THE UPCOMING SECURITY TOKENS REVOLUTION

Introduction

I have been predicting the fall of crypto markets since january of this year, starting to exit all my crypto positions already in december and by february completely moving to cash. While doing this I was thinking about the famous Warren Buffet’s move in the 70s when he sold all his stocks while the market was booming and returned all the money to his shareholders. It took another year and half for a market to crush. With markets its important to remember that at some point the market will reflect the fair (intrinsic) value of the underlying asset. In case of most crypto projects unfortunately this value is close to zero. When you have no tools to come up with a fair value of an asset its better not to hold it at all. Is it all over for crypto markets? No its just the beginning. The next wave will be worth trillions of dollars and it will transform the world as we know it. This next coming wave will be represented by security tokens. Legislation is important for crypto assets first of all to protect investors. Institutional money will move into the space only when fund managers will be able to obtain the required level of disclosure about various assets and as a result will be able apply various well known techniques of security valuation. This will be possible with security tokens. Crypto currencies have given us the technologies to kick of this revolution and we are entering its second phase which will be much bigger than the first. In fact I believe that all securities in the world will be eventually replaced by security tokens. So I suggest to take a look first at what is technologically different with security tokens that could initiate such a massive transformation.

Rapid Settlement

One of the first security token exchanges calls itself tZero for a reason. All securities today take from 1 to 3 days for settlement. This is where abbreviations T+1,T+2,T+3 come from. The only securities that are settled same day are US treasury bills. You could read this investopedia article to learn more about this. Its also worth listening to one of Partick Byrne (tZero CEO) speeches on youtube to learn about the incredible complexity of current US stock settlement mess. What is surprising is that not only the process is slow its also extremely unreliable and the entire system already collapsed couple of times. Blockchain brings ideal solution for immediate trade settlement. So it becomes cheaper, faster and much more reliable.

24/7 Trading

All exchanges around the world have their operating hours. With the advent of security token exchanges this will become a thing of the past. Trading of security tokens will be 24/7.

Unlimited flexibility of possible financial instruments

It seems that there are plenty of financial instruments offered to investors today which fall into three categories primarily: debt securities, equity securities and derivatives. There are also hybrids of debt and equity like preferred shares, convertibles and warrants. Each of these categories include many subtypes. The emergence of smart contracts however allow creation of literally unlimited new types like for a example a revenue sharing token. The actual financial engineering is given back to the hands of issuer. Technical flexibility to design whatever instrument you wish for is combined with built in regulatory compliance. The protocols to enable all of it include: Harbor’s R-Token [1], Polymath’s ST20 protocol [2], the ERC-884 proposal [3] for shares compliant with Delaware Corporations Law, and Open Finance’s S3 Protocol [4]. All these are examples of how transactions will be validated on chain and in real time so that only authorized investors can buy or sell specific security tokens.

First we will most likely see the following 4 classes of security token structures:

• tokenized VC funds
• share-like tokens including revenue share tokens
• Asset backed tokens
• crypto bonds

Increased liquidity and market depth

All securities today fall into two main categories: private securities and public securities. Private securities are much cheaper to issue however when it comes to secondary trading multiple challenges arise that greatly increase trading costs and decrease liquidity. Not only such trading requires multiple middlemen like brokers and exchanges there are also countless regulations that need to be followed. Private securities must fall under exemptions so that onerous filing requirements could be avoided. There are exemptions that limit number of total investors, the type of investors, exemptions defining holding period and many other rules. There restrictions differ by jurisdictions and compliance with all the rules and regulations of both the issuer and investor jurisdiction is required. Fortunately smart contracts allow to automate all that. When security tokens are issued all the rules for their secondary trading are encoded into smart contracts making it impossible not to comply with existing regulations. Since all the investors have to go through KYC/AML procedures on security token trading platforms that are being built compliance becomes fully automated. For example if you are not an accredited investor by US regulations you will not be able to buy the specific token. Such token can’t be sold to more than 99 investors for example and so on. The result of this is increased liquidity without the associated costs.

When it comes to offering security tokens to the general public US Reg A+ regulation offers a great alternative to a typical IPO. Back in 2012 US Congress passed the Jumpstart Our Business (JOBS) act in order to encourage small-business growth. This law intended to support small- business growth and employment by decreasing regulatory hurdles for companies willing to go public and also allowing firms to have more private shareholders.

In 2015, addtional Title IV of the JOBS Act went into effect, allowing companies to raise money from general public and not just accredited investors.

Reg A+ allows U.S. or Canadian companies to:

• Raise up to $50 million over12-month period through “public solicitation” of the company shares while having the offering exempted from filing to SEC.
• Submit the offering memorandum to the SEC prior to conduction mini-IPO to get response first.
• Enjoy a faster review process with offering memorandum required to be made public just 21 days before SEC qualification and the beginning of roadshow.
• Combine public funding (through Reg A+) with private funds from venture capitalists to raise more money.

With the features listed above Reg A+ is an ideal legislative framework to follow to issue security tokens to raise money from the public in a complely legal way as oppossed to ICOs that we have seen so far.

In a typical IPO as much as 700K could go to lawyers and auditors. The beauty of Reg A+ STO is that legal fees along with token and smart contract development will cost you only around $50K–75K. There are also AML costs per investor which are not significant, marketing and advisory fees. Please visit STO section of our website for more details http://tethacrypto.com/sto/

Automated and streamlined issuance & compliance

Since the process of issuing private securities is similar for a particular jurisdiction its possible to easily automate the process. It is possible in theory for one platform to automate the issuance of security tokens that will comply with legislation of any particular jurisdiction or even with jurisdictions worldwide. The issuer could select himself investors from which jurisdictions he is willing to target and which to exclude. Everything will be coded into smart contract.

Fractional ownership

There are many lucrative assets that are available only to specific high net worth investors. For example airports are well known for their profitability. Most airports today are owned by private equity funds. Tokenizing airport creates a unique opportunity for general public to participate in these profits. An airport could easily produce annual income of 20% for an investor. Such level of profits with relatively low risks are simply not accessible for a retail investor today.

Typical process of issuing a security token

What are the steps of issuing your own security token ? There are four main steps:

1. Hire an advisor
2. Hire legal counsel
3. Engage with one of issuance platforms
4. Marketing roadshow

Advisors and legal counsel will help you to structure the offering and technical platform will facilitate the actual creation of a security token with the required functionality. Many platforms are being built and its better to engage advisors which will help you to understand the important differences between the platforms. For example some platforms like polymath create tokens that are independent of the platform and will continue to exist even if the platform itself goes away in the future. Harbor on the other hand has other advantages when it comes to regulatory compliance but if something happens to the platform the actual tokens will have to reissued. Each platform has its own advantages and disadvantages which are important to distinguish beforehand. The entire process is most likely to take about 6 months.

Security tokens ecosystem

New platforms and solutions for security token ecosystem are being created daily. At the time of this writing we have on our list 19 tokenization platforms, 7 exchanges, 6 market makers and security layers.

Its my job in Tetha Crypto to speak daily to both potential issuers, lawyers and issuance platforms so I would be happy to answer any potential inquiries. Please contact me directly at ilia.frankstein@tethacrypto.com

Your comments about this article are also greatly appreciated.