Security Token Offerings (STOs) — The first great use case for Blockchain technology?
Is Blockchain dead? If you look at most of the reporting around crypto winter, it seems to be. Pretty much all crypto currencies tanked. ICOs, once raising millions of dollars based on spurious (but usually grandiose) claims, have mostly evaporated. Small teams claiming to revolutionise banking, or insurance, or shipping, or whatever, have disappeared.
What we are seeing now, in my opinion, is the second wave of blockchain applications. Companies with existing businesses are rationally evaluating blockchain technology. Blockchain technology provides significant advantages, e.g. immutability and decentralisation. Companies with very clear use cases are applying Blockchain technology, if it creates sustainable value. In fact, blockchain developer was the fastest growing job category in the US in 2018 (according to LinkedIn).
Some of the most obvious use cases for blockchain technology are within supply chain applications, identity verification, and financial services. One of the trending topics within financial services are security token offerings (STOs).
With recent regulatory changes, STOs are happening, today. Arguably, STOs constitute the defibrillator of the presumed dead blockchain movement. And, as such, are definitely worth understanding.
ICO vs. STO
So what are STOs? In his blog post, Stephen McKeon, professor of finance at the University of Oregon, provides a handy definition of security tokens:
“I define security tokens as any blockchain based representation of value that is subject to regulation under security laws. That includes tokens representing traditional assets like equity, debt, derivatives, and real estate, and it also includes pre-launch utility tokens that are deemed securities by the SEC.”
One significant difference between ICOs and STOs is how value accrues.
Most ICOs peddled utility tokens. Utility tokens are supposed to increase in value as more people use the underlying network. However, to be fair, in the past most increases occurred due to speculation. Still, investors hope to choose a network which will gain widespread adoption, increasing the demand for their utility tokens. With increased demand, the value of the token rises and profits can be realised by holders. Some ICOs also tried to sell unregulated security tokens, however regulators very quickly cracked down on these (rightly so).
Contrarily, STOs are regulated by the country’s financial supervisory institution (e.g. the BaFin in Germany). Security tokens represent ownership of a real-world asset such as real estate, debt or equity. Holders of security tokens have the same creditor rights as other investors. Stricter regulatory oversight should increase the trust brought towards these tokenised assets. The first tokenised assets we see are debt and real estate. I expect smart people to find all kinds of cash flows which can be tokenised, packaged and sold off.
Why are security tokens better than conventional securities?
Security tokens can be used to fractionalize assets, facilitating joint ownership. Since tokens are generally fungible even small assets can be split up between investors. For example, retail investors could acquire small pieces of a bigger asset — let’s say a new residential complex in Berlin. Until now an investment like this is reserved for the more affluent, who can afford fund shares, silent partnerships etc. With security tokens, multiple retail investors can share the proprietorship of an asset, down to a tiny share. Want to invest €200 per month into 10 different apartments? No problem, as the indivisible real-life asset can be fractionalized on the blockchain. This leads to an overall reduction in trading barriers and increases the liquidity of assets.
The second advantage of security tokens over conventional securities is how much tedious work can be automated. Although security tokens are regulated like conventional securities, the settlement is easier. Smart contracts that are hardcoded on the blockchain could e.g. automate parts of the settlement. The rent could be automatically disbursed to all holders of the tokens on the first of every month, automatically. KYC and AML processes could run in the background, based on identity tokens (vs. my bank manager copying my passport for the 52nd time).
As security tokens are not tied to any one jurisdiction, true global trade (potentially around the clock) becomes possible. An investor from Sao Paulo could invest in a German bond offering. Or a German investor could support microloans in Africa. All in the same wallet, with the same infrastructure.
Finally, security tokens help remove intermediaries from the transaction process. Issuing securities is complicated and costly. Besides the regulation it requires dealing with custodians, banks etc. These not only add cost, but generally force customers to use sub-standard infrastructure, outdated processes etc. Since the blockchain secures full transparency for all participants, these middlemen become redundant as the trust-building agent.
