Myths around Security Tokens
We are pleased to welcome Axel von Goldbeck for our weekly Interview on Security Tokens.
Axel is a Partner at the Berlin office of DWF LLP, a globally recognized legal services firm specialised on blockchain technology. Today he is talking with us about common myths on Security Tokens and will help us to debunk some of them.
Enjoy the Interview.
1. Where do you see the biggest pros and cons doing an STO as a means to raise funds?
One of the biggest pro is the regulated nature of security token offerings. Security regulation is at its core investor protection. Although one may question some of the more excessive expressions of that endeavor, the basic idea behind it — creating an informational level playing field between those who need funds and those who want to invest — is the right approach. It is all the more right for a sector that is infamous for its promises but regularly struggles to deliver results. In other words: Being compliant with security regulation shows a serious effort to not only take the money from investors but accept responsibility/liability for wrong information; not to be misunderstood as liability for failures which, of course, may occur. Apart from that, security tokens as a form of dematerialized security have their potential in being easy to issue and transfer and their cost effectiveness. All this, however, only if and when the infrastructure required (platforms, KYC-Servicers, exchanges, custodians etc.) is up and running. Once this is done, there are no arguments for conventional security offerings anymore.
2. What would you recommend to projects considering doing an STO?
An STO project is a complex project with a large number of steps to be taken, either parallely or step by step. An experienced project management is key for its success (and not all founders are good project managers). Roughly, the following issues need to be worked through
- clarify/simplify your business model
- look for experienced partners and advisors to assist you in the process
- choose your markets (countries, investor type) carefully
- get tax issues right
- clarify regulatory issues; there is no STO offering without regulatory impact
- provide a secondary market (exchange) for your investors
3. How far are we when it comes to trading of Security Tokens? What are the biggest problems and how/when will they be solved?
The biggest issue is the obvious lack of licensed security token exchanges. Many myths exist around this issues. While there’s a lot of talk about security exchanges, a closer look reveals that most of them are only in the making or are limited to certain investors and/or products. To my knowledge, as of today there are only a small handful of licensed security token exchanges in the world. One of the biggest problem is that token exchanges are supposed to be used by anyone. But regulations only provide for exchanges on which professional traders (brokers) are allowed to trade. There is no established legal framework for security token exchanges for retail investors yet. The lacking regulation makes it difficult for existing players/stock exchanges to broaden their business model. However, this problem will be overcome, and I am prepared to bet that 2019 or 2020, when the volume of STO offering is growing, will be the years of security token exchanges.
4. Can you explain to us how the transfer of Security Tokens works, both technically and legally? Is my ownership of an asset “just” stored on the blockchain or is there an “offline copy” keeping track on my transactions (change of ownership)?
An ordinary token is simply code that gives evidence of an underlying legal relationship. In the case of a security token the code is evidence of a financial claim against the issuer and/or voting rights, a title or anything else comparable to a ordinary security as defined in the MFID or national regulations. Under the MIFID regime no material form is required of a security. That means a codeline stored on a blockchain can be regarded as a valid security. The German Bafin expressly confirmed this in its publication of February 20, 2018 and in approving the BitBond prospectus early in 2019. As the representation is time-stamped, immutable and safely stored on a blockchain, the representation can be regarded as safe enough to be relied on as a legally valid representation. There is no-offline copy. An offline copy can’t be part of a decentralised systems because no automatic update of the block would be possible.
Transferring a Security Token technically means changing the ownership registration in the way the respective blockchain protocol provides for in the register and sending the key to the register to the new owner. Legally, such transfer is regarded either as an assignment of claims, a transfer of contract (Vertragsübernahme) or title (Übereignung) depending on the respective asset.
5. How will it work from a regulatory point of view to transfer Security Tokens across citizens of different legal jurisdictions?
Regulators do not normally care for transnational transfers of securities. Their job is to protect investors in their own jurisdiction by providing regulations for almost any dealing with securities: storing (custody), brokering, advising on investments and of course, exchanging securities. That means that all activities around transferring securities from A to B require a license. With regard to the transnational character of securities trading, the European Union set a common regulatory framework for members of the EU (that was adopted by members of the European Econmic Area). Technically, security trading is already completely global although it is less easy to „physically“ transfer conventional securities into other jurisdictions. The technical standards for security clearing and storing are not harmonized yet. This issue is easily solved by security tokens.
If security tokens are transferred into non-EU jurisdiction the respective national security law have to be complied with. This makes STO offerings a complex issue depending on the number of jurisdictions targeted. For these reasons, STOs are often confined to a few (whitelisted) countries only.
