Security Tokens: Asking The Right Questions
Security token offering guide for beginners
Security Tokens! Just like those crazy black Friday sales, they surely have got a lot of attention of late. STO (Security token offerings) has become one of the most searched words on Google. And why not? They actually are that interesting. So, understandably there are a lot of curious minds out there with a lot of questions willing to understand why there is so much hype around security tokens. Well, in this blog I answer the right ones and hopefully give you enough reasons to believe in the craze surrounding them. No technical details, no in-depth analysis, just honest answers to get you started.
Why not ICOs?
With venture capitalists and angel investors being scarce, ICOs proved to be a great alternative for new start-ups to raise money and somehow this flawed model has managed to raise more than $20 million. ICOs are simply a crypto form of crowdfunding during which, a company exchanges future crypto-tokens (of the brand’s own creation) for traditional or digital currencies that currently possess value (Bitcoin, Ether, etc.). The hope of investors is that the digital token will generate prominent usage and circulation, thereby increasing its value.
There are a few reasons why ICOs were a huge success in 2017 and early 2018. First off, what a great and easy way to raise capital and get your ideas up and running! All you needed was a great whitepaper outlining how your project is going to work and some code to issue tokens. With the ERC-20 standard established, creating your own tokens on ethereum was never an easier deal. Also, startups don’t have much time with them and not maintaining enough momentum could lead to an early death. The legal paperwork it requires for setting up a corporation, or a holding account, or a term sheet is very expensive, and the process of having investors read all of that material before signing on is usually quite lengthy. With ICOs there are limits on these necessities, and the amount of time and money it takes to get things accomplished are much easier to deal with. Take for example Storj, a relatively new (and the first) blockchain-based cloud storage company that enables its users to rent out excess storage space. For its simplistic nature, the company’s ICO generated an impressive $30 million in less than a week!
However, all that glitters is not gold. ICOs surely bought a lot of glitter with them but the worrying trend with these ICOs and the money they are raising is that not enough of the projects are leading to success. ICOs have picked up a bad rap in recent times, with some major names hitting major difficulties — such as Tezos, which suffered a slew of lawsuits after infighting between the members shattered its progress.
Data collected over 2017 saw 913 projects with token sales with 435 (48%) a success, raising $5.6 billion. 131 (14%) didn’t survive this stage and as many as 347 (38%) stayed unreported, with no data displayed. Some even had their websites and all traces of them disappear. In May 2018, there were 195 ongoing ICOs listed on ICObazaar that were planning to close sales. However, only 91 public sales were closed, with a total of $2.57 billion raised.
The data indicates that there are a few big problems with the ICO space in terms of not delivering on projects after investors have taken part in ICOs. This partly comes down to failed ICOs, but also down to a number of scams and lack of investor protection. A company can hold a successful ICO, then disappear with all the money. Not so glittery now, is it? Lack of regulations and its volatile nature has led to decreased trust from investors towards the ICO space.
Another concern is the intervention of the Securities Exchange Commision (SEC) which has affected the ICO market of the U.S to a great extent. This happened because of the infamous DAO hack. As a lot of people invested and got back nothing in return due to lack of regulations, the SEC intervened to “protect” the interest of the investors. As an investor you won’t want to take part in an ICO which might be in risk of intervention by the SEC and the company you invested in is stuck in legal proceedings rather than working on its project. Moreover, the tokens issued by ICOs are just utilities and do not give you any kind of rights (voting rights or dividends) in the company issuing them. Are they really worth the hype?
This lack of regulations and elephant risks in ICOs is the reason why investors and issuers alike are looking for alternative ways of raising capital. The terminology is changing, as is the way in which these offerings are made.
What is a security?
If you have any experience in finance or investment banking, you might well have an idea what securities are but for the layman (like me) out there, here goes —
Security, in simple words, is like a certificate that has monetary value and can be traded. This certificate proves an investor’s ownership in the company and provides him/her with certain rights such as voting rights and receive dividends based on the company’s profit to name a few.
Securities are generally classified as either equity securities, such as stocks and debt securities, such as bonds and debentures (I won’t discuss stocks and bonds here but you might want to google them if you are curious). What’s important is that the sale of securities to investors is one of the primary ways that publicly-traded companies drive new capital for operations.
Once these securities have been issued, they can then be traded between investors on the secondary market. In the U.S., the securities market is regulated by the SEC, which is the Securities and Exchange Commission. The various actors in this market such as the issuer, investors and brokerage firms etc are subject to stringent regulation terms so that the entitlement of all the parties involved are equally respected.
