Author: Karen Zhu
Token economy has developed for nearly 10 years since Bitcoin caught people’s attention in 2009. ICO, the IPO in token era, enables utility tokens to enjoy an explosive prosperity in 2017. It boosts the token industry without doubt. But on the other hand, a lot of investors have suffered severely due to the issuer’s illegal behaviours under the current blank enforcement of legislation.
INTRODUCTION OF TOKENIZATION
Bubble in token economy is collapsing and governments start to regulate this industry. Both issuers and investors become skeptical with the original fundraising pattern of tokenization. Participants in this market have got a common view: it is time to develop a new type of regulated asset-backed security token.
Let’s take a look at the traditional equity market. The estimated market value is enormous with more than 70 trillion USD while IPO is an unsatisfying financing channel because of high benchmark and long-circulated period. Retail investors are barely possible to participate in debt and real estate investment fields since both of them require a large amount of money. We can see that the old investment pattern restricts liquidity of asset.
STO (security token offering) acts like a bridge to link traditional asset market and digital market together and as a result, has triggered a new round of discussion.
In this report, we offer a new angle to learn and know about tokenization from its concept, categories, classification, flaws, industry chain and governments’ regulations.
1.1 Concept of Tokenization
SEC classified cryptocurrency into two types: utility token and security token. Utility token represents usage license of products and services provided by issuers and companies issue utility token as a mean of fundraising for its projects. We can similarise utility token as pre-sale of products and services.
Security token usually possess intrinsic value backed by real assets like equity, shares of company or staple commodity. Issuance of security token can be methods of payment of dividends, profits sharing, payment of interest or investment of other token and assets. Holders of security token are able to receive profits generated by security token itself. Market of security token is expected to be wide since it can be applied in many fields including PE fund, real estate, debt market and so on.
Currently there is no exact definition of security token and it can be considered as a regulated asset tokenization based on the pervasive understanding among the industry participants. This notation implies two points:
- Issuance and trade of security token should comply with rules set by governments’ authorized organizations.
- Both tangible and intangible assets are circulated in blockchain as security token.
We can tell from the implications that regulation is specifically important to security token. If issuer want to issue security token in US, then this token would be included in SEC’s and related organizations’ regulated framework. Also the issuer would be restrained by federal law. Security token needs to be registered in SEC (possible to be exempted if the issuer fulfills certain clauses like Reg A+, Reg D, Reg S etc.) and follow Security Act. Regulation would inevitably increase the cost of issuing and trading security token.
Although regulation brings constraints to security token issuance, security token is still a superior investment fields comparing with existing ones:
- Lower barrier for investment and trade: tokenization makes fractional trade possible. A building pricing millions of dollars can be divided into thousand of pieces by tokenization and retail investors can therefore participate in this market.
- Improvement of asset liquidity: many high return investments like PE fund have lock-up periods. Investors need to wait until years for them to liquidise their money. If funds can be tokenized, investors would be able to buy and sell shares of funds any time.
- Lower issuance cost: traditional IPO have extreme high time and money cost which occupy 4–7% of fundraising amount according to PWC. STO can low down this amount to a large extent.
- Lower supervision frictional cost and achievement of global trade: supervision difficulty and cost would be eliminated by systemized regulation framework. Asset trading among various countries and organizations would face zero barrier.
- Improvement of market efficiency: regulated security token can be traded globally and therefore pricing system would be fairer with efficient price discovery process.
- Widening fundraising channels for small and medium enterprises: there are more than 650,000 new companies being set up in US every year.But not many of them can receive enough financial donations from Wall Street, Silicon Valley and angel investors. Therefore, regulated security token issuance or STOs can help SMEs gain access into new fundraising channels.
1.2 Types of Security Token
Just as its name implies, security token is backed by real assets like asset equities. Meanwhile, security token can be used to pay dividends and interests and as a result, holders of assets can receive profits generated by them.
If we use the classification methods from traditional financial market, security token can be categorized into the following 5 types:
- Cash Asset: this kind of security token is backed by fiat money. Recently there are many stable coins being issued and they can be backed by fiat money, other cryptocurrencies or algorithms. However, investment characteristic of stable coin itself is so little that can be ignored.
- Equity Asset: security token is baked by ownership of entities. For example, you have the rights to share 10% of a company’s profits if you own 10% of this company’s equity. Tokenization of equity stock can be based on stakeholders’ percentage of ownership and rights of votes.
