The Evolution of Capital Formation
Security Token Offerings (STOs)
Over the past year, Initial Coin Offerings (“ICO”), a new crowdfunding mechanism using blockchain technology, has captured the attention of millions of technologists, entrepreneurs and investors worldwide. This ICO ‘boom’ eventually peaked in Q1 2018 and the bubble burst shortly thereafter, with global cryptoasset market valuations declining over 80% since.
Part I — Introduction to Security Tokens & Blockchain Technology
If history has taught us anything, it’s that these bubble cycles are typical when discussing technological advancements. Using Carlota Perez’s framework; technology cycles are broken into two distinct phases: the installation phase and the deployment phase. Her model demonstrates that technology revolutions are typically “over-hyped” in the short-run but remain relatively “under-hyped” for the long-term. We believe this to be true of blockchain technology particularly as it relates to capital formation and financial markets.
A Security Token Offering (“STO”) is a financial security issued in the form of a digital asset; which typically represent ownership rights in an underlying company and/or its assets. This is distinctly different than the aforementioned ICOs, which were “Utility Tokens” or digital tokens that provided access to a project’s future product/service with no tangible claim to an asset or equity ownership.
Part II — The Value Proposition of Security Token Offerings
The STO model marks an important evolution in capital formation, as it pushes the industry into the digital age. Smart contracts allow for the creation and distribution of programmable scarce digital tokens, which results in numerous benefits for both issuers and investors:
Part III — Roadmap for Deployment
The securities industry has several important stakeholders: professionals such as bankers, lawyers, accountants, as well as, key intermediaries such as exchanges, custodians and regulators. Blockchain technology has been touted to “disintermediate and decentralize” these middle-parties. We disagree with this view, as we believe that these parties play a critical role in successfully completing deals. The technology cannot eliminate their function, rather it will streamline and augment their responsibilities in order to improve and create efficiencies in the future. We discuss several ways these parties will need to evolve their roles to adopt this technology into their processes.
Since the introduction of the STO model, there have been many applications proposed. Given the current technology stack and surrounding infrastructure, the possibilities for unique deal structures and custom asset exposures is limitless. We highlight several potential uses:
- Revenue & Royalty Streams: The STO framework will allow issuers to capitalize on the increased investor appetite for yield bearing investments in the current low interest rate environment. Examples of this would be a tokenized right to a revenue or royalty stream from real estate properties, franchised retail operations, commodity resources or even digital assets or licenses.
- Tokenization of Debt Securities: With tokenized debt securities global retail investors can participate in the original funding transaction and gain exposure directly to the underlying security. In addition to traditional corporate bonds, real estate mortgages and even sovereign debt; tokenized debt offerings can be structured using asset backed loans. Auto debt, equipment financing and trade receivables are all debt instruments that can be digitized using STOs.
- Existing Public Companies: Using existing assets to unlock balance sheet liquidity by creating a tokenized security could be a cheaper funding option for many companies when equity market prices are low. Depending on the market environment the cost of equity capital could be unattractive for many companies. However, using the STO framework to tokenize productive assets to fund operations would be a more viable solution.
In conclusion, it appears that we are only scratching the surface of what is possible with the use of blockchain technology and tokenized securities. We don’t believe a “revolution” will unfold, rather an “evolution” of the existing infrastructure and framework will take place. The added benefits of transparency, automation, security and a less centralized structure will create opportunities for the existing ecosystem players. The industry at large is still in its early stages, with several key infrastructure pieces still missing such as regulated and liquid secondary trading markets. That said, we anticipate that this framework will be one of the fastest growing areas of the capital markets industry over the next 12–24 months.