Are Single-Project-Based Security Tokens a Bad Idea?
TL;DR: No, they may well even be genuinely good economics, a Ludwig von Mises’s delight
Security token offerings (STO) are a new hot trend in the blockchain space as far as fund raising is concerned. Projects trying to promote this type of funding and create the related infrastructure believe that STOs can solve or at least mitigate the problems that ICOs have: the investor protection deficit and the regulatory uncertainty.
While many definitions of a security token are possible, I prefer the idea that a security token is a digital asset that creates a legal rights for a holder with respect to a certain enterprise or product (e.g. a building or a movie). This contradicts the approach so far used by the US SEC and some other security markets regulators (that considers any token with an investment aspect a security) but this approach is fundamentally flawed and indefensible and will surely be mostly abandoned in the future.
At a higher level, security tokens can be classified into tokenized traditional securities and novel assets that do not exist in the traditional security framework. Noelle Acheson even proposed to only call the latter “security tokens” to avoid confusion but I will follow the terms as they are used in actual practice. In addition, the core potential selling point of security tokens applies to tokenized securities, too. Blockchain technology applied to registering asset issues and transactions involving them can democratize access to both markets of traditional securities and other assets.
It is, however, the novel-asset security tokens that create the most interesting legal and economic questions. One potential type of such tokens may change the way companies (especially those creating novel products all the time) finance their business. Namely, instead of raising money for funding the enterprise as a whole (be it via shares or bonds), investors may be offered to fund the creation of particular products (be it movies or pharmaceutical drugs).
Of course, there already exists a limited way of doing this, namely, protected cell companies. However, so far, according to Guernsey Finance, this approach to doing business is available only for companies in the sector of collective investment schemes.
Agenus Inc.’s STO and Tabarrok’s critique
There is already at least one company that publicly announced the intention to conduct an STO tied to a particular product. As reported by Bloomberg last week, U. S. pharmaceutical company Agenus Inc. is planning to conduct an STO tied to the future sales of an experimental cancer drug. Its goal is to raise $50–100 million in this manner.
Renowned economist and economic blogger Alex Tabarrok has offered an interesting critique of just this kind approach with respect to the STO project of Agenus on the Marginal Revolution blog.
Tabarrok’s main point is that single-project-based security tokens fly in the face of the basic financial idea that investors seek diversification of risks. Investing into shares or bonds of a major pharmaceutical company may be attractive precisely because many drug candidates it attempts to develop may be flops but a few successful ones may, nonetheless, make it highly profitable, and it is difficult to predict the successful drugs in advance.
Tabarrok’s critique makes sense but I do not find it as convincing as he thinks it is. The most obvious retort is that the desired diversification, if it is so important to investors, may be easily achieved through holding many different single-product-based security tokens.
Intriguingly, an economist who, unlike Tabarrok, takes seriously the economic reality that does not conform to the assumptions of the mainstream mathematical models, may realize that project-based security tokens may be a boon for the economy. The subject that Tabarrok’s preferred approach to economic analysis completely disregards is economic calculation.
Project-based security tokens as a good economist’s delight?
Ludwig von Mises, who was the first economist to precisely formulate the central problem all economies face, namely, calculation, or distribution of an enormous multitude of resources among countless possible uses, would probably be particularly delighted to see them arrive.
Mises rightly realized that prices, and profit and loss signals they enable — however imperfect — are the only real tool for determining whether the use of capital and labour by a project is economically justified. That is why, according to him, any significant productive effort that eschews price signals (a socialist economy in the extreme case) is doomed to almost completely blind groping in the dark.
If we take Mises’ logic further (which he himself did), we may ask ourselves why stop at the level of the whole enterprise. If we calculate the end commercial result for each project that an enterprise undertakes, we can make economic calculation even more precise. Of course, the top management of many modern large firms probably tries to do exactly that to a certain extent but it is unclear to what extent this is systematic and sufficient.
However, following the profitability of particular divisions of a large enterprise may be a daunting task for separate shareholders, especially if their holdings are too small to enable them to individually influence the decisions about what to do with the divisions of the firm that are not profitable (enough) in their view.
In addition to this, market prices for stocks and bonds of enterprises can often lead to knowledge discovery. Managers may be overoptimistic about certain projects but if markets give them an unambiguous signal that the given project is perceived in a poor light, they may make them reassess its feasibility. Finally, if the management pursues too many unreasonable projects, they may face a threat of hostile takeover, even if their own shareholders are too myopic to act.
In the private companies context, the potential of security tokens is even more intriguing. Private companies may lack the discipline imposed by the stock market but sometimes this may be outweighed by other considerations. However, with project-based security tokens, such companies may in a sense get some of the benefits of public listing without having to face some of the downsides. For instance, a security token may give holders a right to part of the project’s profit without endowing them with the ultimate control over the firm. Thus, market signals without the takeover threat.
Finally, project-based security tokens may allow to democratize the access to capital markets and bring more capital to firms. First, many small investors may face excessively high cognitive costs when deciding whether to invest in a major company with lots of production projects. But they may have enough time and motivation to consider projects individually.
Of course, all of the above comes with the caveat that project-based security tokens may be associated with higher transaction costs overall than their traditional security counterparts, if only because multiple listings need to be made instead of one. For instance, one could easily imagine an absurd scenario where a security token is issued for producing each month’s worth of a product or producing a product for a given area, and so on. Clearly, such moves would not make sense. Even setting deliberately absurd hypotheticals aside, some aspects of project-based security tokens may prove more costly to handle than in the case of tokenized traditional securities. For example, tracking amounts to be paid out to holders by means of oracles will likely require more complexity in the project-based tokens case.
However, this probably only means that project-based security tokens are not a Swiss army knife of capital markets. Quite possibly, they should not be used by all firms in all contexts. Just like not all blockchain projects should have used ICOs back in 2017.
Furthermore, the question that companies will face is not necessarily a binary one whether to use project-based STOs or traditional security offerings. For instance, the above-mentioned Agenus Inc.’s security token will be backed by future revenues but those revenues are capped meaning that anything that goes beyond that will be included into the profit calculation of the company as a whole. Other ways of combining the two types of fundraising are also possible but it would be far beyond the scope of this article to attempt to spell them out.
In the end, only practice will show whether the concept of project-based security tokens is viable. However, firms who would like to attempt them should not be discouraged by critique from experts that do not take complex economic realities sufficiently into account.
