Security Tokens: Current Roadblocks and the Promising Future of Security Tokens

**Note: I am NOT a lawyer. This is not legal advice.

Since the crypto crash in early 2018, the narrative has shifted from ICOs to security tokens. A lot of the hype surrounding security tokens is focused on their potential to disrupt the way investors and securities issuers operate today. While I agree that security tokens have the potential to create tremendous value, it’s important to remember that we’re still in the early stages of the security token 1.0 wave.

In this post, I’ll take a look at how we got to where we are today, discuss some of the current challenges and then opine on where we’re heading.

From Bitcoin to ICO’s
At first there was just Bitcoin. And the only way to get bitcoin was to mine it (or to buy it from someone who had mined it). This was before Mt.Gox, Coinbase, or any of the other exchanges we have now.

As bitcoin got more popular, other coins and tokens appeared on the scene and exchanges followed suit to provide them with the necessary liquidity. The first ICO (Mastercoin) was issued in 2013, a year later Ethereum raised money through Bitcoin in 2014, and by 2017, hundreds of millions of dollars were raised through ICOs.

KYC and whitelisting wasn’t required to participate in ICOs at the beginning. This changed when the SEC released the DAO report in July of 2017, which stated that digital assets could be securities. The SEC’s findings made token issuers more conscientious of avoiding unlawful activity. Some projects responded by incorporating outside U.S. jurisdictions (Singapore, Malta, etc.) and blocking U.S participants, while others conducted private sales that resembled traditional fundraises from angel investors and VCs. Protocol Labs and Cooley LLP standardized this private fundraising model, which subsequently emerged as the “SAFT”(Simple Agreement for Future Tokens).

So, what exactly is the SAFT?

The SAFT
The SAFT is just like YCombinator’s SAFE contract but for tokens. The SAFT is best understood in two stages: 1) The ‘pre-functional stage’ which is a security, and 2) The ‘post-issuance’ of utility tokens when the network is launched.

The SAFT itself starts off as a security that goes through proper securities exemptions (Reg. D 506c). Once the network is launched, utility tokens are delivered to the SAFT holders, and the tokens are made available for public trading.

The main premise of the SAFT is that a pre-functional utility token (i.e. tokens that exist with no built network) is most likely to be a security, while an already functional utility token is less likely to be a security. This is because of the fact that a token that’s circulating within a functional network is likely able to sustain value independent of the actions of some central party — exempting it from the part of the Howey test that defines a security as something that has value “solely from the efforts of others”.

A high-level overview of how a SAFT works:

Overview of Issuing a SAFT

The fundamental issue with the SAFT is that it lays out one, very particular — albeit clever — way blockchain tokens could fit within the SEC’s framework. In other words, it is still unknown whether the SEC will agree with it or not. As such, it’s still uncertain whether a post-functional “utility token” is a security.

The SEC has not directly commented on the SAFT model. They are, however, scrutinizing ICOs that have used this model. This suggests that the SEC thinks tokens released in accordance with the SAFT model could be, in fact, securities.

So how do projects do this legally? What if you just declare it as a security from the start?

Enter Security Tokens
Although asset tokenization and security tokens have been talked about since 2017, much of the conversation was eclipsed by all the ICO hype. Since the ICO model has since crashed and burned, there’s been renewed interest in security tokens.

Due to uncertainty around tokens being securities or not, the concept of security tokens has become very attractive to not only issuers but also investors. STOs (security token offerings) were initially marketed as the “safe and sustainable” way to invest. Now, security tokens and utility tokens are being used interchangeably, wrapping them up in a single narrative. However, it’s important to remember that the early conversations around security tokens were focused on the tokenization of assets, equity, etc.

The very first security token, BCAP, was issued by Blockchain Capital. It tokenized their venture fund. Soon after, we saw other projects like tZERO and SPiCE VC issue STOs as well. All three of these projects have one thing in common: they were not issuing security tokens to work within a blockchain-based network.

Security tokens can be beneficial to the industry, but that doesn’t mean that everything should be “tokenized”. Combining a security token while also issuing a utility token to use in an open blockchain network can become a huge complication.

Let me explain.

Utility Token vs. Security Tokens
Utility tokens were originally meant to be used to access some kind of service or utility; this is analogous to buying a Chuck-e-Cheese or Dave & Buster’s token that lets you play arcade games. However, with ICOs, utility tokens became a fundraising mechanism for investors to buy for speculative purposes — not for the exchange of goods or services. Herein lies the issue — whenever capital is raised via token, the token’s probably going to be classified as a security.

Security tokens, on the other hand, are meant to be classified as securities — they’re just a digital wrapper (token) that represents an asset (equity, real estate, derivatives, etc.). Therefore, they’re securities that can only be traded on exchanges that have a broker-dealer license through an ATS (Alternative Trading System). Let’s say, for example, that you were an early investor in Chuck-e-Cheese. Could we go there and use our equity shares to play an arcade game? Of course not, using an underlying security as a utility simply doesn’t make sense.

The most obvious reason is rules and regulations. There are a ton of rules on how securities can be traded depending on different regulatory exemptions. For instance, for a Reg D 506(c) offering (under which most projects register), projects can only raise capital from accredited investors and the securities are restricted with a lockup period. Transforming the security into a utility token available to the general public breaks regulatory laws. If this token becomes available on an exchange without a broker-dealer license, the broker-deal could be operating as an unregistered exchange — this happened recently when the SEC brought charges against EtherDelta.

