Is The STO Undertow Killing ICOs?
The STO wave is coming.
When? The answer depends on who you ask.
This article is not advice nor predictions, simply my perspective after spending the past 15 months engaging over 30 different securities commissions, financial intelligence units, and financial authorities throughout North America, Asia, Europe, Africa and even Australia.
The consensus among these market influencers is encouraging. Most of the regulators I have met around the world see blockchain as an innovation that can enable greater transparency, access to capital, and liquidity. While we provide these regulators with live demos of our end-to-end security token issuance and multi-jurisdictional trade restriction management our objective is greater than “show and tell”. Most regulators have only heard about how blockchain can make their job easier, our goal is to show them what that looks like…
While still in it’s infancy, the crypto-asset industry has now been around for a decade. The technology has threatened institutions, incumbents, and fintechs alike as the entire fabric of capital markets begins to shift. While the media and most VCs who lost the ICO game point to the price of Bitcoin, Ethereum, or Altcoin du jour and say “crypto is dead”.
They couldn’t be more wrong. Sure the market is contracting. I think we can all agree it needed a solid correction but the bigger story is in the infrastructure that is now available for issuing and trading securities and commodities as digital assets in full compliance of the securities regulation in over 150 countries. That’s right. Prospectus exempt securities, available to accredited and non-accredited investors as a liquid, global pool of capital.
What a time to be alive.
Earlier this year in July, the Token Alliance released its first white paper with the objective to establish appropriate business and legal parameters for digital token issuances. If you’ve read my previous piece on New Token Standards or Open APIs and SDKs? you’ll sense the skepticism towards the establishment of so-called new standards. But all that aside — tokenization of financial instruments has continued to gain traction, with over $20 billion already raised through coins and tokens in the past 3 years.
The financial sector is renown for being historically slow to evolve, meanwhile the cost of compliance is crippling most financial institutions in 2018 — exceeding 15% of GROSS ANNUAL REVENUE. That’s right — the multi-billion dollar, multi-national bank you see everyday — their largest expense line is now KYC and BSA/AML compliance.
This has helped to create a false narrative that regulation is anti-innovation. However, quite the contrary, those that choose to move forward quickly and disregard regulation — will ultimately fall behind as new, compliant innovation reaches the market, opening the doors to institutional capital. Security tokens are one innovation that must be built to the standard of securities instruments in the traditional market.
Utility Tokens and Security Tokens
The two most well-known types of tokens are utility and security. Utility tokens tend to be issued in two scenarios:
Scenario One: They are issued with their value based on the fact that they can be used within a particular ecosystem; they were purchased in exchange for a service and are essentially “digital coupons.” For example, if the issuer of the utility token (Company X) provides cloud storage as a service, you can use your utility tokens to access that storage.
Scenario Two: In the second scenario, utility tokens hold what we would consider perceived value. This is because they are being issued for projects that have not yet been developed and represent future access to a company’s services or products.
The defining feature of utility tokens and which differentiates them from security tokens is that they are not meant to be used as investments. Unfortunately, simply stating that a token is not meant to be used as an investment will not be enough. Most projects that claim to have “utility tokens” still hit the key points of the Howey test or other relevant case law, deeming them in fact, securities, and subject to securities laws. Additionally, many projects will simply allude to the fact that you are buying low and things like a restricted token supply will make it go….well…to the moon — a great way to get the conversation started with the SEC.
Security Tokens
Security tokens have real-world assets backing them up. For example, the tokens could represent equity in a company or real-estate which gives them tangible value, with an assignable fiat currency value. They can be liquidized, pay dividends, share profits, pay interest or be invested which makes investing in these tokens attractive. These tokens must adhere to securities laws. Currently, there are major use cases emerging for three different categories of securities: debt, equity, and derivatives.
These subcategories hold different types of value. The securities umbrella also further extends outward to asset classes such as bearer bonds, royalties, convertible notes, options, smart swap contracts and smart futures contracts and so on. Simply put, you can equate the subcategories of assets under securities in the token market to those in the traditional financial market.
Debt tokens are issued out by lenders and represent debt owned by a company. They can be thought of as loans or IOUs often with an interest rate multiplied or compounded against the principal amount loaned (invested) to a company. They are a type of capital raised through debt that enables the buying and selling of loans within a high-liquidity environment. Depending on the wording of the legal agreements, as well as the structure and functions available in the token, debt tokens may incur unique tax and reporting requirements for anyone issuing, or in some jurisdictions even transacting with, the token.
Equity tokens are the most common form of security tokens and in many cases, investors believe that the terms equity and security token are synonymous. On the contrary — they do not mean the same thing and the terms should not be used interchangeably. Part of what makes equity tokens so attractive to investors outside the crypto space is their similarity to equity shares in a company. These tokens earn issuers the capital they need to develop a network, and in exchange, investors purchasing equity tokens could earn returns such as dividends and in some cases, the right to vote on company proposals. Equity tokens have opened up Pandora’s Box and a plethora of questions on governance issues — do equity token holders have voting rights? What are the mechanics for shareholder majorities and board elections? While these questions remain unanswered, many believe that equity tokens will become the predominant ICO token.
Derivatives form the foundation of financial stability in traditional financial markets. They are used to transfer risk from one person to another and can be thought of as insurance contracts on the variation value expressed on an underlying asset. Prediction Markets are in their infancy and have begun placing option bets on the future of specific stock based on derivative products. Financial derivatives are not as common in the crypto space today but many projects are emerging and with security tokens becoming popularized many believe this is set to change sooner than later.
