Security tokenization (really) explained.
Security token offerings are more than just a last-ditch effort to do an ICO.
Over the past 1.5 years, I have worked on building a Security token advisory business, I have talked on this topic at global events from New York to Hong Kong and helped many people who considered a Security Token Offering (STO). I have learnt what you already know: nothing is easy.
Market bubbles repeat and people tend to herd. That’s why we hate ICOs — they’ve had a bad aftertaste of the tulip mania. Billions of dollars have been burned on premature projects with no commercial viability.
But the prospect of easy money that the ICO seemed to facilitate so well for a certain limited time still excites many founders and businessmen. With the ICO hype gone, security token offerings are therefore understandably often seen as a last ditch effort to run an ICO. But that may be wrong. STOs could, in fact, be the next best thing after bitcoin that blockchain has brought us.
STOs use blockchain for what it can do best — recording transactions without middleman — they are real ownership rights recorded and transacted on blockchain.
Here is why it’s better.
Present day securities are still analog. Stocks, bonds and all other investment products are just documents that serve as a proof of their holder’s rights. At best, they can be traded electronically when they are dematerialised at some kind of central register (such as Depositary Trust and Clearing Corporation in US). They cannot perform any function by themselves. Someone has to do all the sending, receiving, storing and clearing around transactions.
More importantly, our deeply rooted mistrust for other human beings means that we always need a middleman to check whenever we do transfer of ownership to someone else. These multiple authorities cost money and they are, of course, susceptible to error.
When someone buys or sells a stock, for example, that order is processed by multiple middlemen and third parties, who at each step (from sending an order to exchange to actual transfer of the stock certificate from one custodian to another) have to record something and keep their own version of truth in their own ledger. The case of Dole Foods Co. (and many others) demonstrates how that can lead to major and costly errors.
Blockchain automates this process without errors, and it is humanless — it removes the need for control by a middleman.
What is a security token.
There are very many explanations of blockchain. In essence it is just a single ledger of all transactions updated when new transactions take place subject to a consensus of computers.
Ethereum is the most widely used blockchain protocol for security tokens. As explained here, a token of any type on Ethereum is it’s own mini-database of who owns what. The token is just an entry in the token contract, and who owns a token is recorded in the contract. A token is never in your wallet. Instead, your token is just an entry in the token contract such as:
When you hear ERC-20, this is the format in which the token contract is written. Using one common format (interface) means that tokens written in it can be transferred, requested, approved in the same way as any other ERC-20 tokens. It’s similar to your credit card — it doesn’t matter if it’s Visa, Amex or Mastercard, they all have the chip and numbers in the same place — that way they can be read and used on terminals anywhere you go.
A security token is just a new representation of ownership. It is the paper stock certificate converted to digital programmable form.
Programmable means that it can be automated, such that dividends or trading rules can be executed and imposed automatically.
This is thanks to smart contracts — lines of code which work on an if -> then basis. They are recorded on the same blockchain where the tokens. They control how & when transactions happen.
Smart contracts are self-executing lines of code that wait for a certain condition to happen before they perform their function. You could, hypothetically use smart contract to sell your flat. You would send the ownership title that has been recorded on blockchain to a smart contract that holds it until its if condition (most likely the receipt of payment from buyer) is satisfied. This is not currently possible in most countries because the laws haven’t caught up with the technology. More on that later.
Another simple smart contract could be dividend payments. The code is written so that it waits until a certain date occurs — it would be, for example, connected to the internet outside of blockchain via oracle to check the date before it sends out a dividend payment to tokenholders, while also withholding taxes automatically depending on their domicile.
Now this is important: when you think about it, security tokens could really replace large part of present day’s financial infrastructure together with all the intermediaries that are running it because they can be automatic and they eliminate the need for an authority.
Time and again, finance has undergone some form of a fundamental shift — from the invention of stocks and trading by the Dutch to electronic trading in the 80s and later algorithmic trading after 2008 — security tokens may just cause a shift of similar magnitude.
The real advantages.
Security tokens are often explained as revolutionary since they enable fractionalized ownership — that is, assets which were previously unavailable to smaller investors can now be cut to smaller pieces that are easily investable thanks to blockchain. This is only partly true.
To what extent fractionalized ownership is or is not possible is more a matter of country’s legal system.
