The 2019 Truth On Security Tokens

As we approach 2019, let’s break down all the arguments for and against tokenizing securities. This note has everything you need to know about security tokens (and a little bit you don’t) heading into the new year.

1. Why Loopring Cares

In Loopring Protocol 2.0, we’ve extended the non-custodial exchange functionality to be much more powerful and versatile. Part of this means supporting other token types beyond the ERC20 standard we’ve focused on thus far. Our protocol supports security tokens by implementing support for the ERC1400 Security Token Standard.

To be clear, ERC20 vs ERC1400 doesn’t determine whether the token is a utility token or security token; they just lend themselves more faithfully to different use cases.

Purpose-built for securities, the ERC1400 standard mainly differs from ERC20 by introducing tranches to support partially fungible tokens and enforcing limitations on token transfers. This means rules can be attached to tokens — and to subsets of those tokens — which would allow issuers to encode securities regulations or any other logic for their transfer and ownership.

ERC1400 is still being refined and specified by its authors and community contributors. Eventually, we will see some commercial implementations of the standard, such as Polymath’s ST20, incorporate the ERC1400 interface.

A future post will go over the in-depth technical details of how Loopring-built DEXs can incorporate the standard. The rest of this post will try to describe why or why not security tokens may be the next big thing.

2. Why Security Tokens May Or May Not Be A Massive Opportunity

What’s a Security?

Before we talk about anything blockchain or token related, let’s quickly find out; what is a security?

A security is a tradable financial instrument that represents an ownership position in a corporation (equity), a creditor relationship with a corporation/gov’t (debt), or other rights to ownership as represented by derivatives (options, futures, etc.).

Securities — stocks, bonds, certain real estate interests — are legal concepts, thus different countries and jurisdictions recognize and treat securities differently.

Most famously, the US Government sees a transaction as an ‘investment contract’ (security) if it passes the Howey Test: if the transaction involves (1) an investment of money, (2) in a common enterprise, (3) with profits to come solely from the efforts of others.

If yes to all 3, then it is an investment contract, and must be registered as a security with the US Securities and Exchange Commission (SEC) or qualify for an exemption (by selling to accredited investors only, for example).

Keep in mind, all of this matters because the SEC (and other nations’ securities regulators) have a mandate which includes protecting investors. They must make sure that companies offering securities for sale to the public tell the truth about their business, the securities, and the risks.

Also keep in mind the distinction between public securities: what most people are familiar with, such as equities on public stock markets open for anyone to trade; and private securities: representing ownership in private companies, mostly made available to accredited investors, or other investors according to private placements.

Enter Tokens

Historically, it’s been a physical certificate asserting one’s ownership of these investment contracts, but, increasingly, it’s electronic records in a database. This is where tokens come in — a natural progression to digitized ownership.

Indeed, security tokens are just taking these securities and representing them on a blockchain. You can represent any off-chain asset as a token, not just securities: e.g., asset-backed stablecoin USDC (tokenized dollars), or DGX (tokenized gold).

So, what’s the fuss about security tokens? Why is having ownership interest represented as a cryptographic token much different than having it represented as a number in a custodian/transfer agent’s centralized database?

The Old & Improved vs The New

Firstly, I like to view security tokens in two broad buckets:

  1. Taking any old security and putting that record on the blockchain — each piece of paper/share being represented as a token. We can call these tokenized securities.
  2. Alternatively, not having originated in the ‘real-world’, a digitally-native token that grants its holders similar rights to the above (ownership/claim on profits/interest payments, etc.). All of their value is contained or derived from on-chain activities. We can call these digitally-native security tokens.

This is mostly to say that blockchains will (and have) sprung up new business models that are entirely blockchain-native, and thus ownership interest therein will also be blockchain-native…or at least blockchain-first.

I say blockchain-first because, besides the fact that blockchains are obviously a prerequisite for type #2, my above distinction may be irrelevant for the sake of this post, because either way — if the issuer is domiciled or interacting with citizens of a certain jurisdiction — it will be subject to its securities laws.

So, if it wants to be compliant, it will have to register its digitally-native security tokens in the real world, anyway.

This point is where security token skeptics pose a reasonable question: what is the point of having a blockchain if the token — the asset — is still administered according to legal powers, and is not an immutable record?

If the blockchain acts as an almost after-the-fact abacus – with true ownership interpreted by registrars and judges – why do you need it at all?

Security token supporters have answers that we explore in the next section.

It’s worth noting that, before even weighing their merit, I find it somewhat of flawed logic to say security tokens are useless, if only because that implies approaching the problem from a crypto-only point of view.

