Through the Crypto Lens: Understanding STOs (EN)

Security Token = Utility NFT?

“The next generation for markets, the next generation for securities, will be tokenization of securities.” — BlackRock CEO Larry Fink

The global pandemic has witnessed a remarkable surge in the value of various assets, including stocks, cryptocurrencies, and real estate. As a result, there has been an escalating demand for alternative investment options, including previously exclusive sectors like real estate and art, which have captured the attention of a wider audience seeking fractional ownership opportunities. However, despite the growing interest in security tokens, they are still in their early stages, leaving many individuals unfamiliar with their rationale and future outcomes. Moreover, several crucial factors require attention to establish a robust trading framework for these securities. With that in mind, this article aims to delve into the fundamentals of security tokens, examine relevant guidelines released by the Financial Services Commissions, and provide insights into how the crypto industry envisions the future of these securities.

What are Security Tokens?

The Financial Services Commission defines security tokens as follows:

Security tokens refer to the digitalization of securities using distributed ledger technology under the Capital Market Act.

Under the Korean Capital Market Act, there are six categories of securities. Among these, four types (equity securities, debt securities, derivative securities, and securities depository receipts) are securities that are widely known to investors, while the remaining two types (revenue and investment contracts) are relatively new and unconventional securities that have emerged more recently.

Securities are classified into three categories based on the format in which they are issued

1. Physical securities: paper-based/certificate-based securities.
2. Electronic securities: recorded and stored in a centralized account (the current predominant method for executing transactions).
3. Token securities: recorded and managed on a distributed ledger system.

In essence, security tokens are not “new” securities themselves, but rather traditional securities that are issued and managed using a modern approach through a distributed ledger.

The Necessity of Security Token

The significance of security token arises not only from the unique characteristics of “tokens” but also from the emergence of unconventional securities known as “investment contracts.”

An investment contract refers to “a contractual arrangement that allows a specific investor to invest funds in a collaborative project and receive a share of the profits, primarily generated by others involved”. Notably, the growing trend of fractional investment is a prominent example of an investment contract. Historically, investment contracts have primarily been associated with investments in artwork or music copyrights. However, their application can be broadened to encompass diverse funding areas, such as real estate portfolios and project-specific funding (e.g., financing for the iPhone 15). Consequently, the advent of investment contracts introduces a novel paradigm for a wide range of investment products and funding approaches, and their growing significance is anticipated.

In traditional methods like electronic securities, registration is typically centralized and managed electronically through a securities company, with strict qualification requirements imposed on the issuer (i.e., the securities company). However, the utilization of distributed ledger technology offers notable advantages by alleviating the requirements imposed on account management organizations. Multiple participants can engage collectively, without relying entirely on a single institution, thereby mitigating concerns related to data integrity and corruption. This decentralized approach is especially deemed more suitable for investment contracts that have frequent small-scale issuances, and it is expected to contribute to the reduction of transaction costs and time while enhancing overall transparency.

Security Token Guideline

In February 2023, the Financial Services Commission approved Security Token Offerings (STOs) under the Capital Markets Act and issued detailed guidelines for conducting these offerings.

(1) Principles for Assessing “Security” Status

• The principles align closely with those outlined in the Fragmentary Investment Guidelines from April 2022.
• The guidelines provide illustrative examples to aid in assessing the status of securities and offer specific explanations regarding the requirements for investment contracts.

(2) Regulatory Framework for Issuance and Distribution of Security Token

• Security Token Issuance Authorization: Recognition of security tokens as a valid form of securities issuance under the legal framework governing electronic securities.
• Introduction of “Issuer” Account Management Entities: Creation of specialized account management organizations that fulfill specific criteria, enabling them to directly issue security tokens.
• Establishment of Over-the-Counter (OTC) Brokerage Services: Formalization of small-scale OTC distribution platforms for investment contracts and (non-monetary trust) income securities.

Major Controversies Surrounding Security Token Guideline

(1) Separating Issuance and Distribution

• The primary contention regarding the guidelines revolves around the Financial Services Commission’s decision to ban issuers from managing distribution. This measure aims to prevent issuers from exclusively promoting and distributing their own security tokens. However, critics argue that the separation of issuance and distribution may hinder issuers from receiving fees during the distribution phase, potentially reducing their motivation to choose and issue high-quality offerings.

(2) Converting to Electronic Securities upon Listing

• The ongoing debate revolves around the requirement to convert security tokens back into electronic securities before listing if they meet the listing criteria of the Korea Exchange (KRX). The Financial Services Commission’s stance is that this conversion is purely a technical matter. They argue that the guidelines were established due to concerns about the distributed ledger’s ability to efficiently and reliably handle a large volume of transactions during the distribution phase.

