The Case for Security Tokens
The blockchain fundraising world is moving on to Security Tokens- find out below the why, the what and the how.
The security token discussion is finally moving to Asia- conferences around security tokens such as the Security Token Future event in Hong Kong has started to attract audience and inspired interesting discussions around designing security token offering platforms and finding first use cases of blockchain technology on securitizing physical assets.
Globally, players in the blockchain space have been actively positioning themselves to the next wave of blockchain fundraising. Back in June this year, Coinbase, now a US$8B company, acquired Venovate Marketplace for their ATS license, the license is a requirement for listing and secondary trading of tokenized securities. In less than a month, Sharepost followed suit by announcing SEC approval for its ATS license.
Along with these are institutional investors’ bets into STO related projects- TZero secured US$114M plus from private equity firm GSR and other institutional investors, while Harbor raised US$28M series B from Andreessen Horowitz and Founders’ Fund.
Introducing the new kid around the block- Security Token Offering (STO).
Security Tokens
In 2017, most discussions around security token still concern whether a cryptographic asset is a utility token or not (if it is not a utility token, then it is a security token)- this process is largely governed by the passing/failing of the Howey Test.
As the trend evolves, security token became much more than just being ‘not utility token’, but a version of “programmable ownership” of its underlying asset put onto a blockchain. The token can now be a share/fraction of a share in a company, an LP interest in a fund or a trust or a member share in an LLC, with your ownership and transactions around your share of a security becoming visible to permitted parties.
The vision around security tokens
Like most blockchain projects, the vision and the use case of a security token centers around the removal of a middleman to broker the security. This is particularly relevant in the world of private markets where securities of unlisted companies can be highly illiquid and middlemen charge huge liquidity premium just to match buyers and sellers in the secondary private market.
Issuing/handling of securities can potentially become autonomous processes as well. With the availability of smart contracts, the issuer of a security can build in features of securities such as dividends payouts and even voting rights into the token itself. Eligibility checks (accredited investor or not) may also possibly be handled at token generation events.
Migrating the securities on the blockchain platform also means the possibility of near instantaneous settlements. In the current settlement infrastructure, stocks and securities transfer take up to T+2, but settlement on blockchain can be done as soon as the blockchain ledger is updated, depending on the throughput of the protocol on which the security token is based on.
The ultimate vision can even be the interoperability of securitized assets- creating token markets between securitized assets. If this can be built, this can unlock an internet of value where assets, for instance, revenue generated from IPs, can be traded with an LP interest in a private real estate REIT through tokens, thus bringing in additional avenues of liquidity.
But then again, these are grand visions of STO which may still be many years away from coming into reality. Here are a few potential roadblocks:
The immediate roadblocks around security tokens
First of all, the promise of removing middlemen will lead to a shift in responsibilities of structuring such securities most likely to the sellers. If the purpose of issuing security tokens is to market your offering to more than just accredited investors in a cheaper way by undercutting your middlemen, you may want to rethink doing that for the time being- some early attempts to conduct security token offering earlier this year resulted in pretty negative feedback.
At the end of the day, The investment banking world justifies their fees not only for bookrunning, but also deal underwriting, ensuring regulatory compliance and also work with lawyers to file out painful S-1 filings (or equivalent filings in other jurisdictions) so that mistakes like the above do not happen. Sellers of security tokens need to build up the necessary know-how to structure a security offering properly before STOs can become mainstream because smart contracts are irreversible in nature and security structuring on top of it needs to be done right particularly in the first go.
Secondly, security tokens’ values need to mimic that of the underlying ‘real world’ assets. Imagine tokenizing fractional ownership of a residential building in Asia- if out of its 1,000 occupied flats, one of the flat owners passed away from a suicide attempt in the flat, this brings down that single flat’s value as Asians generally don’t like to live in flats where people died in and as a result, reduces the building’s value as well.
While this event will generally make local news, foreign investors in the token in Alaska, for instance, will not hear of the news and still value the residential building without discounting the event, thus creating information arbitrages- thus, security tokens need to ensure token assets’ value consistency to that of its physical assets, something that can be hard to achieve particularly in the private markets.
Thirdly, programming regulatory compliance into tokens is HARD. Every security token needs to build in KYC/AML checks on all participating crypto wallets during primary issuance and secondary trading, and different jurisdictions have varying securities laws which need to be taken account of at the token generation level if the project is truly targeting global liquidity. As of yet, projects are only starting to come out with security token generation standards and it may well be quite a few years away before a functional security token operates seamlessly and globally.
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