Digital Securities: A Primer

Disruption is everywhere.

Think of companies such as Uber that have had a profound impact on the transportation industry. Not only has the company single-handedly changed consumer behavior around transportation, but Uber also destroyed the value of owning a taxicab medallion. In the 1930s, New York City officials instituted taxi medallions to limit the number of drivers on the road. That cap was set at 13,000.

A vintage taxi medallion

As the population grew, the demand for those medallions soared as an increasing number of drivers wanted access to a growing market in need of a ride. At its peak, a single medallion sold for $1.3M in 2014. These medallions were coveted and had a real value pre-Uber. Today, you can toss them away and take a large tax write-off. Most recently, a taxi medallion sold for as low as $150,000, a far cry from its peak just a few years before.

Think of Airbnb, who is challenging the hospitality industry. What will happen to hotels when you can get a clean, spacious apartment at half the price? Why would a traveler stay in a tiny hotel room when they could stay in an actual home and feel like part of the city they are visiting?

It turns out that the disruption is not one of hurting the hotel industry. Indeed, in an article published by the Atlantic in February this year, the data showed a different trend. The hotel business is booming. Business travelers prefer them, and Airbnb helps drive the cost down in hotels by reducing the demand. The true disruption is that Airbnb has had the unintended consequence of helping drive up the cost of rent: it has shifted the burden of rising rental prices from hotels to the locals that live in the area.

These disruptions, and many more, were all financed by Venture Capitalists, who are more than happy to disrupt any and every industry. The only thing they are unwilling to disrupt is themselves.

The ICO Boom

The craze that caught everyone off guard. Companies are raising money directly from the public? They are not going after professional investors such as venture capitalists and funds? No. They are going directly to the source.

Better, these companies are not selling backpacks on Kickstarter, nor do they even want US dollars. These companies doing ICOs want cryptocurrencies, such as Bitcoin and Ether, in exchange for new cryptocurrencies, tokens that functioned within their proposed business like tokens at an arcade or earning rewards coupons that can be redeemed for services. How will these companies pay their employees, pay for the physical office spaces they rent, with Bitcoin?

Turns out, it is quite simple. You raise $50M in Bitcoin and Ether during your ICO, and then you exchange these cryptocurrencies into fiat like the US Dollar as you need to. Similar to having a savings account earning interest, only it’s a lot more volatile. You would not be wrong to describe it as a gamble. In some cases, that $50M turned into $200M. In others, that $50M is now only $20M.

Regardless, the real story was this: entrepreneurs were raising money directly from investors on their own terms. No VCs, no banks.

Trouble in Paradise

Despite that, or perhaps because of it, there was a problem with the ICO model. Not all was bright and shiny in the land of cryptocurrencies even though billions of dollars flooded the market, and companies with not even a working product could raise tens of millions of dollars in a day.

The problem was this: companies doing ICOs did not exactly follow the laws of the land. They understood the promise of blockchain; they understood the promise of cryptocurrencies; and they understood that their business needed money. They also understood that an ICO was a remarkably easy way to raise capital compared to other means.

What they didn’t understand, or perhaps simply did not pay enough attention to, was this new asset class they were selling: the utility token. What was it, really? How would the federal government view such an asset? The state? Did no one stop to think that the regulators would almost certainly take interest in this amount of money flowing from the public into private businesses, businesses that had no obligations to its investors? If we take a moment for the US, this is particularly acute within the context of the Great Depression, where unprotected investments broke the national economy.

The SEC first vocalized their stance in 2017, and as the crypto community ignored them, they only sang the song louder: they believed the majority of those so-called utility tokens are securities. The ‘utility’ is a misnomer. That means the majority of ICOs were illegal because the sale of securities requires entrepreneurs to register the offering (this is expensive and not practical for a startup, or even a medium-sized business). This is analogous to going public with an IPO. However, there is an alternative.

The Exemption

Signed into law in April 2012 by Barack Obama, the JOBS Act (Jumpstart Our Business Startups) is a game changer for fundraising. The Act allows entrepreneurs to raise capital directly from the public through the sale of securities. Does it work for ICOs? You bet.

Using the JOBS Act protects both the company raising capital and their investors. A no brainer for both parties. Recently, many ICOs have gone this route after their lawyers politely declined to help them raise money through the sale of utility tokens. The lawyers reminded their clients that they have risk. They have a reputation to uphold, and that reputation is what their business is built on, how they get new clients. No lawyer wants a reputation of violating securities laws. This is why Cooley, which is an extraordinary law firm, is out of that business.

As the marketplace realized that issuing securities without following the rules is a bad thing, that there were consequences to it (surprise!), a new narrative began to take place. ICOs are being transformed and replaced by STOs, or Security Token Offerings.

