The four categories of crypto tokens or “digital assets” are open source cryptocurrencies, ICO coins, Reg D compliant initial offerings, and tradable securities. If you are considering issuing your own assets, or handling existing assets, you should understand where they fit in this list.
Open source cryptocurrencies
In the beginning there was bitcoin, an open source cryptocurrency. An open source cryptocurrency is used to reward participants that are part of an open source community. They organize themselves by agreeing to run the same code. They share resources, and they distribute rewards to resource providers in the form of crypto coins or tokens. Bitcoin pays for “mining”, which is compute time used to make the blockchain reliable and difficult to modify.
Open source cryptocurrencies have created massive new value, as measured by market capitalization. They gain value because monetizing a large open source community is an important and NEW business model.
Bitcoin is a first generation implementation of this idea. It seems likely that some next-generation platforms will emerge with an equivalent level of value.
It is important to remember that new bitcoins were never sold. Every bitcoin was created as a mining reward. Because of this, bitcoin and its relatives are legally treated as money, or a commodity, rather than an investment security. They are actively traded in many jurisdictions outside of security laws. These coins are resistant to regulation because they actually are decentralized.
ICO coins ARE usually sold in order to raise money for investment in a project. The investments range from building pure open source software, to investing in business operations that have nothing to do with open source software. There are some very good ICOs. The Ethereum ICO was (after a rocky start) fabulously successful. Good ICO issuers tend to get close to the original idea of sharing resources in an open source community. They tend to use coins for interactions between computers, paying for API calls and compute time, which is useful because computers do not have bank accounts. Some centralized companies have made honorable use of tokens for discounts and staking.
However, many ICOs are bad investment offers. They are bad startup stock investments, with no rights for investors, packaged for easy trading. One popular tactic for selling coins with few investor rights is to say that customers will be forced to acquire a coin in order to pay for a service. This subtracts value, because customers don’t like to acquire a weird coin in order to buy a service. To get their business, issuers have to give up on the coin, or offer a significant discount. These discounts are often in the range of 50%, which gives a measure of how much value is being subtracted by the coin. This type of “you must pay with my coin” deal is not likely to survive.
Some countries have embraced ICOs as a way to bring new capital into startups. They are banned in China, which already has lots of startup funding channels and is concerned about restricting the movement of capital. ICOs tend to be classified as illegal security offerings in the US and a number of other jurisdictions, where regulators consider them to be unfair workarounds of existing securities laws. Coins that are not sold as securities will often be classed as product presales and subject to sales tax, VAT, and income tax. Regulation of the offerings is effective because they have a central issuer.
My prediction is that the age of the ICO is over. There are not enough truly decentralized and open source business models to support a lot of good ICOs. Investing in other types of business models will require issuing securities.
Reg D compliant initial offerings
The first attempt to sell tokenized investments in compliance with securities laws was to require that the initial buyers be qualified with KYC, AML, and accreditation checks. This makes the initial sale compliant with securities laws in the US. There are similar rules for selling to “sophisticated investors” in other jurisdictions, such as the UK, Japan, and Singapore.
However, this strategy is very limited. After you sell a coin as a security, it needs to be handled as a security before it can go to “secondary market” trading and other uses. So, the issuers that have sold coins in this format are stuck with trying to do some sort of conversion from the security to unregulated coins, or to fully compliant, tradable securities, as described below.
A tradable security represents a claim on an issuer, such as a stock or a debt or a royalty (revenue share). This type of asset is regulated in almost every jurisdiction. The most universal requirement is that owners have to go through AML checks — Anti Money Laundering. Governments want to know that security owners are getting their money from sources that are not criminal or sanctioned, and that they pay their taxes. This check is often described as KYC/AML (where the “know your customer” phase is the onramp to AML).
Cryptocurrencies can be owned and traded by computers. Securities are different. Security owners must be qualified in some way as people or entities.
Every security, including a public security, needs some sort of check on investor qualifications. In the US and many other jurisdictions, securities can be classed as “private”, because they do not release enough information to qualify as a public security. These securities have additional rules and qualifications. In the US, they can usually only be acquired by “accredited” investors with at least $1M in assets, and they have transfer restrictions. Other jurisdictions have similar rules that apply to “sophisticated” or “professional” investors.
These qualifications apply beyond the initial sale. The issuer is obligated to qualify future owners of a security, when they acquire the security in an exchange trade or OTC / wallet to wallet transaction.
To enforce the qualification requirement, blockchain securities need to be equipped with some sort of programmed compliance. There are two ways to do this. One way, used in Ethereum, is to program the compliance directly into the scripts that represent the security. These scripts check some on-chain data — whitelists or attestations — to decide whether to approve a transfer. The other way, used in Stellar, is to set the chain to check with an off-chain authority. This application needs to check its off chain database and sign off on the proposed transaction. Both methods rely on keeping a list of qualified investors, from the issuer, or from some syndicate of agents and platforms exchanges that the issuer trusts.
Equity, or stock, is the most flexible type of security, because equity owners can share in the profits of any line of business. But, equity issuers have extra qualification requirements. Equity issuers are obligated to keep a registry — a list of their stockholders. This is both for regulatory reasons, so that regulators can track down owners, and for investor service reasons, so that owners can vote and receive distributions. There are two ways to maintain this registry. The issuer can maintain it, by pulling information from the syndicate members that qualified the investors. Or, a centralized transfer agent can maintain it, by forcing all of the investors to come to one exchange or portal. The transfer agent approach is simpler, but the issuer registry is more useful in a global distribution network.
Securities are already widely traded in a sophisticated distribution and exchange system. So, why do we need blockchain securities? We need them because the older system evolves slowly and painfully. It has a lot of complicated parts that need to be integrated into any change, it is walled off by licenses, and it is siloed by country. There are a lot of features that securities investors and issuers want that are taking decades to insert into the older system. This includes features such as global distribution, immediate settlement and delivery, and automated compliance and reporting. The blockchain-based system can provide these features because it evolves much faster. It is simpler, and innovators can access it more easily. It’s a classic disruptive technology. It’s currently too simple and crude to replace the older system. But, the open blockchain system is evolving more quickly, and it will start to grab pieces of the market that need new capabilities.
Currently, the blockchain version of tradable securities is a tiny market. There are few buyers. A generous estimate of issuance volume would be $2B/year, which is about 0.1% of total securities issuance. Where will blockchain securities have an impact? A lot of work is focused on improving the private offering market for startups and real estate, which currently has very little automation, distribution, and transparency. We’ll see a bigger impact when completely new applications emerge, the way that cryptocurrency emerged. I’m focusing on a new structure for handling tokenized assets that I call SPV + ETF. As features improve, we will find more applications.