As publicly-listed cryptocurrencies start to shrink in value, many believe crypto is over; and hopefully, if they’re referring to the assets that provided no core value to the digital asset industry, they’re right. What people seemed to fall in love with regarding cryptocurrency was simply put, the technology and the profit. While some admired the radically individualized nature that a ‘self-bank’ would propose, the larger percentage got involved because of the promise of blockchain-tech and boundless riches.
Although many companies misfired in their promises of how their token could solve the world’s worst problems via the blockchain, the factual capability of blockchain is and will remain that there’s a lot of unbelievable things you can achieve in finance with the tech. Thankfully, the recent crypto price burst wasn’t in vain.
Security Tokens (STs), Security Token Offerings (STOs), and digitized securities are potentially the result of the ‘blockchain solution’ promise. They are a fully compliant, overseen, regulated, and audited version of the Wild-West of Bitcoin you probably keep hearing about. Prior to any discussion as well, this is not to pitch the technology to the reader at all; due to the partial belief that a lot of the content written about ICOs revolved around extremely one-sided opinionated pieces, this post has been written with the pure intention on being informational. Rather than persuade the reader, this was meant to inform them as to why capital seems to be redirecting towards STs.
STs offer a multitude of different functionalities for existing companies in an entirely compliant way. A quick example: linking a said ‘token’ directly to a voting right within a company; all virtually. Imagine a company board’s voting session completed in real-time all virtually on a smart phone, and having the vote results immutably recorded? That’s just a small possibility. (We will discuss this functionality later; here is an overview of how the process works for now:)
The premise of the Security Token model, from a very basic view, is that the issued ‘tokens’ serve to act as digital regulated financial instruments. As such, anything that classifies as a Security Token should just as easily be distinguishable as a security within whichever jurisdiction it plans to launch. If you have the capability to do an offering physically, many financial regulators are saying as long as you find a way to adhere to the existing frameworks, there’s a limited problem. Technology aside, any token should be from start to finish structured, ran, and legally abiding in each and every regard. If all legal parameters are met, then it can then be potentially classified as a ‘Security Token’. To simplify, just ensure whatever ST is being issued is completely compliant. Work with a reputable legal firm.
Security Tokens maintain the best of both worlds; potentially conservative and secure finance and radically explorative cryptocurrencies. STs, however, have a very big edge over the majority of existing cryptocurrencies you usually see on Coinmarketcap. Subsequently, this advantage is the first main pillar that entices companies to the Security Token model:
Security Token Price Doesn’t Rely On Bitcoin Price; In Fact, They’re in Most Cases Completely Uncorrelated
One of the things that make Security Tokens so attractive, and is arguably the reason why Wall Street loves STs and STOs so much, is that Security Tokens are in their technological nature considered to be cryptocurrencies, but their prices aren’t exposed to the downside volatility that the cryptocurrency markets are currently undergoing. We’ll delve deeper into the tech involved later, but for now imagine if we removed the entire ‘price/get-rich-quick’ stigma from cryptocurrency momentarily and focused remotely on the immutability, transparency, and utility involved in them. Then let’s take the safety offered through completely compliant traditional financial offering models (for sake of pure example, a United States Reg D offering), and combine the two. What we essentially have is an unstoppable, limitlessly configurable, almost ideal financial security. Before getting ahead of ourselves, let’s then apply it for the markets; an obvious worry would be, well what would stop a group of syndicates from purchasing a lot of this said ‘ideal security’ and inflating prices? Market manipulation? Wash trading? Overextended speculation? Security Tokens have the function to be intrinsically binded, and that is all their price is relative to, and partnering exchanges will always be sure of that.
Security Tokens are programmable, editable, and configurable to be versatile for multiple conditions. In the case where a Security Token is binded to, say a company’s revenue stream (which is perfectly possible in existing ST programming frameworks), the holder’s price is only reliant on the company’s revenue stream. If the company were to build a model in which profits of the company revenue are then distributed and shared via dividends on the blockchain, the price of these tokens is simply reliant on profit obtained by the company, not cryptocurrency market speculation. This is what stopped many valid and verifiable investments in cryptocurrency in 2018 from thriving and makes them subject to dramatic decreases; purely bearish cryptocurrency market speculation, nothing intrinsically valuable or invaluable.
Security Tokens offer their own price, their own market, and their own participants, just entirely virtually while adhering to the correct regulations.
Security Tokens Are All About Compliance
Security Tokens are entirely compliant, start to finish, in the absolute utmost method, which is contrary to many ICOs. In many cases, the process can, but is not limited to, work like so; a company has an idea for a platform that it thinks is brilliant and wants to raise money for. It has a problem though: it wants to offer investors direct liquidity in the company dependent on the company’s impending revenue stream via ‘digital shares’, which would make this deemable as a security offering. This direct link to revenue offers brand new investor confidence.
The theoretical company doesn’t have the capital to go public, though, nor does it want to at the moment. They, therefore, work with legal counsel to establish how they’re going to raise capital for their newfound company privately and legally enable investors to have direct access to the revenue stream, tied together by immutability on their Ethereum-blockchain issued token.
