Security Tokens
In this post we discuss how security tokens differ from classic securieties, and in Part 2 and Part 3 we go into those points in more detail. In Part 4 we look at a strategic framework for where security tokens can outperform, and in Part 5, Part 5b we look at a specific applications.
Note: Colin Platt commented on a pre-view version of this post; I have decided to include his comments as notes and address them explicitly as I think they make very interesting discussion points
2017 was the year of the ICOs — “Initial Coin Offerings” — that has seen billions worth of tokens to buyers with little regard of applicable regulations, in particular securities regulations meant to protect vulnerable investors. Now whether or not those regulations apply depends a lot on the jurisdiction, with the US throwing the widest net when the Howey Test is used to determine whether or not a contract is an investment contract or not. In other jurisdictions — notably the EU — things are slightly different, and securities laws don’t apply as widely.
To make a long story short — a lot of people jumped through a lot of hoops to claim that their tokens were utility tokens and therefore not subject to securities regulations. The SEC has started to challenge some of those, and the SEC and other regulators will slowly and steadily work their way through the system — so 2018 was the (first) year of the prosecutions, and also the backend of the ICO. More excitingly though 2018 has also seen the first Securities Token Offerings or STOs which are like ICOs just that they do comply with applicable securities regulations, which has the nice side effect that they can actually be structured like securities, and applications do not have to invent a bogus utility token that is not really needed for anything but raising funding. And to keep the network safe of course. And to reward network participants. And world peace.
There are probably at least 100 projects out there that are working on creating regulatorily compliant security token platforms, and our prediction (not investment advice) is that we will see a lot of activity in those. In short: 2019 will be the year of the securities token offerings! Which means it might be a good idea to have a look what securities tokens actually are, and how they differ from non-token securities and investment contracts. (It might also be a good idea to look at how securities tokens differ from non-security tokens, ie what the regulatory requirements are, but this is for another time).
Securities and investment contracts
We want to compare security tokens
note: the term “tokenised securities” might be a more appropriate term to describe “security tokens”; some people actually make that distinction, with one being protocol tokens that are considered securities under the Howey test, and the other ones being bona fide old-school securities that happen to be registered on the blockchain
to its alternatives, might make sense to briefly discuss what the alternatives are. Slightly simplifying the matter the alternatives to security tokens are securitiesand more generally investment contracts which, as the name suggests, are legal agreements (“contracts”) that underlie certain investments. It turns out, a well-designed security token is just that: a legal contract that underlies certain investments. The only difference to classic investment contracts is that the presumption of legal ownership in this case is tied to the knowledge of a certain secret, that secret being the knowledge of the private key that is associated with a specific crypto address.
What are the alternatives to this knowledge of a private key in the classic world? In principle there are a number of different options, but the most important one by far is being designated as the owner in the blessed (central) registry. The second alternative — but now generally discouraged or even outright forbidden in many cases — is being in physical possession of a piece of paper, that piece of paper often referred to as “bearer security” (or simply as “bank note” or “cash” in the case of money).
I used the term “presumption” above, and that is important: in the classic world, none of above assert that someone is indeed the owner of that particular security or investment contract — they simply create a strong presumption that, in the absence of evidence to the contrary — that person is indeed the rightful owner. However, if for example Jean-Paul Smith ended up being erroneously registered as the owner, whilst the rightful owner is his brother Jean-Pierre Smith who is living at the same address, then the register is wrong and needs to be corrected. Similarly, if Bob stole Alice’s bearer security then he is not the owner, even if he is in possession of it. (However, if Carol bough that security off Bob in good faith then she might be the rightful owner; if this does not sound fair then simply think what might happen if an entire chain of transfers had to be unravelled 100 transactions later because a security had been stolen at one stage).
How security tokens are different
Having laid out or comparison universe — securities tokens, centrally registered securities, and paper-based “bearer” securities — let’s now go through a number of key properties those different means of “owning” an investment contract have. We’ll start with a short description of the properties we consider important, and then we will discuss them in detail below.
Custody. For physical securities, custody refers to where the actual pieces of paper are held, how their owner is registered, and how they can be transfered to a new owner. For dematerialised securities custody only refers to the second part of that.
Registration. Registration refers to the registration of the investors, allowing the company in particular to contact them and to understand their identities.
Liquidity. Liquidity refers the ease with which someone who wants to sell can find a buyer, and vice versa. Liquidity depends on the size of the position the buyer or seller wants to shift.
Ease of Settlement. Ease of settlement refers to how hard (or easy) it is for a buyer and a seller to complete the ownership transfer.
Clearing. Clearing refers to the process that ensures that trades always settle correctly, typically through a trusted third party.
Payments. Payments refers to how the payments in respect to the security are handled.
Communication. Communication refers to authenticated communication between the issuer of securities and the investors. This category also includes voting.
Authentication. Authentication refers to how the owner of an investment contract can prove their identity.
Fungibility. Fungibility refers to whether different securities of the same type are distinct, and/or can be distinguished. Note that those are slightly different properties — eg bank notes are fungible in the sense that every 10-dollar not is worth the same, but nevertheless they all have a unique serial number.
Traceability. Traceability refers to whether a specific security can be traced when it is traded between investors. If it is strongly traceable then it can be traced forever, if it is weakly traceable that information will wash out over time.
Tainting. Tainting refers to whether assets that have been obtained unlawfully are tainted, meaning that there is a risk that they’ll be returned to their rightful owner, even if the current owner has obtained them in good faith.
(Im)mutability. (Im)mutability refers to the ability to adjust the ownership records so that they match the ownership in the real world in case those two have diverged
Recovery. Recovery refers to the ability to recover lost assets, eg because of lost certificates or lost private keys.
API access. API acces refers to if it is possible to execute ownership operations through an electronic API, and if yes, how easy and how standardised this access is.
This is the end of Part 1 of this post; in forthcoming blog posts we will discuss those differences in detail (Part 2, Part 3) and then lead a discussion for which types of investments and asset classes those properties are most useful.
Stefan Loesch a managing partner at LexByte, an advisory firm specialising on tokenised investments. He has more than 20 years experience in financial markets, and his previous roles include advisory at J.P. Morgan and McKinsey and quant development at Paribas. He is the author of “A Guide to Financial Regulation for Fintech Executives” (Wiley 2019).
