Thoughts on Security Tokens
Anyone who’s been following the development of tokens closely knows there is a general consensus on the classification of tokens into three broad categories:
- Utility tokens,
- Security tokens,
- Equity tokens (technically a part of security tokens, but they are important enough to be a separate, stand-alone category).
Utility tokens are generated in order to tokenize a specific product or service. The tokens are then used to pay for the good that will be used or consumed.
Security Tokens represent an ownership stake in an asset. The asset can be either digital or physical.
An equity token is a stake in a particular asset — a share in a company’s equity.
By far the largest category of actively circulating tokens are utility tokens.
There are two main reasons for this:
1. Utility tokens enable tokenization where previously impossible.
Imagine the possibility of being able to purchase a “stake” in the underlying technology that powers the internet, way before mass adoption happened. In particular, imagine buying a “stake” in the TCP/IP protocol that all internet connected devices in the world (roughly 5–6 billion devices) use to communicate with each other.
If one could tokenize the TCP/IP protocol such that using it would only be possible by paying for it with a particular “TCP/IP” token (either pay-as-you-go, a deposit or even a subscription model), one could effectively be buying a “stake” in a core technology of the future. Due to the token being irrevocably tied to the underlying technology/protocol, one would own the technology directly and not through a proxy such as owning equity in the company that owns and develops the technology.
2. Avoiding financial regulations that govern securities.
With the current regulation almost anywhere in the world, it is somehow implied that consumers do not need protection when buying goods and services, but they do need protection when buying/investing in financial instruments (or at least they do not need as much protection when buying goods or services). There are some well-grounded reasons for this. It is much easier to check whether a pair of shoes are what the manufacturer claims they are, than it is to check whether a particular financial instrument (security) is what the issuer claims it is. That is why countries around the world have passed fairly complex, detailed and strict laws that govern the securities market. The anarcho-libertarian crypto movement was clearly not in favor of the traditional form of regulation and therefore decided to stick with utility tokens. This class of tokenization should in theory be far more similar to goods and services than to financial instruments.
The proliferation of utility tokens
There are now more than one thousand different tokens, most of them being self-proclaimed utility tokens.
The proliferation of utility tokens brought about two distinct issues.
First, for some products and services, it is difficult to build a use case around a utility token. The token was oftentimes derived as an afterthought, a necessary means to perform an ICO and not really a core aspect of the overall solution. This means that a token buyer thinks they are indeed buying a “stake” in the technology, however it is very simple for the token issuer to “bypass” the token (making it possible to use the technology/product/service without the token), thereby making the token obsolete.
Second, and more importantly, imagine all crypto projects suddenly gain traction. Users will need to have a separate token for every product or service that they will want to use. Imagine needing to have a Netflix token for when you want to watch a movie, a Strava token for when you go running, a Facebook or Instagram token when you look at a social feed, a Youtube token when you would like to watch a video.
Society already knows that having too many currencies lowers the overall efficiency of a market, increases transaction costs, and causes currency risk.
Multinational corporations that do a lot of business in markets with many different currencies, employ financial experts to hedge the currency risk.
Anyone living in a small country such as my home nation of Slovenia, can tell you that it is no fun having to exchange currency every time one crosses a border. Slovenia is so small that if you’re driving from the capital city of Ljubljana in any direction for about 2 hours, you end up in a different country. Before the European Economic and Monetary Union and the common currency (the EURO) was implemented, all the surrounding countries had their own form of monetary currency.
The fact is that nobody wants to live in a world where you need one token to shop in Walmart, another one to shop at Safeway and a third one to shop at Whole Foods. Same goes for crypto.
If utility tokens eventually gain traction, one of two things will be likely to happen.
Society will end up with one universal token that every vendor or service provider will accept, or each service will have its own token, but there will have to be an intermediary services that will exchange any token into any other token on the spot, instantly.
This latter scenario is problematic from the “token economy” point of view. Currently, the logic behind the value of tokens is that once a product gains traction, there will be more demand for the token, which at a fixed supply will inherently drive the price of the token upwards, rewarding early “investors” with a capital gain.
But if a service exists that offers instant token exchange when paying for a product or service, there will be little or no base demand for the token. Why is that? This twitter thread offers a good real world example: https://twitter.com/bendavenport/status/1011005759637749761.