They model their offering (completely dependent on jurisdiction) in the form of a private issue, apply for the proper exemptions, and are given the green light to raise capital privately from accredited investors. Let’s say Investor A invests $100,000 and is given the Security Token at a fixed price of, for example, $0.5, meaning he will retain 200,000 STs for the theoretical company. In abidance to some security laws, this may sometimes mean locking up the tokens for a set date as well. The company has proper economists set the token price linked partially by 80% to the company’s incoming revenue stream (profit-share model) and 20% to subsequent subscribers to this new ‘platform’. The code is deployed and audited so the investor can see exactly how the security is divvied up. Price moves then only dependent on the performance of the company. Investor A’s vesting period for his locked investment completes, he finds a suitable purchaser via the partnered exchanges, and then decides to sell the tokens after the company posted positive revenue for 2 years. This is only a very brief example also, and doesn’t get into the even more expansive parameters that can be enabled with Security Token Offerings.
Security Tokens Can Be Digitally Linked to Real World Assets
In theory, you can link a Security Token to anything that’s virtually configurable. That seems to be the immense interest behind it. We have things on the internet that we can’t give proper value for in real life simply because of technical limitations; our Instagram accounts, YouTube videos, video game profiles, rare code and so much more. Digitized securities offer this ability. We also have things in real life that we want to access real-time value for that we many times can’t. Prime example? Real estate.
Security Tokens are very commonly issued and linked to commercial real estate. This enables fractional, immutable, and transparent ownership in the value of the asset. As the STs can be binded to the real estate’s face value, you have the ability to purchase a security token representing 1/10th the value of an apartment in Manhattan (issued completely compliantly and verifiable on the blockchain). Assuming there are no fees, if the value of that apartment appreciates by 10% over the next year, so does your token. That ownership is transferable or sellable on the verified exchange partner with the said company. Why stop there, though? Art pieces, commodities, even events are all possible for digitization.
While we’ve seen this method attempted before in the form of Wall Street’s infamous ‘Asset-Backed Securities’ we haven’t seen its full potential. With entire customizability and editable parameters based on jurisdiction we now have more opportunity.
Similarities to Collateralized Debt Obligations (CDOs)
Many think that Security Tokens are very similar to Collateralized Debt Obligations (CDOs), which were in part the blame for the 2008 financial crisis. While there is a similarity in that they can both function as Asset Backed Securities (ABS), Security Tokens maintain large versatility and adaptability, whereas CDOs are more statically functional. CDOs are divided into ‘tranches’ or certain debt, typically layered in a way that is supposed to offset riskier debt obligations from the safer, more reliable loans.
You can code a Security Token to function exactly like a CDO, as long as the approval is there. The main difference that should be stressed between the two is that Security Tokens possess the programmability to function as a CDO, whereas CDOs do not have programmability at all. Security Tokens are more so frameworks, capable of being linked to debts, but not absolute. CDOs are entirely static representations on paper. With proper Security Token framework and a very serious amount of compliance oversight, you can even go as far as to say CDOs can theoretically be more reliable & transparent if issued on a blockchain. Another difference is that with a blockchain linked CDO, all obligations and distributions are recorded immutably via the ledger, which eliminates trust needed. Although a top-tier accounting firm will just as well get the job done in maintaining the legitimacy of cash flow for a CDO, absolute immutability in many cases wins over investor confidence in the long run.
Availability — The Current Debate
Security Tokens function primarily as securities, but they’re mainly taken advantage of alongside a private offering for a company. This means availability involving the investment at hand is dependent on the laws and restrictions in said jurisdiction. At the moment, most Security Tokens in the U.S. are as many are aware, only available to accredited investors privately, as the tokens are representative of some form of ownership in the private company. While the average retail investor may not have access directly to these new assets, oversight is changing rapidly to ensure that all sides of the story are met. Right now it can be argued there is an institutional bias, however. This is solely because the majority of Security Tokens function ideally for private investments, which are structured in most jurisdictions to disallow retail investors. There do exist retail-available STs, but their availability is definitely limited.
Security Tokens are frequently only available to private institutional investors but with reason. The important thing to note about this is that Security Tokens enable publicly-issued company liquidity for private companies (for the first time ever). Private offerings were to many, antiquated, and overdue for a revamp. Liquidity in Private Equity and VC placements are extremely low and can take multiple years to even see some sort of face value (All with proper causation, of course). If sought out, however, STOs and digitized shares now enable newfound liquidity for these older less-liquid investment vehicles.
Conclusively, Security Tokens cannot be entirely summed up in a singular Medium post. They are new, innovative methods of maintaining financial security rights and how they function and is arguably one of the most important inventions of the decade. They harvest the technology and utility of cryptocurrency while retaining safety from traditional finance. While still in its infancy, Security Tokens have already begun to make massive impacts on markets, adding a new parameter to blockchain technology.
John Iadeluca is the Managing Director for Banz Capital. Banz Capital is a digitized security and actively managed digital asset fund dialing in on private investments in the blockchain sector as well as alternative trading methods including High-Frequency Trading, OTC & Dark Pool market analysis, triangular and quantitative arbitrage, and more.
This post and the information contained herein is for informational purposes only. Under no circumstances does any of the information posted represent a recommendation or solicitation to buy or sell any securities or interests. Any such offer or solicitation can and will only be by means of the appropriate offering materials, only in jurisdictions in which such an offer would be lawful, and only to individuals who meet the investor suitability and sophistication requirements in such materials — which should be read in the entirety before considering such investment.