An Observation of Crypto Security Tokens

By Warfield Capital on ALTCOIN MAGAZINE

A security token represents an investment vehicle whose sole purpose is to capture and produce monetary value over time. Investors buy security tokens to realize returns in the forms of dividends, the price appreciation of an underlying asset, or via other multiplex value creation models. That being said, it is important to note that security tokens are the antithesis of utility tokens, and, as such, should not be viewed equally. For this reason, we provide the reader with a rich perspective of (i) what qualifies a token as a security token, (ii) the regulatory parameters that are important to consider, and (iii) a high-level overview of the working components that are integral to the security token environment.

How to determine if a token is a security

In the United States, the US Supreme Court case of SEC vs. Howey established a test to determine whether or not an arrangement involves an investment contract (a type of security). As such, there are four elements that have to be met in order for a token to be categorized as a security.

A contract constitutes an investment contract that meets the definition of security if there is…

To that end, if a token satisfied these four conditions, it shall be deemed a security token — and should be treated as such.

Regulatory Considerations for Security Tokens

Furthermore, selling tokenized securities bears significant regulatory challenges for issuers and investors alike. Private securities, for example, must fall under exemptions with applicable laws to avoid public filing requirements. Some of these exemptions include limiting the total number of investors, only allowing specific types of investors (e.g., accredited investors), or implementing a holding period. Unfortunately, most companies do not take the proper steps to ensure that their tokens are compliant with the regulatory requirements in each jurisdictional boundary; and, in effect, regularly offer tokens that are non-compliant with the existing regulatory frameworks.1

Moreover, it is important to keep in mind that different jurisdictional boundaries have different regulatory requirements. And compliance with these different regulatory requirements differ in each jurisdictional boundary as well. In the U.S. alone, for example, private securities are required to comply with regulations such as the:

● Securities Act of 1933
● Securities Exchange Act of 1934
● Investment Adviser Act of 1940
● Investment Companies Act of 1940

These regulations apply not only to the initial offering but to all secondary trades as well, where the seller still remains responsible. Keeping this in mind, one can imagine that enforcing these regulatory requirements and compliance standards is a significant hurdle to overcome when issuing security tokens.

What are the different types of security tokens?

Listed below are the different types of security tokens:

Dividend-Generating Security Tokens: These security tokens disseminate regular dividend payments back to its holders.

Value-Appreciation Security Tokens: The value of the security token is expected to appreciate over time but does not pay dividends. Security tokens that are structured on this model rely heavily on protocols that correlate the value of the underlying asset with the value of the token holdings. Examples of this would include tokens that represent shares of private companies, artwork, gold, or diamonds.

Hybrid Dividend-Value Security Tokens: This model is a confluence of both Dividend-Generating and Value-Appreciation security tokens. Keeping this in mind, token holders of this kind benefit from receiving regular dividend payments while also gaining from the equity generated by the underlying token.

Security Token Derivatives: Security token derivatives will represent market derivatives in the following ways:

• Swaps Model→ These security token derivatives can exchange the dividends or cash flow produced by two different security tokens in order to serve as a hedge against future market conditions.
• Options Model→ The owner of the security token option will have the right — but not the obligation — to buy or sell an underlying security token at a specific price on a predetermined date.
• Forward-Futures Model→ Smart contracts can be instructed to buy or sell a security token at a specified future date and at a previously agreed price.

The case for tokenizing traditional assets

Liquidity is a driving force behind tokenizing traditional assets on blockchains. In other words, tokenizing previously illiquid assets will augment their liquidity, thereby making them more tradable.

Moreover, illiquid assets are extremely “costly” to trade due to the friction (i.e., fewer market participants, lack of volume, larger spreads, and larger price impact) that is native to their being. As such, illiquid assets suffer from an “illiquidity discount,” preventing issuers from capturing the full value of the underlying asset.

For example, let’s suppose that there are two companies which are completely identical — except for the fact that one is a publicly traded company and the other is private. Because the publicly traded company is traded on a stock exchange and thereby assumes greater liquidity than the private company, there is less friction for its trading. This, in effect, gives the publicly traded stock a “liquidity premium” over the private company. In other words, because the public company is easier to trade, it assumes a greater value than the private company — although both companies are completely identical. Herein lies the great promise of tokenizing traditional assets on the blockchain.