Their question is: What can securities do for crypto?

It’s a fine question. Maybe a lot, maybe a little. Certainly, there ought to be something interesting at this intersection.

It’s equally reasonable and important, though, to approach it from the lens of (legacy) finance: What can crypto do for securities?

Here, even if only second fiddle to centralized scorekeepers, there are still, I believe, meaningful benefits to be had.

The rest of this post will try to briefly (and incompletely) list the commonly asserted positives and negatives about security tokens. I will do it in the way of a claim and counter. If I am missing any, please share in the comments.

3. Shares On A Chain

First of all, it’s fair to start by saying, there are so many unknown unknowns here. As at the dawn of Internet adoption, we envisioned using our cool new protocols to make things better — like being able to scan/copy our newspapers and put the images on a website. We couldn’t have imagined a radically different news format that may be possible — e.g., Twitter.

So, similarly with security tokens, we have the potential efficiency improvements that we all suppose to be aware of, as well as an entirely new design space which we can hardly predict.

Of the outcomes we can predict, the claims and counterclaims for why we should use blockchains to record and transfer security interests are:

Claim 0: Liquidity Will Be Increased and Improved

I start with this one because I think it’s the most important, or, really, that all the other claims are simply inputs towards this goal (from the POV of investors and issuers).

Counter: Tokenizing securities is not a magic recipe for liquidity. Tokens can be equally illiquid as their legacy digital or paper certificates. Tokens do not beget liquidity.

Analysis: Technology does not generate liquidity. Buyers and sellers create liquidity.

Is there a large, deep pool of people who are willing and able to buy and sell certain security? Do they want to buy and sell in large quantities? Is price sufficiently known or discoverable that buyers and sellers are near each other in bids and offers?

The above questions are captured in what is called market depth, and is the true tell of liquidity. Market depth is most often defined and measured by bid-ask spreads and price impact of trades. I wrote about market depth over here, where we also learned that liquidity is not binary, it’s a continuum.

In that post, illiquidity was defined as:

The expense you incur on immediately reversing your decision after a trade — i.e. the cost of buyer’s remorse.

So the real question is, how could tokenization move us further along the liquidity continuum? How could it increase market depth for private securities?

The answer is: tokenization will increase market depth by removing frictions around trading private securities.

Private security tokenization is only valuable if it reduces friction to make buyers and sellers more likely or interested to trade. The theory goes that friction will be reduced along a whole number of dimensions (which are represented in the rest of this post). Liquidity is the first claim because I believe it is ultimately what other claims facilitate.

The dimensions that will reduce friction in private securities, in rough order of importance (in my opinion):

Unique to blockchain tokens:

  • Asset Interoperability
  • Programmable Compliance

Easier with blockchain tokens:

  • Fractional Ownership
  • 24/7/365 Trading
  • Rapid Settlement
  • Reduced Costs

So we will get to all these, but, truly, I must admit, the conditions for liquid secondary markets are completely irrelevant if not for the absolute first step: the asset itself. Interesting, desirable assets foster liquidity.

It sounds obvious and completely detached from technology, but it is fundamental: valuable and attractive private securities — which market participants have hitherto had a hard time trading — must become tokenized for security tokens to ‘succeed’.

Attractive assets become quality securities, which attract quality investors, who attract more quality issuers, and so on.

In the same way that most dApps and projects have learned the hard way that “decentralized for decentralized’s sake” is not a valid product idea (users demand the best experience regardless), neither is “tokenized for tokenized’s” sake. A second-class security is not better than a first-class due to tokenization; it is still garbage in, garbage out. The asset must stand on its own.

Tokenization, does not change the underlying value of private securities — they should still be valued by their fundamentals. But with a liquid secondary market, we can tack on a liquidity premium. The liquidity premium comes from the ability to more easily and cost-effectively buy/sell a security. [You can also think of this as the removal of the illiquidity discount.]

It’s safe to say there is interest in all sorts of private companies, real estate, sports teams, art, and much more. What do stakeholders stand to gain?

  • Investors gain access to investment opportunities previously precluded, and trade them in liquid secondary markets.
  • Issuers are able to tap more capital, more quickly, and from more people and places, ultimately reducing their cost of capital.
  • Regulators gain greater visibility into markets and participants, and more easily enforce compliance.

Let’s see exactly why tokenization will engender liquid secondary markets for private securities, and why that, in turn, may initiate a Cambrian explosion in private capital formation.

4. Why Tokenization May Lead To Increased Liquidity

Claim 1: Tokenization = Interoperability.