(3) Limitations of Public Blockchains

• The Financial Services Commission has not outright banned the use of public blockchains but expressed their view that separate virtual assets should not be employed to record transaction-related rights. While it is feasible to conduct transactions with fees, authorities have concerns regarding payments made in specific coins/mediums and potential profit-seeking behavior associated with them. Considering factors such as KYC (know your customer), AML (anti-money laundering), and the complexities surrounding hard forks, the commission believes that private chains are more suitable than public ones.

The Future of Security Tokens from the Industry’s Perspective

The key challenge faced by the current STO market is the lack of liquidity. Investors are attracted to this emerging market primarily due to the potential for attractive prices, but governments aim to stabilize prices to discourage speculative behavior. This conflicting interest restricts investor participation and leads to limited liquidity in the market. Resolving this conflict and finding a balance between price stability and investor engagement will be crucial for the future evolution of security tokens.

Developing security token involves extensive consideration and research. So far, most discussions about STOs have taken place within institutional settings like securities companies and have heavily drawn upon traditional finance methods. But security tokens also leverage distributed ledger technology. Considering a thorough understanding and drawing from the crypto industry’s valuable experiences of rapid experimentation and learning, it is essential to contemplate the development of security tokens and anticipate changes within the industry.

Governance

The adoption of security tokens can enhance the authority of shareholders.

Previously, shareholders had to physically attend in-person meetings and hold paper securities to exercise their rights, resulting in reduced participation from minority shareholders and giving significant weight to board decisions. However, the transition to electronic securities and the introduction of electronic voting have significantly lowered the direct and indirect costs of exercising rights. This transition has empowered shareholders to participate in a wider range of activities while saving time and reducing expenses.

The adoption of security tokens simplifies the post-rights process. In the crypto industry, decisions are typically made through governance voting, where all token holders can freely propose and vote on motions. When applied to security tokens, blockchain technology enables transparent governance voting, eliminating the need for additional confirmation with depositories or custodians. This shift is anticipated to empower investors, granting them a more active role in the projects they invest in. Developing and implementing effective governance mechanisms are anticipated to play a vital role in revitalizing security token trading.

• Ex) When a security token is issued for the development of the iPhone 15, investors can propose and vote on specific features or colors they want to be included.

Utility

Utility NFTs can be compared to memberships that offer tangible advantages to their owners. For example, if you possess a Poovilla NFT issued by Shinsegae, you can enjoy valet parking services at department stores. Similarly, holding a Bellygom NFT from Lotte grants you the benefit of acquiring movie tickets at Lotte Cinema.

As mentioned earlier, the development of security tokens is closely tied to the advancement of investment contracts. As investment contracts continue to evolve, they present opportunities to offer alternative rewards beyond traditional dividends found in conventional revenue or equity securities, enabling investors to enjoy a wider range of diverse benefits. For instance, Lucentblock’s “ownership” platform provides various fringe benefits, such as exclusive menu offerings or 10% discount coupons for store visits. Moreover, we can learn from the current practices in the NFT industry, where benefits are based on the number of NFTs owned or different tiers of ownership. Ultimately, these benefits encourage investor engagement in governance and inject a variety of factors beyond simple return on investment, making the STO/Security Token market more captivating and diverse.

• Ex) In the context of security tokens within the K-pop group industry, there are several utilities that can be offered. For instance, investors holding 1 share of security tokens could participate in a fan signing ticket lottery, while those holding 5 shares could enter a concert ticket lottery.

And so forth

In addition to facilitating the trading of security tokens, we can look to the crypto market for guidance on its future development. For example, if the current trading of security tokens has followed the order book trading method used in stocks, we can also explore alternative approaches like the ones utilized in NFT trading platforms such as OpenSea for over-the-counter (OTC) trading. Furthermore, from a technical perspective, we can look to the current crypto market as a guide for the future growth of the security token market. This includes learning about secure storage solutions and ensuring smooth interoperability between different blockchains (such as using bridges when dealing with various securities companies or distributing issuances).

Conclusion

• Security tokens offer more than just fragmented investments; they have the potential to transform financing approaches. In the past, companies would raise funds collectively and then distribute them to individual projects. However, the advent of security tokens enables direct funding of specific projects. In addition, these tokens provide an efficient means of securitizing assets that are relatively illiquid, such as private equity funds, luxury cars, artwork, and beyond. Security tokens are poised to become a significant consideration for companies and other financing needs in the future.
• While the emphasis on STOs has mostly been on institutional (traditional finance) matters, we must not overlook the implications from the crypto industry. Although security tokens differ from cryptocurrencies, they share the foundation of distributed ledgers. Hence, the valuable experience and knowledge accumulated over almost five years in the crypto industry can significantly contribute to the development of security tokens, offering diverse solutions and perspectives beyond technical aspects, derived from past trials and errors.

Disclaimer

All content in this article is intended to communicate and provide information and is not intended as the basis for investment decisions or for recommendations or advice for investment. The contents of the text are not responsible in any shape or form including matters that pertain to investment, law, or tax matters