In short, let’s assume that every time I want to watch a movie on Netflix, I need to pay for it with a Netflix token. I have all my crypto money in a stable coin (let’s say it’s EOS) and only exchange it into a different token when I need to pay for a product or service. When buying the movie, the EOS to Netflix token exchange occurs at a spot rate and I am able to pay Netflix with the required token. In turn, Netflix is a large company and wants to hedge against currency risk and so financial experts at the company decide that the Netflix token’s price is very volatile and they should hedge the currency risk. They decide that when any payment is received, there is an immediate exchange of the Netflix token into a more stable currency (EOS). In such a scenario, the only time anybody will be hodling the tokens will be the time needed to do the EOS -> Netflix exchange, settle the payment and do a reverse exchange from Netflix -> EOS. Depending on the speed of the blockchain to confirm the payment transaction and the speed of the exchange service to exchange the tokens, it could be as little as a few minutes, or eventually even seconds. This means there will be very little base demand for the token to drive the price up.
One could argue that people can still drive the price up by hodling the token out of belief that the price will appreciate, thereby reducing supply and materializing their belief (what in the traditional finance is known as a “short squeeze”). However, one could also argue that this will affect the liquidity of the token, prolonging the time needed to settle a payment and making it more difficult to hedge against currency risk. The net result could well be that the token becomes much less desirable over the long-run. And even if that is not the effect, driving the price up by artificially lowering demand is not a strategy that can work over the long run.
It is safe to say that the current utility token valuations are based on expectations of hockey stick growth purely based off demand. For the reasons explained above, this is unlikely to happen.
Does it then still make sense to have utility tokens?
(Disclaimer: Iryo is currently using a utility token model, but basing the solution more on “staking” and less on payments, which to us makes a lot more sense.)
There is an increasing number of calls for security tokens. What is particularly interesting for companies is the use of an equity token.
As explained earlier, the idea behind equity tokens is the tokenization of the ownership structure of companies themselves. This is, unlike the utility token, not an innovation in itself. For all intents and purposes, shares in publicly traded companies are the tokenization of ownership. So why would tokenizing company equity make sense?
The question that must be asked is, what are the advantages of tokenization in general? The first one was already discussed — directly owning a piece of an emerging technology (rather than owning it through a proxy, i.e. equity in a company). But that is only possible with the use of utility tokens.
The second advantage is increased liquidity (or liquidity premium), nicely described by Balaji Srinivasan: “A token has a price immediately upon its sale, and that price floats freely in a global 24/7 market. This is quite different from equity. While it can take 10 years for equity to become liquid in an exit, you can in theory sell a token within 10 minutes/…” (https://news.earn.com/thoughts-on-tokens-436109aabcbe)
The third advantage lies within larger liquidity pools. Tokens can be traded globally, non-stop, without intermediaries. This means there is potentially, by an order of magnitude, a greater number of buyers and sellers. In contrast, shares are a highly “centralized” financial instrument. They are registered with a central authority and traded on very closed and centrally-run exchanges (that close down over night, etc.). It is also very difficult and costly for a company to go through the process of listing its shares on an exchange (to hold an IPO).
The liquidity premium and the increased liquidity pools is what makes issuing equity tokens (rather than issuing shares) desirable.
Equity tokens: What are the potential problems?
1. Losing the private key.
2. Lack of financial regulation / oversight.
3. Difficulty ensuring “non-digital” rights that stem from token ownership are fulfilled.
1. Losing the private key
This is something very few people are talking about, but the first question one should seek to answer before equity tokens become a standard should be: “What happens when I lose my private key?”
In crypto, all tokens are bearer instruments, which means whoever has the instrument in their possession is the rightful owner. There is no central registry where one could ever check who the rightful owner is. Technically, the possession is demonstrated by proving you have access to the private key that corresponds to a public key that the owner claims to control.
If the private key is lost, any and all tokens under that account (i.e. the corresponding public key) are forever lost. In the case of utility tokens, that only means one has lost some money and can no longer get the product or service that they could have gotten with those tokens.
If those tokens are indeed equity tokens, the issue becomes much more complex. If a token is designed to represent ownership in a company, the potential consequence of losing one’s private keys and therefore implementing a recovery solution must be known beforehand. Would it mean that the person who lost their private key lost their share in the company? What if the stake was more than 50%? Who is the new de-facto decision maker in the company? What happens to the remaining shareholders?