Not only will all assets represented as tokens be able to ‘speak’ with each other, but they’ll be able to play nicely with the whole blockchain ecosystem and its supporting products/services.

Counter: I’m not sure of a good counter to this one :). If someone has a good counterpoint, please share in comments.

Analysis: The innovation is not digital versus paper; most asset ownership is already represented in digital documents. The problem is that even digital representations do not speak with each other — they cannot cross the chasm.

Our public stocks, equity in a home, interest in a friend’s startup, and — notably — our money, live in walled gardens.

Right now, the closest we get to interoperability across assets is an aggregated portfolio view. But, you cannot (without great effort) place part of your equity in that friend’s startup and some of your TSLA shares as collateral for a loan to increase your holdings in an industrial building — let alone from the same interface.

Standardization of securities is not novel: we can hold all our public stocks in one online broker. Security tokens, however, may come to represent many different types of assets in the same wallet. Interoperability means reduced friction, but also assets referencing each other and interacting in unique ways, creating new financial instruments.

As Stephen McKeon states, “The arc of technological evolution bends towards interoperability and interoperability is facilitated by standards…Blockchain offers us protocol standards upon which everyone can build, and that is a big part of why this is the right technology to re-engineer the financial plumbing today.”

Currently, Ethereum interoperability is mostly facilitated by the ERC20 token standard. Wallets can hold/interact with any token that adheres to the standard. In the future, wallets may come to support a few of the most popular standards of ‘value exchange’.

I may own a stake in my local restaurant — represented as an ERC1400 token in my mobile wallet — paying me monthly dividends in DAI, that I can immediately use to pay for my meal at the restaurant. Maybe if I’m out of DAI (here, ‘money’), the restaurant owner stands ready to repurchase the equity tokens I hold — so I pay for my meal with a piece of the restaurant.

You can see here that with seamless value exchange and deeply liquid assets, the demand for money as an intermediate commodity may in fact be reduced.

With open standards, global liquidity pools can form across asset classes and across (decentralized) exchanges.

Claim 2: Programmable compliance is a win-win-win for issuers, investors, and regulators.

Compliance by code — in the security tokens themselves — makes everyone's’ lives much easier.

Counter: I’m not sure of a good counter to this one either. If someone has a good one, please share in comments. [I promise after this one I actually have counterpoints.]

Analysis: By encoding the patchwork of pertinent legal frameworks, and removing uncertainty on a per-transaction basis, friction is removed, which should bring in more assets/issuers/investors.

Parties in trade need not incessantly worry about different jurisdictions’ rules, and if they are in breach. By encoding the rules at creation — and being certain they will be followed at the smart contract level — restrictions can be relaxed, such as letting the security trade ‘wherever’, and allowing the logic to determine if the buyer/seller/venue is permissible, otherwise throwing an error.

For example, the code can check if buyers are KYC’d (with whitelisted addresses previously checked by a third-party); if they live in a jurisdiction where the security is allowed; and if this new marginal buyer will take the security over the prescribed limit of investors, say 2001.

In the current system, performing a trade may require checking permissions and statuses across multiple ledgers maintained by multiple parties. Allowing and ‘papering’ the change in ownership is a process wrought with friction and cost, and involves a lot of human oversight.

While some regulators are apprehensive of a future where all financial assets may be tokenized, I think it’s reasonable to believe that one day they may mandate securities to tokenize for the enforceability it offers. They would never have to chase paper trails again, everything self-executing, and if something did go awry, the proof is there, immutable.

Claim 3: Fractionalization.

Fractional ownership will open up many investment opportunities currently unavailable to the average investor because of high unit costs, and allow the issuer (owner) to more easily and widely access capital.

Counter: Fractionalization does not require a blockchain, it can be done right now and accounted for with an Excel spreadsheet. Fractional ownership of an asset or company — and wide distribution of the shares — was an innovation four hundred years ago. There are modern equity crowdfunding platforms today that provide investors access to private securities.

Analysis: How many shares or hands an asset can fractionalize into, and who can own them, is a legal consideration, not technical. There are numerous exemptions in the US which allow capital to be raised privately, and they all have tradeoffs — only being able to target accredited investors, or raise a certain amount of money, have a maximum number of total holders, etc.

Prototypical examples are for commercial real estate and art. I’d like to own the nicest building in my city, but I can’t afford it. Indeed, retail investors have a hard time accessing or affording more targeted, single property plays; such opportunities are usually limited to an institutional/HNW crowd.

If the current owner chopped it up into 1500 share-tokens, I may be able to afford 1 slice of it. But, again, they can do that right nowWhy is this not happening more?