Regulatory breakthrough in Germany
Why is the German regulator BaFin concerned with STOs at all? The mission statement reveals the answer: one major duty is “safeguarding the integrity and stability of the financial system and protecting consumers as whole”. STOs grant investment opportunities to private investors, a group particularly worthy of protection (and who lost disproportionate amounts of money in the ICO craze). Considering the disruptive potential of STOs, it can even have implications on the stability of the financial system. This supervision is necessary.
In February 2019 we witnessed a breakthrough in the regulatory framework of security tokens in Germany. BaFin allowed the issuance of security tokens for the first time. The first company to receive an official approval is Bitbond. The Berlin-based company offers loans to SMEs and the settlement is conducted on the blockchain. Bitbond now aims to collect up to €100M in an STO, to lend out. Companies wanting to offer security tokens face significant reporting obligations. This includes the filing of a prospectus, in the case of Bitbond of 74 pages.
Bitbond’s offering marks one of the first STOs in Europe and positions Germany as a forerunner in that field. BaFin’s positive attitude towards blockchain-based funding may be a surprise for some people. Only a few months earlier, BaFin prohibited an ICO of the company Rise. Rise develops AI-based trading strategies for retail investors. It advertised with catching slogans such as “Invest like a Billionaire”.
Although I am normally very critical of German governmental institutions in regard to innovation, technology (or most other matters), the BaFin is actually very cooperative — especially if you make sure to protect retail investors.
Practical implications of STOs in the wild
Let’s look at an example of STO adoption in practice. Let’s assume we operate a digital real estate crowdfunding platform (there’s a few out there). Shifting to security tokens has several advantages for the crowdfunding platform. It reduces the transaction costs that arise from high fees for brokerage services by over 90%. Minimum investments can start with 1€. Tokens can be traded on the secondary market easily. Transactions can be processed in less than one minute (e.g. on Ethereum blockchain). And international investors can buy the tokens.
However, building on the blockchain requires an infrastructure layer connection. In computer terms, it’s a bit like messing around with TCP/IP, if you’re really developing a food-delivery app. Today, developing blockchain software is challenging. Experienced blockchain developers are difficult to find. The systems need to be maintained, secured against malicious actors, and adjusted to regulatory changes.
One of the HV Holtzbrinck Ventures investments is a company called Upvest. Upvest is building a multi-protocol blockchain API, that simplifies the development on blockchain protocols. Upvest abstracts away most of the gnarly details and provides a clean interface for developers. A bit like Stripe, which allows you to ignore all the stuff happening behind the scenes to accept credit cards.
What we love about Upvest
As mentioned, Upvest helps developers to integrate blockchain technologies into existing processes. Today Upvest provides three key APIs (with more to come).
The Wallet API allows companies to store (and recover) crypto assets. The Transaction API allows companies to trigger transactions. And finally, the Data API provides current and historic information about the state of the network.
Upvest is based in Berlin and has 20 FTEs of which 15 are engineers. With currently five paying enterprise customers, and more than 600 developers on the waiting list, early signs are promising. It will be exciting to see what developers do with the service.
End of infomercial break.
Outlook
Let’s dare to take a look into the crystal ball. What impact could security tokens have in the next few years? I expect we will see a huge increase in the volume of tokenised assets. Real estate is an early adopter, as the benefits of fractional ownership are so obvious. But why not think of every asset generating a revenue stream as a tokenisable asset. Powerplants? Cows? Your local pub? Who knows?
The technology will also improve. Asset swapping will allow you to switch between assets in one transaction, without moving to fiat, saving transaction costs. Smart contracts can increasingly automate rote processes. Ever more protocols will appear and interconnect.
In the end, tokenisation will empower more retail investors to participate in attractive investments. With fractional ownership and lower minimum investment thresholds, market liquidity will increase. STOs will contribute to a more liquid, efficient, and fair market.
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