While ICOs were undeniably successful — they have raised over $15 billion in the last 18 months after all, they caught the eye not only of the SEC, but the Treasury, the 50 State administrators, and the big ad networks. With the amount of rampant fraud in ICOs, Facebook, Google, MailChimp, and others got so nervous that they banned ICO advertising.

STOs differentiated themselves from ICOs by operating within the light of regulation and legal restrictions. With the JOBS Act combined with an STO, you now have a framework that allows entrepreneurs to issue securities to their investors.

But what kind of securities are those investors buying? The good news is that within the JOBS Act, with the different exemptions at entrepreneurs disposal, Regulation A+, Regulation Crowdfunding and Regulation D 506(c), there is a lot of flexibility to design security tokens that meet the needs of entrepreneurs and the demands of investors. Equity, debt, revenue share, you name it.

Leaving Paper Behind

Digital securities may be a new buzzword, but it makes sense when you think about it. In the past securities were paper, literally. Your ownership of a stock was written down on paper and kept in a warehouse somewhere. Now these securities are digital, and this is in itself is a huge step forward.

With digitization, a security now can have special properties, including the ability to track the owners of those securities digitally and the ability to trade those securities with minimal costs. In the past, you needed to wake the lawyer and pay legal fees in order to decide whether a security could be traded and, if so, to whom. Then you have to pay additional fees after a trading match is made, and then more fees after the trade. While these fees were great at keeping the legal profession healthy, these fees made most trades impractical, especially small ones under $50,000. Imagine spending $5,000 on a $10,000 trade. Then imagine spending $5000 on a $500 trade. The model just doesn’t work for investors wanting to trade small amounts of securities.

So how is this changed with digital securities? The simple answer is this: what the ATM did to the bank teller, digitization does to the broker, the lawyer, and everyone else in between the buyer and the seller. If a security is digitized, it is now possible to make a $500 trade in privately-held securities and come out ahead. Digitization gives small amounts of securities liquidity.

Why not pay $25 to a broker-dealer in order to buy or sell $500 worth of common stock or debt? You could argue that broker-dealers cannot live off $25 because the brokers have to pay expensive office rent for that view of downtown’s skyline and to maintain the ludicrous lifestyle of slick brokers. Fast cars, lobster, and cigars. Yachts, scotch, 3-acre homes, and a vacation cabin.

But if you pare down the excess, if you increase the raw number of trades, then it is possible for broker-dealers to run a business off these small fees. It is possible right now.

The future has landed.

So how does it work? A digital security is issued by a company or a broker-dealer and sold to investors when a company raises capital utilizing the JOBS Act. These are public offerings, and the securities can be sold to the general public, to thousands of investors should thousands of investors find the offering of worthy interest.

The company issuing the securities hires an intermediary who can write the smart contract on Ethereum or Stellar, two blockchains well-suited for this purpose, though there are certainly others. The smart contract is a token, a digital marker that will track the ownership of the security itself. It also has some other functions that we will get back to in a moment.

The next step in this process is issuance. To properly sell these digital securities to the crowd using the right exemption, investors have two options: Regulation A+ (often described as a mini-IPO, in which companies can raise up to $50M in a given year) or Regulation Crowdfunding (in which companies can raise up to $1.07M in a given year, but it is a leaner regulation and companies can launch faster and more cheaply than a Regulation A).

Then, the purchase. Once the investor has purchased digital securities through either a platform or a broker dealer, a transfer agent needs to record the transaction and then post it on the blockchain. This promotes transparency in the process as the general public can see how many securities exist, how many were issued, and which wallets own them. There is no privately identifiable information on the blockchain at anytime.

Trading securities is significantly easier because all of the information required to determine whether the trade is possible is located in the smart contract. When was that security issued? What exemption was used in its issuance? Is there a lock-up period during which that security can’t be traded, and if so, when does it end? Are there restrictions on who can buy the security? All of those questions are key to securities trading, and it’s possible to eliminate the attorney if the broker-dealer has confidence in the immutable and trusted information located on the blockchain.

Why is a broker-dealer involved? Securities laws are complex and designed to favor the use of a broker-dealer to handle transactions. Broker-dealers are companies supervised by FINRA, a regulator created by the SEC. FINRA’s job is to make sure those under their supervision are doing the right thing and providing accurate information to investors and only allowing legal trading, per the questions above and other restrictions. Add to this the complex regulations of 50 individual states when it comes to security transactions within their own borders, and you can now imagine why a broker-dealer is required. There is simply too much to keep track of.

However, the problem with broker-dealers is that traditionally they are heavy and expensive. This was true yesterday, but a new form of broker-dealer is emerging and getting their licenses. This new breed hails from the technology industry. Software is in their blood. They know how to automate everything and deliver shares for pennies instead of thousands of dollars.

Imagine a world where entrepreneurs can sell securities to consumers for very little costs, and those consumers can later sell them to others, either for a profit or a loss, but for very little costs in the actual transaction.

That world is coming, and digital securities are leading the way. Hello world.

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