Maybe it’s because the experience isn’t great. Investors aren’t clamoring for it because they are uncertain: how it works, the nature of the security, if they’re eligible, where to get it, if they need to make new accounts for it, if they can trade it after the fact, etc.

Note: many of these problems go away IF claims #1 (interoperability) and #2 (auto-compliance) hold true. Thus, the funky math is that fractionalization + 1 + 2 + rest of claims below = greater than the sum of its parts.

And while fractionalization doesn’t require a blockchain, its use can likely accommodate greater divisibility by default.

We also may not have seen more success with these platforms because the quality of assets hasn’t been compelling yet. But asset owners also stand to benefit, so perhaps we will see higher quality offerings in the future. If issuers can syndicate deals more widely, with lower cheque sizes, they will have more flexibility.

If an owner wants to raise cash on their commercial building today, they mainly have two choices: sell it outright, or borrow against it. It may be hard to find buyers for a specific (large) size interest you’re looking to sell. And if you do find one, they can likely squeeze you on valuation or negotiate control provisions since they know they’re only one of a few bidders. Wider syndication can lower the cost of capital for companies and security issuers.

Ben Hunt noted that “Financial innovation is always and in all ways one of two things — a new way of securitizing something or a new way of leveraging something…Securitization is a ten-dollar word that means associating something in the real world with a piece of paper that can be bought and sold separately from that real-world thing.”

In this light, blockchain would continue the long tradition of ‘unlocking’ asset classes that have yet to be securitized (and fractionalized) into small enough pieces to be made available for everyday investors. The resulting ability to express opinions financially makes markets more efficient, allocating capital to areas where it will be most productive.

Claim 4: Security tokens allow for 24/7/365 trading.

And that’s cool and useful.

Counter: You don’t need a blockchain to trade around the clock, you can do that right now. The reasons it’s not done in many markers are (1) exchanges/traders/issuers want the time-off, (2) coordinating attention/activity within specific hours increases liquidity.

Analysis: You don’t need a blockchain here, but ‘world computers’ are always-on by default, thus going from working-hours to all-hours is trivial. The global nature of blockchain simply lends itself more to timezone-less marketplaces.

Exchanges may not need to even increase staff — just shift them — since the settlement is handled by the blockchain (and token-encoded rules). Again, we see that the claim is currently possible, but not actually happening in practice. Blockchains may simply make this easier.

Claim 5: Security tokens allow for rapid (instant) settlement.

This is a positive for private security trading to reduce uncertainty and counterparty risk. It even represents an improvement for public securities; public equities typically settle ‘T+2’, so ownership of the stock actually changes hands 2 days after the trade was executed. Private securities can take much longer, on the order of weeks or months.

Counter: The settlement systems are byzantine, but they work. Moreover, sometimes the complicated mix of participants and time delays serves a purpose — instances which necessitate extra time, such as reconciling securities which are being lent out (for short selling), etc. Even if a token trade can settle near-instantly, ‘papering’ of the transfer in ownership still exists in the real world, with the attendant delays, so what’s the point?

Analysis: The settlement system is highly complex, and blockchains could remove a lot of that. I’d posit that blockchains can do a much better job than previous tech, given the degree of certainty regarding transaction recording.

Even if security token transmission can be reversed or ‘force transferred’ by a special admin account, it gives the necessary assurances to any party that something happened on a public chain.

The legal transfer of ownership (as well as ancillary time delays, such as requiring GP approval to sell some private shares, etc.), means time may still be needed in the real world. Blockchain can certainly squeeze this shorter, but perhaps keep it long enough to allow the legacy rules/players remain in place — if needed.

Finally, maybe blockchain settlement can really speed things up by virtue of having the token transfer automatically set the rest of the settlement wheels in motion, if other processes can also be sufficiently automated by smart contracts. [This kind of goes back to interoperability + prog. compliance: transfer sent, compliance checked, asset info checked (currently lent out?), other asset info referenced (did derivative expire in money?), etc.]

Claim 6: Cost reductions all around the security token lifecycle.

In issuance, administration, and trading, security tokens move a lot of the compliance and advisory layers to the code, baking them right into the securities/contracts themselves.

Counter: Advisory and other professional services are necessary for navigating regulatory frameworks, for relationship building between issuers and investors, and more. There are some high-touch areas where humans are needed and costs can’t be cut.

Analysis: Humans will not be fully extricated from the security issuance or trading process, but even a small administrative improvement, for example, with cap table management (who owns what) would be very valuable.

