instead see founders fully engaged in delivering the growth story. In terms of the investor, the token will be able to be programmed with a distribution of profits, ie a dividend if certain conditions are met and perhaps the opportunity to vote on company issues.

Brown Bag Craft Brewers Inc wants to build a new brewery. They have identified the freehold premises, costed out the new brewing vessels and associated kit and have a clear strategy on how to sell this extra capacity. They want to borrow the money over a 7 year period and will pay a 6.5% coupon . This would be a debt issuance. To do this the company would create a tokenised loan which would have to be secured against the freehold premises and the purchased kit. It may also require a debenture of sorts to be secured against the business as a whole. Investors purchasing a security token of this loan would thus receive their loan repayment each quarter as part of the programmable nature of the token itself.

The first thing you notice from the two very simplified examples is that much of the process is automated. Tokens are programmable smart contracts that feature the operational terms of the respective offers. Investors on-board according to whether the token is available to them within their jurisdiction. This is a simple white listing process operating in the same way that any ICO white list functions today.

What happens next? This is where we enter unknown territory but we think security tokens will NOT present the same levels of volatility seen in the current ICO marketplace. The development of secondary exchanges for security tokens is well underway. tZero is a notable mention here and partnering with Polymath is an exciting space to watch. Circle’s purchase of Poloniex another to watch as Goldman and Wall Street gear up to enter the space. GBX in Gibraltar already has advanced their own move into developing an exchange for security tokens. The expectation is that these exchanges become the go to equivalents of the NYSE, NASDAQ and the like. This will drive liquidity and with greater liquidity we should see prices move with less volatility.

Investors that have participated in the primary issuance of either an equity or debt based security token as outlined above, then have the opportunity to sell those in one of the secondary exchanges currently in development. Again, the programmable nature of the security token itself will essentially ‘lock-out’ any investor not able to own that security token. The use of a digital identity service such as SelfKey will provide an opportunity for potential security token investors wanting to participate on the exchanges, to effectively be white listed.

A security token based on an equity share of a company will likely behave in the same way it does today as on conventional exchanges. Price will be driven by sentiment, by company reporting and by wider macro conditions. Those tokens offering additional and accessible utility benefits, a free morning coffee, may see additional layers of price action. An issuance of debt is still linked to the performance of the company and it’s ability to service the debt. The price of the token should thus behave a lot like a corporate bond would.

Security tokens do not eliminate risk. As with any investment, your tolerance for risk will dictate how you invest. What we are saying is that crypto currency investing in ICO’s is like throwing darts with a blindfold on. Investing in security tokens still requires you to do your due diligence but we would expect to see the first wave of security tokens to be well understood concepts being delivered by well established companies. As a result they should behave more rationally, present more liquidity and thus drive the acceptance of security tokens as the future of securitization.