Conceptually, it is relatively easy to cut ownership of pretty much any asset into many pieces by putting on top of the asset a holding company. This company can then, of course, have many shares allowing a large number investors to co-own the asset. The issue is that in most countries of the world, a register of such shares has to be kept by local authority, such as a company house or a central depositary, and anytime the shares are bought or sold, the transaction has to be notarised. This tends to make both the issuance and even more the transfer of those shares seriously difficult and costly.
Let’s say you want to allow small (retail) investors to own a piece of a Ferrari. You set up a new company, which issues shares of EUR 1,000 to people. After the company sells enough shares, it buys the Ferrari and puts it in a garage. Voila, you’ve securitized a Ferrari.
The problem is, every time one of your little investors wants to sell their share, they would have to go to a notary, and in some cases the shareholder register would have to be updated at a local central authority (for example company house).
This makes the pieces of Ferrari held by your investors, of course, very illiquid, since trading them would be very impractical and costly. In addition, if you would want to issue those shares to your investors via internet (such as through a crowdfunding website), this could lead to substantial additional costs and the involvement of further intermediaries. In Germany, for example, the issuance of dematerialized shares (i.e. so you don’t hand the investors a paper stock certificate but dematerialized share over internet) would require you to issue use one global certificate (Globalurkunde), which is further divided into smaller shares. This global certificate would have to be registered with a depositary (such as Clearstream in Germany).
The analog nature of the securities together with the financial regulation in most countries mean that fractionalizing ownership can, in fact, be very costly and cumbersome, and that you may need work of several intermediaries.
In such countries, of course, tokenization does not bring any benefit whatsoever. The requirement for notarization and the recording of the shares (in this case represented as tokens) on some central register would remove both the benefit of automation and decentralization associated with blockchain.
Perhaps unsurprisingly, tax havens are best at facilitating blockchain. Delaware is the most popular corporate base in the US thanks to its low taxes, efficient regulatory environment and judicial system. Similarly, Liechtenstein in Europe offer low taxes and a friendly legal and regulatory environment for funds and investment managers.
Both Delaware and Liechtenstein are good examples, being two countries on the opposite sides of the ocean that are making effort to further develop rules and framework that would serve blockchain implementations in finance better. By their very nature, they are also suitable as bases for an outside company founder or asset owner — in other words: they can be used for tokenization for foreigners.
Both Delaware and Liechtenstein allow companies to issue shares that are recorded and tracked by the companies’ own shareholder register. This means that the requirement for some form of approval by a central authority described above is removed, and that both issuance and trading of the shares is incomparably simpler, although since companies can effectively maintain their own shareholder register, i.e. tracking transactions in their shares can be, of course, very difficult without some automated technology. Security tokens are ideal in this case because they automate it on-chain.
There are still gaps in the procedure of fractionalizing ownership and it can be very costly in both countries.
In accordance with Delaware law, for example, a company can only track the transactions in its shares in the form of security tokens on-chain if the name, address and the number of shares of each stockholder are recorded on the ledger. Since currently no on-chain solution can be used to store that stockholder information privately, the issuers are required to store it off-chain, which is certainly not as seamless as it could be, involves the need for reconciliation and a risk of error. In Liechtenstein, similarly, the shareholder register has to be kept off-chain, and even worse, a custodian has to be appointed by a company to do this.
Even more problematic is the trading of those security tokens. If the companies would want to list their security tokens on an exchange, they would also have to be registered with a central depositary such as DTCC in US or Clearstream or Euroclear in Europe, thus, once again, completely removing the benefits of blockchain. This is also partly the reason why there are very few (really operating) security token exchanges in the world. In US, some of the trading is facilitated by alternative trading systems (ATS), which are essentially just brokers with online trading systems, not real exchanges. Not everyone can access or trade on ATS, and they are mostly for institutional investors.
The promise of automation and decentralization of security tokens can only become a reality if everything is elevated on-chain. This means that as Marc Borion explains in his article, all terms and conditions associated with a company’s share, as well as its connection to other external factors have to be represented on-chain: the certificate of incorporation and bylaws of the company would need to exist and be enforced onchain, all its funds must also be held onchain, all other securities of the company must be digitally native and onchain, all disclosures of the company must exist onchain and all governance (including board and shareholder votes) must occur in an elevated form on-chain.
Only then can a company’s share become self-executing fully automated financial instruments. But believe me when it happens, it will transform finance world.