- Debt Asset: fixed loan enables holders to gain fixed income after a specific period of time like interests. Investors can have stable earning through investing in this type of security token. Also parts of the earnings would be distributed to portfolio managers.
- Real Estate Asset: there are two methods to tokenize ordinary houses. The first one it to follow the same way of equity asset by dividing them into smaller shares. The second one is to treat is as a debt asset and tokenize their renting revenues.
- Commodity Asset: Investors group their money up to buy a rare item or service. Issuer can tokenize the ownership of this item or service for investors to have a new investing channel. If owners of this commodity are willing to rent this item or service out, they can tokenize them as fixed income assets.
Other than cash, the other four asset classes can be tokenized and bring benefits to investors including increasing liquidity and others. Besides these common investment, alternative investment field, for example, arts and antiques can be tokenized. We can see from these examples that potential of security token is unexpected.
Security token can also be classified into equity token and asset token. Equity token represents ownership of assets. Asset token is a license of goods in real world. These kinds of goods can be gold, real estate and others.
1.3 Flaws Existing in Security Token Issuance
We cannot ignore several negative impacts of STOs solely because they have great potential. Tim Byun, used to work as bank examiner of Federal Reserve Bank and Federal Deposit Insurance Corporation, has stated flaws existing in STOs comparing with ICO:
- Qualified Investors Limitation: Unqualified investors from US might probably cannot invest in STO projects anymore. Issuers need to be a registered member under SEC framework or be granted exemption. This qualification also means based on SEC’s regulation, STO projects would probably only be investment targets for qualified investors or high net wealth people.
- Higher Cost Comparing with ICO: Underwriter is needed like IPO to guarantee STO is complying with SEC’s regulation. This would increase issue cost for a large amount and fundraising amount would be decreased as a result.
- Secondary Market Trade Limitation: Unlike utility token, security token can solely be traded in licensed exchange platform in local country. Other than that, even utility token can only be traded among qualified investors.
Except for those flaws we’ve been talked about, there are some problems related to operation and custody:
- Public Administration: Responsibility of routine administration and operation is hard to designated if there are too many owners.
- Liquidity Bubble: Asset price would experience fluctuations when liquidity increases and then generate asset price bubble.
- Technical Security: There are loopholes in every kind of technology. Investors would be facing huge loss when KYC/AML process or tokenization protocol being changed.
The whole industry need to explore more and to find out satisfying solutions for these flaws and problems.
1.4 How SEC Classify Security Token
How SEC would classfy security token remains a crucial part for both existing tokens and incoming utility and security tokens since security token needs to be regulated by Security Act and other government organizations. Currently SEC is using Howey Test to classify whether the token is a security.
Howey Test requires “investment contract” to meet all following 4 conditions to be considered as security:
- Investors need to contribute cash or equivalents;
- All contributions are grouped into the same project or a fund pool;
- Aims for investors is to earning profits;
- Profits are earned only by issuers’ or third party’s operations.
There are subproblems included in each condition to be marked with a grade. When the grade reaches one certain value, this “investment contract” can be regarded as a security.
There is a simple two dimension test for quicker classification:
- Is the token be resold as an investment?
Token can be considered as a box in which more money or certain product and service can be generated by money being input. If both input and output are money, then this token can be classified as a security.
2) Do investors rely on one individual or one entity?
We need to examine whether the value of token is been created by one person and one entity or a group. If it is been created by one person or one entity, it can be classified as security.
Based on this two dimension test, we can use the following chart to put tokens into certain quadrant:
It is worth noting that, positions of tokens in these four quadrants are not settled. Characteristics of token can be changed with times especially when token was originally issued for its utility quality and then it developed to possess investment quality. Sometimes issuers tend to issue a utility token but actually popularize an “investment contract”.
The blurring line between utility token and security token makes tokens facing compliance risk. If governments decide to regulate cryptocurrency in a serious, cooperative manner, there are many cryptocurrencies would be classified as security token and then forced to quit from mainstream trading platform.
Apart from Howey Test, Reve’s Family Resemblance Test, Risk Capital Test are other tests for classification of security. Meanwhile we should notice that these are only tolls of SEC is using and SEC owns the final interpretation right.
Read more: Global Market Landscape of Security Token
Disclaimer: The contents of this article are for reference only and do not constitute any investment advice or solicitation. Please do not rely on this document for investment decisions. Investment involves risks. The authors have tried to ensure the accuracy and reliability of the information provided, including the data, but it does not mean that such information can be used as a guide for investors. Any inaccuracies or omissions in the information will cause any loss to investors. Or damage, no liability is assumed.