One way to think about this token model is to think of it as two separate events: 1) raising capital, and 2) issuing tokens meant to be used within a network. The latter should not be a security since its original purpose is actual usage. Therefore, it shouldn’t be involved in any way with fundraising activity. The capital raise itself should be done via a security token, which itself shouldn’t be used on a network or traded (trading must fall within one of the exemption rulings). Of course, this all depends on what type of exemption the project uses (i.e. Reg A, Reg CF, Reg D, Reg S). I’m assuming projects are under the most widely used exemption: the Reg D offering.

Some projects have created structures in which the security token eventually becomes a utility token (similar to a SAFT), while there are other projects that have created two distinct tokens — one for equity and another for utility.

The big question is how will the SEC enforce the latter?

The Dual Token Structure
StartEngine’s Howard Marks has written about the two-token ICO as a way to avoid the above dilemma. The solution he proposes is the RATE (Real Agreement for Tokens and Equity), which he says “allows a company to issue two tokens, one as equity, represented by the capital table of the company and issued in accordance with securities laws. The second token is offered to the investors as a perk.

This second token — the ‘perk’ — would essentially serve as the utility token which would be delivered via airdrop.

Marks admits in another post that the second token’s security-or-not classification is questionable. It could be a security depending on certain factors (like getting listed on an exchange). To distinguish between the two, there needs to clear separation between the security and utility tokens. In other words, accredited investors holding security tokens shouldn’t mix with those buying it on a public exchange to trade for some utility. Maintaining such a walled garden is definitely not easy.

All this makes the coexistence of security tokens and utility tokens very nuanced. I have yet to see an example of a harmoniously functioning dual token structure.

Now that we’ve covered the roadblocks on the dual token design, let’s look at where we are in the tokenization of securities.

Tokenizing Securities: Issuance Platforms and Exchanges
The security token ecosystem is still nascent as infrastructure is still being built, making it unavailable to investors. The ecosystem itself is about a year old, so this is unsurprising. The ecosystem can be simplified into parts — primary issuance and secondary trading.

Primary issuance is just the primary market — it refers to the platforms that issue security tokens (e.g. Polymath, Securitize, Swarm, Harbor, etc). Secondary trading — of the secondary market — are the exchanges that allow security tokens trades. These include tZero, OpenFinance, amongst a few others. One thing to note about these tokenization platforms is that they are not exactly self-service. In short, you can’t expect to use them without also consulting a lawyer.

There’s a lot that happens between issuing a security token and that token making its way to the secondary markets, but let’s keep it simple and succinct. Some of the these things include:

  • KYC/Whitelisting
  • Transfer restrictions
  • Cap table management
  • Lockups
  • Compliance with different regulatory exemptions (not to mention international laws)
  • Integrating into exchanges
  • Custody

Traditionally, these things were taken care of manually by a team of compliance and administrative professionals. Now that platforms are trying to “automate compliance”, they have to take care of all the things once handled by the professionals.

Some platforms have features that take care of some of the above. Whatever isn’t supported, the issuer has to address on their own.

Once the token issuance, KYC/whitelisting, and exchange integration has been completed, we need to turn our attention to being able to answer the following:

  • How is privacy handled?
  • How does the system handle dividends?
  • What about stock splits?
  • What happens when there’s a merger or acquisition?
  • What about stock voting?
  • How are preferred shares vs common shares handled?

Since we’re still early, many of these haven’t yet been integrated into platforms’ functionality. All of the behind-the-scenes work associated with traditional securities needs to be addressed with digital securities. This has yet to happen. However before we even begin to consider the above, there’s one huge puzzle piece that needs to come together and that’s liquidity.

Liquidity
Liquidity makes markets efficient. Buying something without being able to sell it in the future is, well, nonsensical. The security token exchanges (tZERO, and OpenFinance, etc.) aren’t entirely functional — OpenFinance is still in beta while tZero is in development.

Liquidity in the security tokens market is going to be one of the hardest things to attain because it takes time. Just as Facebook didn’t have a billion users overnight, it will take a lot of marketing and education to onboard the number of investors needed for adequate liquidity and market depth.

Some liquidity pools dedicated to security tokens are already emerging. Examples include Bancor, BnkToTheFuture, Blocktrade, Templum, etc. Consumer crypto exchanges like Coinbase and Poloniex are also acquiring broker-dealer licenses, allowing them to trade securities. Bakkt recently announced plans to build their own exchange. With all this activity, it wouldn’t surprise me if these companies ended up building a separate exchange for security tokens.

Future of Security Tokens
I’m sure you’ve heard all the benefits of security tokens a million times over (i.e. fractionalization, rapid settlement, global, etc.), but the one that excites me the most is the creative bundling/unbundling of investment vehicles. Let’s consider REITs, for example. Instead of having to invest in a bundle of companies (like you do now), you could invest in the one property you were interested in. Expanding this to equities, imagine if you could invest directly in YouTube (instead of Google) or Instagram (instead of Facebook). The ability to do this would be a game changer for investors.

Conclusion
Even though the ecosystem is young and still developing, there’s incredible potential for security tokens to evolve and pave the way for an entirely new way of investing and raising capital. There’s a growing number of stakeholders that are determined to build infrastructure that would bridge the financial world to blockchain technology. I anticipate that security tokens will not only attract hedge funds, private equity, and VC’s, but also bring forth accredited investors who were previously not privy to the deal flow previously only available to institutions and well-known angel investors.


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