6. What happens if I lose the private key to my Security Token?
At the beginning of token trading, your crypto assets were lost when you lost your private key. Meanwhile, a number of token custodians provide back-up solutions for token owners. If a token owner has lost his/her private key he/she may receive a new private keys and new token are generated (as there is no access to the old ones). Such backup solutions can be realised when token investors are identified which is mandatory in most jurisdiction under Anti-Money-Laundering regulations. One of the more advanced method that is evolving strongly is to provide several private keys to various keyholders to enhance security and to safeguard against losses of individual private keys.
7. Many people see a big advantage of tokenizing Venture Capital — thereby bringing more liquidity into the market. Can you explain to us how Security Tokens are enabling this?
First of all, you can finance all sort of businesses (start-up, grown-up companies) or parts of it (individual projects, products, services) by offering tokens. It is equally good for all sorts of businesses. Secondly, this can be done by offering security tokens but also by other tokens, namely utility tokens. Security tokens do not have a specific advantage over other tokens. The advantage of security tokens as opposed to utility tokens is the financial benefit you might offer to investors. Rather than hoping for the increase of token prices (which under US law would qualify a token as a security) the investors can claim and the issuer may offer all sort of financial benefits. As far as liquidity is concerned, at this stage, the liquidity of security tokens is actually quite limited for two reasons: (1) The secondary market is still in its infancy. Only if there is a sufficient number of security token exchanges which are either regulated or otherwise compliant with national laws security tokens can show their strengths. (2) The number of token investors, although growing quickly, is by far not as big as the number of conventional investors. This is equally true for professional and retail investors. Thus, the liquidity hypothesis is a bit early.
Personally, however, I am convinced that security tokens as a digital security have the potential to replace ordinary securities completely or at least to a great extent once the infrastructure is fully established. The advantages of security tokens are obvious for everyone who has tried to invest in foreign securities or to transfer securities from one country to another.
8. Out of your experience, what is the biggest misconception people have about Security Tokens?
The first big misconception is that creating security tokens is terribly complicated because of the many regulations and that existing regulations need to be adjusted to security tokens. Neither is true, at least not generally. Security regulation offers a reliable legal framework which experienced lawyers can handle. Security regulations can be applied by and large (with the exception of exchange regulations) in its current form and require only little adjustments. The second big misconception is that security tokens exchanges can be set up and licensed easily. As discussed, current exchanges are not open to retail traders. That means the existing legal framework does not fit for crypto exchanges and need to be amended. This is a big challenge for all regulators and legal systems.
9. One often mentioned advantage of Security Tokens is that of fractional ownership? Can you explain to us, why this was not possible before blockchain technology came along?
Again, this is one of the many myths around security tokens. Fractional ownership is nothing new in the securities realm. If you own „securities“ today, you normally hold a fractional ownership in a global certificate deposited with a central clearing agency like Clearstream or Euroclear. The global certificate may be equity (a share) or debt (a bond). So, fractional ownership is the rule rather than the exception and definitely no advantage attributed to security tokens only.
Very often fractional ownership relates to property or other tangible assets. Such assets, rather the title to such assets may be tokenized. However, in jurisdictions like Germany title creation to property is subject to the entrance of such title in a central registry. This is a still insurmountable obstacle to asset tokenization of properties. Other assets with no form requirements for title creation many by tokenized and traded. Such tokens will almost always be regarded as security or investment tokens by regulators.
10. Can you describe a benefit Security Tokens are generating by walking us through a process before and after Tokenization/Blockchain came along? Help us to understand the increase of efficiency and cost-saving opportunities Security Tokens can provide?
Creating and trading security tokens on the blockchain is a lot easier and cheaper than it is with conventional securities. The creation may be equally easy/ difficult as there is no difference in writing terms and conditions on paper or in code. The biggest potential the blockchain offers is to streamline the registration and transaction process. With conventional securities, this is still and in spite of tons of technology applied a pretty complex process. The issuer of a security normally needs to involve (and pay) a bank and a central depository. Investors need a custodian. Strictly speaking, all this is not necessary for a security token offering. Running registrations and transactions on the blockchain does not require all these agencies, can be done automatically and could be a lot cheaper than the existing systems. In addition, it is universally applicable.
11. What was the best learning you made during the last year?
Last year was particularly exciting and I learned an awful lot of things. One of the best learning was, that the blockchain does not help you to work around sound economic considerations that have been applied for ages. But the second best learning was that, in spite of many odds in 2018, blockchain is still there and starts to prove its value to the outside world.
Thank you for the Interview!
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