Security Tokens: Hype vs Reality

One of the most exciting parts of our job is coming to work and discussing the future of blockchain technology, potential use-cases, effective governance policies, token economics, and all the various moving parts when measuring value in this industry.

Going forward, we decided it would be more beneficial for the community to share some of these conversations. We will be sharing short blog posts highlighting some of the key takeaways from our daily conversations.

With the upcoming launch of ICON’s security token standard, the first topic we will cover is the practicality of tokenizing securities. While people in the space have been boasting significant benefits, we would like to temper expectations while pointing out a few specific areas where we see some tangible value.

Our View on Security Tokens

In 2018, with the demise of ICOs, we saw a wave of people excited about STOs (Security Token Offerings). Many of these people touted benefits such as faster settlement, fractional ownership, increased liquidity, frictionless global trade, access to alternative investments for all, and generally lower costs for issuing securities.

As stated by the founder of Polymath in an interview with Forbes,

“LP shares, startup equity and even fine art are all typically illiquid assets. STO’s have the potential to unlock this value. They can make small, private non-liquid securities more accessible for everyone.”

After thinking this through, however, many of these benefits won’t necessarily come from blockchain directly, as technology is not the primary bottleneck. The reason these investments are only accessible to the few has nothing to do with technology, but rather, it is strictly a regulatory issue (often times Regulation D)

Additionally, settlement time is a regulatory decision, a global investment platform requires adhering to securities laws in all jurisdictions, fractional ownership is already available, a lack of liquidity could just mean a lack of demand, and many issuers are willing to pay the cost of issuing securities through an investment bank for access to their relationships, not their technology.

At the fundamental level, blockchain is an enabling technology, nothing more than that. Many of the outlined benefits will require regulatory revisions, adoption of new markets, or a paradigm shift in business practice.

Having said that, we still believe that blockchain will add value to securities markets. We believe that “programmability of an asset” is the core feature of a security token, which would enable adding utility functions to a security, baking in compliance, and mitigating settlement costs.

Programmability

There are several benefits that can be seen through combining programmability with traditional securities.

Added Utility Functions

Having the ability to program a specific utility function into traditional equities could add value to the security that was previously impractical. For example, offering stakeholders of a media publication the opportunity to curate the front page. Applying the DPoC approach, passive investors could delegate this responsibility elsewhere, while active investors could take part in pushing quality content. If the publication has a significant user base, having such utility adds more value to the security.

Reduction in Regulatory & Compliance Costs

Having the ability to program specific compliance functions into a security could significantly reduce the cost of compliance-focused staff, while also making the job of regulators easier. It is possible to program rules such as KYC/AML policies, maximum number of holders, distribution conditions, lock-up periods, etc.

With these rules programmed into the asset itself, regulators can rest assured that policies will be self-enforced. The role of the regulator would begin to look more like that of a smart contract auditor.

Mitigating Settlement Costs

While the length of time until settlement is a regulatory decision, the cost of settlement is not. Large banking institutions maintain a strong head count in what is commonly referred to as the “middle office”, primarily to settle transactions.

If settlement features of an asset were programmed directly, the operational costs of maintaining a middle office could be mitigated at worst and entirely eliminated at best, all while still providing a secure way to settle transactions.

You’re Tokenizing What?

Tokenizing seed-stage equity of a startup, in our view, doesn’t really benefit the market as a whole. You end up with the passive investor looking for a quick exit (as seen in the ICO bubble), rather than the longer term support of an active institutional investor. Additionally, you add significant responsibilities and headaches for issuers, including 24/7 price discovery in an inefficient, immature market, more oversight from regulators, and greater disclosure burdens to public stakeholders.

Real estate, however, could have some interesting benefits from tokenization. While early-stage companies are oftentimes difficult to value without tangible assets, the real estate market could benefit from this greatly. With tangible underlying value, real estate investors could more easily arbitrage secondary market inefficiencies using fundamental analysis of the underlying value.

Additionally, much of the current real estate market suffers from what could be called a “liquidity discount” (the opposite of a liquidity premium). Liquidity discounts add to the inefficiency of the current real estate market, as most real estate is purchased at a discount to its intrinsic value because of the immense liquidity sacrifice and difficulty in transferring ownership.

Concluding Thoughts

The blockchain space is exciting and full of promise, making it is easy to get sucked into the dream without thoroughly considering how difficult it would be to get there, and why things work the way they currently do; we think it is important to note that, in the end, blockchain is an enabling technology. Those working on security tokens will have many regulations to navigate, many processes to understand, and many incumbents to appease.

With this in mind, ICON’s security token standard will focus on what programmability can enable. We want ICON’s partners, such as the Korea Financial Investment Association (KOFIA), to have a better understanding of reality vs. hype when it comes to tokenizing securities and work together to build a better infrastructure for the securities market. The value proposition is clearly there, and we look forward to collaborating with others who share a similar vision to help the industry evolve.

Your Partner in Blockchain,

ICX Station — SF