Tokenization containers: SPVs, DRs, Warrants, etc.
On Friday I received a flurry links about derivative crypto securities from TheElephant, DX.exchange, and Mercari stock offered as a “warrant”. All of these are ways of moving securities from the non-blockchain world into blockchain tokens. Within this genre, there are better and worse options.
These structures are basically a regulatory workaround to move shares from one place to another. For example, you can switch exchanges by taking shares from a normal stock exchange, and placing them with a custodian that issues tokens that trade on crypto-style exchanges. Or, you can switch venues by take securities issued in one country and re-issue claims on those shares in a different venue. There is an existing market for this in the form of “American Depository Receipts” or ADRs, which represent billions of dollars worth of non-US stocks trading on US stock exchanges.
This can add value in several ways. We might find that traders prefer to use crypto exchanges with real time settlement and stablecoin currencies. Or, there might be a lot of investors that don’t have access to the original jurisdiction. These are thin layers of value, and I don’t expect them to produce much profit for intermediaries. There might be technicalities in the regulations that allow you to sell one package and not the other. That’s potentially a fatter layer of value.
When you get a derivative that is the promise of a security, instead of the actual security, you take extra counterparty risk.
For example, I would not buy anything from TheElephant.io. This looks like a dodgy ICO deal that has a LOT of counterparty risk. They promise that they will hold private shares and deliver them to token holders when there is an IPO. But, their ICO-y terms imply that you will have no actual legal rights in any reasonable enforcement jurisdiction. What if there is no IPO? What if they go out of business? What if regulators crush them? What if they get sued by the companies issuing the underlying shares (this happened to Swarm fund in similar circumstances)? What if they are not trustworthy? You take all of these risks, for what? For the chance to buy shares that are slightly more interesting than public shares. You can get similar shares on the public market, and you can buy real private shares directly from issuers, on Sharespost.
The deal from DX.exchange is better. They are working with securities that are already public, so the value added is thinner. On the positive side, it’s more like a real depository receipt with a reputable custodian. This is a reasonable tactic for moving shares from stock exchanges to crypto exchanges. However, there is still a level of indirection that would cause me to wonder if it will be difficult for me to collect my security rights. I have go claim them from a company called MPS in Cyprus. Cyprus is one of the few countries in the world which has recently defaulted on bank deposits, with a spectactular financial crisis in 2013. Why Cyprus?
The deal with the least counterparty risk looks like this one: Equity warrants. They are using “warrants” instead of “equity shares” as a hack to get around the requirement that corporations keep a “registry” — a list of shareholders (which is what Aboveboard’s software does). They say that instead of getting equity, you are getting a warrant that you can convert into equity. Will this semantic dodge hold up in court as a difference of “substance” rather than “form”? Lawyers will make the case. If it works, it’s much better than the SPV deals, because you are getting the security directly from the issuer. There is no extra counterparty risk or cost.
There are a lot of good reasons to maintain a shareholder registry. It allows you to replace lost shares, which is very important for a security issuer and greatly reduces the cost of custody compared with a crypto like bitcoin in which you definitely lose your assets if your private key gets lost or hacked. And, if an issuer wants to comply with securities laws that say they must sell only to qualified and AMLd investors, it will be very useful for them to have a registry with attestations about their investor qualifications.
With or without a registry, the “covered warrant” might be useful. For example, it could be used to implement a tokenized ETF. The ETF shares would be implemented as warrants convertible into a proportional share of the underlying assets. You can apply this idea to any type of fund — VC, real estate, public securities.
