Digital Securities & STOs: Reality checks on secondary liquidity and structuring requirements

We wrote an article last year to explain why we thought security tokens would rapidly overwhelm utility tokens (the Emergence of STO, apologies available in French only). Are we subsequently pleased by the latest market developments and all the literature around Security Token Offerings (“STOs”)? Well, not really. Structuring regulated digital securities requires financial, legal and compliance expertise. Contrary to some beliefs within the cryptosphere, this expertise can not be acquired overnight. If digital securities are to sustainably disrupt the financial services, they must be properly structured. Otherwise, STOs and ICOs will suffer the same fate.

Lack of liquidity in the secondary market is the main reason for the ICO capsize

The shift from ICOs to STOs became obvious over the last quarter of 2018, when fund collection dropped dramatically. The capsize has been brutal and sudden. It has been primarily caused by deficiencies observed in most ICO deals structures: (i) non alignment of interests between private sale investors, crowdsale investors and the management, ii) lack of control over use of funds, (iii) lack of due diligences over the investment rationale, the product market fit, the execution risk and the management team, and (iv) the lack of liquidity in the secondary market. Of course, the drop in the total market capitalization of crypto assets did not help. But it is not the main cause, it just acted as a catalyst. The dodgy reputation of ICOs and structural failures did the rest.

In our view, the lack of liquidity played a major role. Investors/crypto currency buyers have realized that market depth remains limited for digital assets and, for any trades to happen, you need a willing seller but also a willing buyer. Unfortunately, for niche assets, there is a limited number of buyers in a bearish market suffering a ‘don’t-catch-a-falling-knife’ syndrome. Retail investors and fund newcomers- the very ones that created the bubble — paid the hard price to figure this out and most of them have exited the market by now. On the contrary, large, experienced investors have been able to lock significant profits, making the most of their fire power and private sale discounts.

This finding urges us to be wary of the current STO development. Issuers and the bulk of the industry consultants have re-branded themselves as finance & STO specialists. They plan to use the utility tokens’ recipes and copy paste whitepapers into prospectuses. And, this time, they promise liquidity will be abundant because institutional investors will enter the market, reassured by the compliant regulatory framework.

Liquidity should not be your killer app

To a certain extent, this should prove correct. New investors with deeper pockets will enter the market and have a first taste of digital securities. And a few dedicated trading platforms will be live in 2019, generally operating under an Alternative Trading System license in the US and a Multilateral Trading Facility license in the European Union.

Yet, it does not mean investors will actively trade their positions (there is in any case a one-year lock up period in the US for major Reg-D exemptions). Firstly, the investment in digital securities will be only available to accredited investors in the short term. Secondly, when structuring your STOs and targeting your potential investors, it is key to consider whether the latter really want to have liquidity. Or whether they are simply looking after asset diversification and want to invest in your company — be it in the form of debt or equity — with long term perspectives. Ask yourself: what is their expected investment time frame and hurdle rate? You may find out that many of these players are long term investors, and not option traders. In the long run, there will be liquidity for digital assets, but, for the time being, it should probably not be your first selling point to investors.

We think digital securities have much more to offer than enhanced liquidity. As an issuer, they represent a genuine opportunity to diversify your sources of funding. They pave the way to significant reduction in issuance & administrative costs as well as banking fees. They will simplify all the tedious financial and regulatory reporting, freeing up quality time for staff with support functions.

The sum of these savings covers the actual cost of launching your own digital securities. Transparency, audit facilitation, enhanced knowledge of your investors and, ultimately liquidity, would come on top.

You would not ask a marketing expert to code your blockchain protocol, would you?

But, to ensure the successful placement of your digital securities, you need to have it properly structured. If you deal with an equity issuance, investors will discuss your company valuation, your KPI, your market fit, your next fundraising round. If you deal with a debt token, lenders will go into the details of your financial statements, assess your repayment capacity and whether the proposed yield matches with the risk. If you deal with an asset-backed transaction, analysts will assess the future cash flows generated by the assets, the proposed legal structure and securities, their enforcement rights and control over the funds. And, for all 3 cases, this will be documented in thick, tailor-made contracts requiring the approvals/validation of many different parties with respective expertise: financial advisors, independent auditors, insurers, lawyers, various departments within each banking/financial institution involved…

These requirements will remain with digital securities. At this juncture, the token is just a technological layer on top of an existing security. This means that you need to be advised not only by blockchain savvies but also by financial and legal experts, who are used to dealing with such documents. They will guide you and help you to anticipate investors’ and regulators’ expectations. Failing to do so, you may be exposed to subsequent subpoenas from the regulators, similarly to what is currently happening in the US for those ICO projects which have raised money without filling any exemption to the Securities Act. If a significant number of STOs are in breach of current regulations, it will create a climate of distrust and deter institutional investors from breaking into that market. The latter will be much needed for the STO/Digital Securities market to genuinely take off. Yet, these institutional investors have to comply with stringent regulations (well beyond KYC/AML/sanctions undertakings) and they must manage their reputation risk. With no possible compromise.

Let’s structure the coming STO/Digital Securities along the same hardlines as the current securities to make sure we have these large investors on board as soon as possible.