The Howey Test
The “Howey Test”, a test arising from the US case law is used to determine when an investment offering instrument is a “security”.
The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.
So, an investment offering is said to be a “security” if
- It is an investment of money
- The investment is in a common enterprise
- There is an expectation of profit from the work of the promoters or the third party.
So, how is this relevant for ICO and tokens? If the token meets all the three aforementioned criteria, then it is regarded as security.
What are security tokens?
A token that passes the Howey test is a security token. These tokens usually derive their value from an external tradeable asset like fund holdings or real-estate pool. For example, a company ABC corporation may decide to tokenize its assets and distribute security tokens to investors as proof of asset ownership. Now, these investors (token holders) may be entitled to an array of financial rights such as equity, dividends, profit share rights, voting rights, buy-back rights, etc. Since the tokens are deemed to be a security, they are subjected to various SEC regulations and federal securities. It can be said that tokenized securities are a digital form of traditional stocks running on the blockchain with compliance rules integrated into the token itself.
Traditional stock ownership is in the form of paper documents or PDFs. In case of STOs, stock ownership is in the form of a token on the blockchain. That simple!
The why do we need security tokens if they are so similar to traditional stocks?
This has to be the most important question. What advantages would replacing the traditional stocks with the digital blockchain system give us? I give some points below on why I think digitized securities can be massive if implemented properly.
Combination of traditional VC and utilities: best of both worlds
I like to call security tokens as regulated utility tokens because that’s what they basically are. Using the power of blockchain to enable trust and remove middlemen along with imposing regulations as needed in conducting traditional IPOs, security tokens take full advantages of both the worlds. This results in faster execution and lower costs (as was in the case of ICOs) with proper regulations and investor security (as in the case of IPOs). Thus security tokens prove to be an attractive intermediate for both startups looking to raise funds fast and established companies looking to tokenize their assets. Not to forget investors, who get to be a part of something secure where their position is well respected in a regulatory sense.
365/24/7 market
Where traditional share markets are off on weekends and close at 5 pm, the security token space remains active as long as the blockchain is active, i.e. 24/7. This huge digital advantage opens up an array of opportunities for investors and businesses alike. Doesn’t matter if it’s 5 pm in New York or 3 am in Tokyo, the space is open for investors all over the world. This is something that can be hard to implement when it comes to real life assets but surely is a lucrative advantage.
Additional features on top of traditional securities
This is, in my opinion, the major USP of security tokens. With traditional securities, as an asset owner, you are entitled to various rights such as governance, voting, and dividends. With security tokens, the options are truly limitless. As long as you can code it into the blockchain contracts, any kind of feature can be enforced along with ownership of these tokens.
Let’s say, for example, KFC wanted to sell its shares to the public. If the company goes the traditional way, the owners of these shares would be entitled to the corresponding profit that KFC makes along with voting rights in the company, perhaps. But the owners went one step further and tokenized their shares on the blockchain and distributed these tokens to the interested buyers. Many additional features were also encoded into this token like if you own the token for more than 6 months, you will get a 20% discount in any outlet. So as an investor, you are not only entitled to the profits but also additional attractive incentives which are not possible traditionally. Even if it is, the best part about blockchain is that all of this can be automated and KFC doesn’t have to worry about verifying an owner’s credibility.
Liquidity
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Cash is considered to be the most liquid asset as it is easy to trade, while real-estate or fine arts are relatively illiquid. So where do security tokens come in?
Imagine you want to sell your real estate property and you even had a buyer ready, it would still most likely take weeks or months for a deal to close even though it is just a transfer of ownership. Tokenized asset, on the other hand, you could complete the deal in minutes. Tokenized private securities give that flexibility to owners to sell their assets freely in the secondary market. Liquidity is greatly enhanced due to the automated transfer of ownership while taking all the security regulations into consideration.
Programmable compliance
Just like additional features, compliance can also be programmed into the token to automate the process of regulated transfer. This basically means that the token can only be owned by and transferred to verified investors. It’s a key advantage that blockchain provides and you will find that most of the players in the STO ecosystem, through their platforms ensure that the transfer of securities, along with being automated, must also follow all federal restrictions and regulations.