Additionally, given the size of the asset categories encapsulated in the private securities market (in the trillions) and the illiquidity discount sometimes reaching as high as 20~30%, it is plausible that billions of dollars in value could be unlocked via tokenizing private securities.

Market taxonomy & components

Furthermore, the security token environment will be heavily reliant upon a multiplicity of components that need to interoperate with each other. Listed below is an initial version of the security token market taxonomy that offers an illustration of the buildings blocks that will define the security token environment:

As the reader can see, there are a myriad of components that compose the security token environment. For this reason, we’ve provided a commentary on its most interesting components below:

Token Issuance Platforms

• Token Issuance platforms help launch security tokens in a compliant manner. Some of the more notable security token platforms are Polymath, Securitize, and Harbor.

Identity

• To enable a robust flow of security tokens within primary and secondary markets, identity protocols for representing issuers, investors, and other entities will be mandatory. Technologies like uPort and Civic are possible solutions.

Voting/Governance Protocols

• Voting and governance mechanisms will need to be “baked” into security tokens so they can be executed on the blockchain.

Collateralization Protocols

• Different collateralization models that can accurately model the financial behavior of security tokens will be needed. These methods for collateralization calculations can be utilized to control and influence the respective security token’s valuation.

Legal Protocols

• Many of the on-chain activities will need to be translated into off-chain legal artifacts. Projects such as OpenLaw are working to solve this problem.

Token Models

• Dissimilar financial instruments should be translated into various distinct types of security tokens. The four types of security tokens that should be considered are listed below:

Debt Tokens: Debt tokens can be utilized to represent debt instruments such as Bonds, Certificate of Deposits, Commercial Papers, Debentures, Fixed Deposits, Government Securities, and National Savings Certificates.

Equity Tokens: Equity tokens can represent shares in companies or special purpose investment vehicles.

Hybrid Tokens: Hybrid tokens can convert debt tokens into equity tokens and vice-versa.

Derivative Tokens: Security token derivatives are likely to become widely adopted in this space. Derivative tokens can be utilized to enable, Token Margin Trading Protocols, Token Options Trading Protocols, and Token Futures Trading Protocols.

Oracle Registry

• Due to the abundance of regulatory requirements in each jurisdictional boundary, security token platforms need to incorporate hundreds of different regulatory models into their products. This, in effect, will enable security tokens to abide by existing regulatory laws and allow the tokens to be easily tradable in specific geographies or industries. As such, oracles will be tasked with providing rich data feeds and compliance models that tokenization platforms can utilize when issuing security tokens.

Privacy Protocols

• At this time, the privacy of security token transactions rely heavily on Ethereum smart contracts. Moving forward, privacy-focused protocols such as zk_SNARKS or multi-ring signatures will enable different levels of privacy for the transmission of security tokens.

Data Intelligence

• In order for security tokens to achieve the adoption of institutional investors, security tokens need to provide sophisticated levels of analytics and intelligence that is comparable to traditional financial securities. This can be achieved by creating a robust and rich data layer.

Liquidity Pools

• Providing access to large pools of security tokens will augment the liquidity of the security token environment. Sellers, in effect, will achieve a liquidity premium when selling their assets.

Exchanges

• Security token exchanges are an integral component to enable greater liquidity of security tokens.

Investor Products

• To garner institutional interest, security tokens should mimic existing financial vehicles such as ETFs, Index Funds, Mutual Funds, etc.

To that end, the security token environment is undoubtedly seeing rapid development. While there are many hurdles to overcome in the foreseeable future, there is a substantial amount of innovation happening to bring security tokens into fruition. Altogether, while the environment remains embryonic at this point in time, we suspect that it will gradually grow in strength and prove itself to be a great influencer of economies in the years to come.

Warfield Capital is a research and investment firm dedicated to deeply understanding the crypto-ecosystem. We regularly publish our best thinking for you to review, so please be sure to visit our website www.warfieldcapital.com for more information.

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The purpose of ALTCOIN MAGAZINE is to educate the world on crypto and to bring it to the hands and the minds of the masses. This article was written and composed by Warfield Capital on ALTCOIN MAGAZINE.