It’s important to remember that smart contracts are neither “smart” nor “contracts”.
A Footnote on Smart Contracts and Legal Agreements
A frequent misconception I come across in the market is the notion that your smart contract would hold all the logic of a shareholder’s agreement, article of incorporation, subscription agreement, regulatory trade restrictions, BSA/AML compliance, etc, etc…this is insane.
A token is simply a “smart share certificate”. Think of a token as a blank sheet of paper — what is written on it will define what regulation is applied to it. It is highly unlikely that any token you issue is “not regulated”, it is more likely you are unaware of how it will be regulated. In the world of crypto-assets, a small adjustment to one line of a smart contract could be the difference between a commodity, a security, and a Ponzi scheme.
For security tokens — maintaining ownership of your token gives you access to the sets of rights, and possibly obligations, that are written out in natural language contracts…aka, legal agreements.
For utility tokens — it is possible to have the token contain all rights associated with it’s own possession. To my knowledge, this “code as law” philosophy — while intriguing — has yet to see any successful precedents. Please drop a comment below if you know of an example.
Digital Asset Regulation As A Service
The current regulation around the issuance of security tokens varies based on a number of dimensions (for example, asset type, jurisdiction, etc.) and each dimension contains various regulatory permutations with a host of regulatory agencies governing them. This complexity is only increasing with new regulations such as GDPR, MIFID2, PIPEDA, CRM2, PSD2, and whatever acronym they think of next. If I can make a prediction with certainty — regulation is not going away and it’s evolution will be slow.
However, there is nothing stopping us from automating most of the regulatory obligations. 2018 has shown tremendous progress in this area, our team being one of many exciting projects spanning custody, stable coins, non-fungible tokens, and perhaps most notably — full compliance to current regulations. Today, the market is throttled by archaic regulatory processes, finance is digital – in most jurisdictions, the regulators are not.
For our team at iComply, the biggest 2018 milestone was being the first I. The world has to successfully screen counter party risk and execute both the buy and sell side requirements of a trade, across multiple jurisdictions, in real time, for a prospectus exempt security. What is even more exciting is that we have been able to successfully do this for wallet to wallet transfers, decentralized, and centralized exchanges using any hot or cold Ethereum wallet.
This wasn’t an overnight win. In 2016, I completed my first proof of concept at MIT. At that time, interest rate swaps were under regulatory pressure due to Basel III, the minimum swap size was $25M USD – the margin required to cover $12,000 of mechanical legal work. We proved two things, 1. that we could reduce $12,000 to under $1 of computation on Ethereum and; 2. the technology wasn’t mature enough to execute $25M transactions. The DAO showed us that.
We patented this technology and called it “Prefacto” because it can enable end-to-end pre and post trade clearing and settlement before the blockchain can make the trade immutable. Integrating this compliance layer with blockchains like Ethereum make it easy for peer to peer trades, decentralized or centralized exchanges to quickly validate and clear a transaction — typically in less than 30 seconds.
It will take time before this technology is ready to support publicly traded or prospectus issued securities. The infrastructure is simply not there yet. For private and exempt markets however, the wave is building…and, it’s a tsunami. At 30 seconds for trade processing the private markets will be able to trade in T-30 seconds rather than the current T-2 days standard in the public markets.
Simply changing the name ICO to STO, ABT or TGE does not mean anything. What matters is the rights and functions of the smart contract, and solid legal documentation backing these digital assets up.
Most of the ICOs from 2016 and 2017 have proven to be a scam, a failure, or a victim of keeping too much crypto on the balance sheets. Those that are still alive are spending larger and larger portions of their capital on legal and tax issues. Without quick remediation, I believe most of these first movers will be quickly eclipsed by the fast followers with better thought out business models, saner valuations, and “compliance-aware” tokens.
In December 2018, OFAC published — for the first time in global history — the first two sanction crypto addresses. While institutional and more traditional investors are beginning to warm up to the possibilities of crypto-ETFs and security tokens, real amounts of capital will not flow into the crypto market until we as an industry can provide assurance that our technology can, in fact, meet or exceed the current standards for the traditional market.
Looking to 2019…
Currently, I know of over a hundred of projects spanning Canada, US, UK, Europe, and Asia that are simply holding steady — waiting for the market to show signs of warming before launching their security token over the new fabric of capital markets. We are seeing new industry milestones such as Harbor’s real estate offering or Spice VCs token trading on Open Finance Network. While these trailblazers are breaking ground every week, I believe we will not see any major shift in the markets until the every day retail investor is able to participate, within reason, in the fruits of tokenization — access to global capital, community, and liquidity.
Matthew Unger is the CEO of iComply Investor Services, a global financial risk and intelligence platform for managing financial KYC, BSA/AML, and securities regulation compliance for token issuers, exchanges, fintech, and online broker dealer platforms.
For token issuers and security token platforms, iComplyICO supports the end-to-end issuance of security, utility, or non-fungible tokens and trading among accredited and non-accredited investors in over 150 jurisdictions as a digital regulatory service. No setup fees. No success fees. Unlimited tokens. Sign up for a free demo today.
For crypto exchanges, security or commodity token exchanges, iComplyKYC enables fully automated screening, to the local standards of the investor/user, for individuals, corporations, and accredited investors in over 160 countries using a single REST API. View pricing or test the API for free on iComplyKYC.com