Fractional ownership
This is something that has got mixed reviews from the experts. The question is that, is it actually logical? Maybe, maybe not but it’s certainly something that deserves a shout because something like this is not at all possible anywhere else other than on the blockchain. Tokenised assets can be easily divided into smaller units enabling fractional ownership. This will attract smaller investors like me who never even dreamt owning a share in real-estate (or even afford it) to actually own a part of it. I don’t need a million dollars in my bank account to become an asset owner anymore. This not only attracts investors but also gives an opportunity to the issuers to have a larger diversified pool of investors. Logical or not, it’s surely interesting and can be revolutionary if implemented the right way.
There have to be some challenges, right?
Absolutely, and some huge ones! No matter how attractive the advantages may be, understanding the challenges is important if proper solutions are needed to disrupt the financial industry.
Complexity
As already mentioned, security tokens are truly securities and are subject to various regulations and federal restrictions. To code all of these regulations in a smart contract can sometimes become strenuous given the complex intertwined set of regulations. Where financial institutions have big legal teams to ensure regulation and still fail sometimes, automating all of that on the blockchain shouldn’t be that easy, right?
Unlike an ICO which is more of a technical thing, a set of technologists can’t ensure regulated issuance of security tokens. You need an experienced team with business and legal backgrounds as well as experts in a range of fields, depending on what you’re tokenizing. In my opinion, the technical aspects contribute a mere 10–20% to security tokens. Rather, it is very important to get everything right majorly in the regulatory sense. However various STO platforms are doing their best to replicate the traditional shares ecosystem on the blockchain, both in a technical and regulatory sense.
Huge responsibility on token issuers
Traditional securities have everything established. Exchanges and brokers all around the world, you just simply call up your broker, if you want to list your shares. STOs, on the other hand, require you to create your own tokens as well as a platform to manage their sale. Getting this crucial part wrong can result in financial loss and obviously legal problems.
This demands for establishment of a secure end to end platform for secure sale and management of tokens which can be very complex for businesses to do themselves. This is where STO service providers will come in and take the responsibility to deal with the complex technical framework and allow businesses to just focus on creating value.
Limited speculation
To be honest with you, security tokens are still a theory. Yes, it may be the next big thing or may have the potential to disrupt a trillion dollar market, but it’s still an idea that is developing. All these new standards and protocols coming out every other week regarding security tokens is what I like to call is the booming ideas phase.
The proper ecosystem is still not established to promote large-scale STOs. Security token exchanges are still under development along with token issuing platforms. What is going to be THE standard that will be adopted for issuance and management of security tokens? How do we list these tokens in exchanges or the secondary market? There are still a lot of questions unanswered but it’s good to see so much interest and effort by major enterprises to answer each of them.
The security token market is still too young to be lucrative enough for investors and issuers to shift their trust from the traditional market to a technology that is in itself, nascent. Still, a long way to go…
What does the future hold for security tokens?
Now that ICOs have cooled down with fewer and fewer projects in the space, concerns have risen among investors and regulators if blockchain is the right solution for handling so much capital influx. To be fair, blockchain technology is still in a nascent stage and I expect newer development and ideas coming into the space driving innovation and encouraging more capital. Although failed ICOs may be a huge reason why the thought of STOs came into being, STOs are not here to replace the utility market or cryptocurrencies like Bitcoin but rather have a financial boom of their own. It is important to understand the stark differences between the two and not to be at fault comparing them. Where ICOs can still work all too well for issuing utilities or your casino chips, STOs target a completely different industry and are here to transform the traditional finance industry. Both of them are still young and very well develop parallelly.
While there have already been a few successful Security Token Offerings, the market is still waiting for regulators to weigh in. However, a lot of big players are seeing the potential in this and are beginning to make moves to prepare for what’s according to them, is an inevitable boom. The graphic below really astonished me given not only the quantity but the quality of the players involved.
That’s a lot of competition in an under-developed market! Or more of a protocol fight. New partnerships, new protocols, new standards have become pretty common now.
The industry is developing rapidly, so much so that, a couple of years from now companies would be forced to join the wave even though they don’t understand the blockchain space at first. There are major challenges and a lot of dangling questions at this early stage but given the massive advantages the blockchain promises, soon we will see crypto assets dominating the finance world.
It’s reported that STOs are expected to make up 10% of global GDP — roughly $8 trillion by 2024. Huge! but not surprising seeing the pace of development now.
Now that the basics are clear, I will be coming out with further blogs doing an in-depth analysis of Security tokens and the STO market. See ya in a bit!
Here at Techracers, we work towards the development of enterprise-grade solutions for compliant issuance and management of security tokens. You can know more by visiting our website:
You can always contact me at arout@techracers.io to know more.