As Stephen McKeon states, When all the ownership claims are tokenized, cap tables will be reconciled in real time by code. All the contractual features such as liquidation preferences, ratchets, and drag-along rights will be baked in to the securities allowing managers to easily run scenario analysis to calculate payoffs under different assumptions.”

5. Conclusion

An important question still lingers: Why is it exactly that tokenization has some people saying every single security will be tokenized?

As we just saw, tokens allow for compliance, automation, and interoperability all across the securities stack. Is this enough to be 100x better than equity or debt crowdfunding platforms?

I’d say that, on their own, each benefit does not move the needle enough. But, in terms of reducing friction, the efforts are multiplicative, and go a long way in facilitating trading of private securities.

That is, the bull case for tokenized securities depends on reducing frictions to the point where private security participants are always a few clicks away from liquid secondary markets.

Some of the worst frictions are regulatory, administrative, and dealing with value trapped in siloed software. With secondary market liquidity as the highest order goal, I believe interoperability may be the largest leap forward.

Current solutions for digital value transfer, crowdfunding platforms included, lack compatibility. I can’t send value from WeChat to Venmo, or from AngelList to Cadre. There are walled gardens everywhere. Security tokens, meanwhile, can tie into the whole Ethereum ecosystem, and to any other asset represented thereon. Also, with open protocols and standards, we mustn’t rely on only a few companies duplicating their efforts across every jurisdiction — something that can take years and still remain siloed.

Remember, securities and their potential liquidity has a lot to do with their legal structure. Crowdfunding sites often intermediate the investor and the investment, something that can be more easily stripped away on-chain.

For those crowdfunders that do match directly, they are often small deals, or of lower quality. If that is not the case — then it is the perception, which is just as important. If issuers believe that crowdfunding platforms should be their last capital-raising resort, then we have a non-starter: adverse selection. Second-tier securities will find second-tier investors, etc.

That is why, as originally mentioned, we need there to be a reason for high-quality issuers — the ones that have access to institutions, VCs, etc. — to prefer going the security token route. For that to happen, we should be targeting the highest quality issuers that have the most to gain from tokenization (over other private capital). Who has the most to gain?

The best fit for security tokenization is for private companies or assets that:(1) consume a lot of capital, (2) are sensitive to cost of capital, and (3) indifferent to the identity of their investors.

If tokenization can bring liquidity to those asset types, issuers will benefit from a lower cost of capital, which can attract high-quality offerings.

For that reason, a lot of the recent buzz is for commercial real estate tokenization, because that asset class has high unit costs, is capital intensive and sensitive, and owners are also usually less ‘picky’ about investors than early stage tech companies, for example.

Either way, institutions are going to need to get involved, as they have a lot of the assets, and a lot of the money.

Tokenizing securities can also be attractive for private issuers who have some sort of maturity mismatch problem — a company with a very long time horizon, let’s say, with investors who are more myopic. By allowing investors to find liquidity in secondary markets without having to pull capital from the issuer, everyone wins.

Looking Forward

To be honest, I can somewhat empathize with security token skeptics. It’s easy (maybe not) to see that blockchain’s (Bitcoin’s) killer app is digital bearer instruments, where truth is purely on-chain. The most valuable thing about this type of property (money) is that it is trustless, and censorship-resistant, and un-inflatable, etc.

Tokenized securities, on the other hand, are about creating on-chain representations of off-chain value. Anytime someone (a person/entity) must map the representation to the real value, it is fundamentally less interesting. But that is also what finance is fundamentally about [see Ben Hunt quote re: securitization above].

Perhaps one day a security token can indeed be a pure bearer instrument, where truth only goes as far the next block and is insulated from ‘meat-world’ considerations. But then again, given securities are legal constructs, if it’s fully on-chain and ungoverned, is it a security?

Before we get to those philosophical questions, we may have a decade or so to simply improve what we’ve got. For the time being, we can focus on more basic concerns as, often, friction reduction comes down to even simpler factors than what we’ve been speaking about— such as UX and social coordination. Just by virtue of giving participants a dedicated venue and interface to focus their asset-specific attention, friction will be reduced.

After this long post, I mostly think of security tokens in one simple sentence:

In the same way that much of corporate (and other) finance gets done on Excel — even though you can use other tools — Ethereum may one day simply be the giant Excel spreadsheet in the sky, making everything so much easier, that we will wonder, how did we ever do without?

I think it will become increasingly obvious that financial assets will tokenize. It’s an accounting technology, it should be no surprise that we use it for…accounting. Then one day…

We won’t call them security tokens, we’ll call them securities.


Thanks for reading,

Matthew


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