2. Lack of financial regulation / oversight
There are some good reasons why the process of taking a company public is lengthy, expensive and highly codified. A company’s value is difficult to evaluate and knowing what price to pay for a share is impossible without objective information about the company. This is why with publicly traded companies, financial regulators mandate the company to expose a certain level of previously internal information so the public can make an informed decision about investing in the company.
Enforcing this is relatively easy if you only have a few centralised exchanges. When there are tens or hundreds of decentralised exchanges around the world, where anyone can list and trade equity tokens (which in itself can be issued by anyone at any time), such regulation is much more difficult to enforce.
3. Difficult to ensure “non-digital” rights that stem from token ownership are fulfilled
Owning a share in a company usually entitles the owner to participate in the distribution of the company’s profits. When a company’s shares float on a centralised exchange, there is also a central registry of all shareholders. When the company pays out its dividends, they know where and whom they need to make the payments to. In the crypto world, with no central authority or registry, that is extremely difficult to achieve.
Similarly, if a company behaves dishonestly and only pays out profits to a few selected shareholders, the regulator can detect that and step in to protect the rest of the shareholders. Detecting such dishonest behaviour in a fully decentralised world is almost impossible.
What could be a potential solution?
A good “middle path” was proposed by our blockchain advisor Luka Perčič.
The middle path would be to try to get the benefits of a liquidity premium and increased liquidity pools, while preserving ownership and ability to enforce shareholder rights.
The middle path would lead to distinct classes of equity tokens in a company. One class that requires registration with a central authority (let’s call those registered tokens) and the other class would be a bearer instrument (called bearer tokens).
One could, for example, set a rule that bearer tokens can never represent more than 49% of the company, to ensure that if the private keys get lost or stolen, there is no change in majority ownership — the majority owners are always known and registered with a central authority.
Registered tokens would need to follow a strict KYC policy, the company along with a governing authority (government agency) would need to run an up-to-date registry of the registered token owners. In case that one of those shareholders would lose their private key, they would re-identify themselves with the company and the government agency, and a new set of tokens would be issued. The old ones would be “terminated” and they would regain control of their tokens. A similar procedure would be done in case of private key theft.
The owners of registered tokens would be able to sell their tokens, but such transactions would again need to be validated and registered by both the company and the agency to make the transaction valid.
Because the tokens would be registered, it would be possible to enforce rights and obligations that stem from the token (equity) ownership. Token owners could participate in shareholder meetings, cast votes and participate in dividend payouts. If the company would fail to comply with the laws and its own articles of association, enforcement by the regulator would be possible. The company could decide to grant the same rights to bearer tokens, but it would not be required to do so. Or it might decide to pay out dividends to bearer token owners and include them in shareholder voting, but only if they would be willing to perform a KYC procedure.
On the other hand, the advantage of owning a bearer token would be the ability able to freely trade the tokens on decentralised exchanges without needing to register the transactions with any third party, thereby reaping the benefits of markets that are global and open 24/7. The trade off would be the inability to recover the tokens in case of private key loss of theft.
This structure could present an efficient way to raise capital for small and medium enterprises.
For example, a company that is much too small to perform an IPO could decide to tokenize its equity. It would start off by issuing only registered shares to existing shareholders. The shares would need to be registered with a government agency and in that process, the agency could force the company to make certain internal information about its business publicly available, in case it would ever want to sell any tokens on the open market. The company could then decide to hold a fundraising event and issue 20% of bearer tokens and sell them on the open market. The information about the company would already be publicly available and accessible to anyone who would want to participate. The tokens would be bought through an ICO and from that point onwards, free to trade on any exchange.
Owners of registered in agreement with the company and the agency could transform their registered tokens into bearer tokens and also sell them on the open market. The process would also work in the opposite way. An owner of bearer tokens, who would like to have the option of private key recovery, could ask for their tokens to be transformed into registered tokens (which could be done after a strict KYC and AML procedure).
This way, achieving a very flexible and liquid structure would be possible, while ensuring corporate rights and obligations are fulfilled. It would bring about a much needed move away from utility tokens, which are currently often chosen not because they are a good fit, but because there are no good alternatives.
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