The Security Token Environment: A Comprehensive Overview

  1. Security Token Overview

Definition

Swiss Financial Market Supervisory Authority (FINMA), responsible for financial regulation in Switzerland describes asset tokens as of: “Asset tokens represent assets such as a debt or equity claim on the issuer. Asset tokens promise, for example, a share in future company earnings or future capital flows. In terms of their economic function, therefore, these tokens are analogous to equities, bonds or derivatives. Tokens which enable physical assets to be traded on the blockchain also fall into this category”.

Considered as the next financial revolution

Since the beginning of 2018, security token industry has been continuously capturing attention from both the blockchain community and the financial institutions. It is indeed perceived as the next revolution in the financial world that could reach trillions of dollars in a just few years. According to the World Economic Forum’s report Blockchain Building Blocks; “the blockchain will become the beating heart of the global financial system”.

Tokenization, the representation of real or virtual assets on a blockchain, is spreading to security trading, income-producing securities (equity, debt), membership rights and more. Its potential for many applications is nearly unlimited while looking to the market size of global financial assets ($294 trillion).[1]

The reason security tokens are rising interest comes from the way they address critical issues and needs from both traditional finance and the new digital economy.

The add-value of security tokens can be summarized with the three following propositions:

1. Enabling companies to easily launch a security token offering (STO) to raise capital with a lower cost compared to IPO

2. Enabling investors across the globe to buy assets with ease

3. Providing an unprecedented level of liquidity to traditional assets, as the digital assets are easily fractionable, transferable and traceable

As a matter of facts, assets’ tokenization has already started to embrace financial markets. The most relevant example is the World Bank which has successfully raised $110M in the offering of a blockchain-operated new debt instrument, making the first bond to be created, transferred and managed over blockchain technology[2]. Another notable example is Binance, being world’s largest crypto exchange by volume, which has partnered up with the Malta Stock Exchange to enable security token trading[3].

We are seeing numerous companies achieving tokenization of their equity through Security Token Offerings (STOs). Among them, we can mention 22x Fund Ltd. that has raised $22M, providing investors fractionalized ownership of start-ups from the famous silicon valley incubator “500 Start-ups”, or St. Regis Hotel (Marriott Group) which has raised $18M on the Indiegogo platform, offering its real estate shares to accredited investors.

We believe security tokenization will bring a whole new management and trading capabilities, allowing equal access and unprecedented price transparency for investing.

The context of STO’s arrival

ICOs opened the door to worldwide fundraising democratization

If you have been paying attention to the news, there is a high chance you have seen the fulgurant rise of Initial Coin Offerings (ICOs) as a method of fundraisings, that have managed to raise $22bn since 2014[4]. ICO, through the use of utility token, is a new way for the company to raise capital for developing its product or service, and grant investors with a utility token giving them access to that product or service and which value should appreciate over time.

Utility token act in the same way as a coupon or prepayment is used to purchase services of product from the company. By so, utility tokens are not designed as investments and do not fall into the scope of securities. People who invest in ICOs hope utility token’s value will increase over time, as demand for the company’s product or service increases. The speculative profit comes from the fact that there is a fix supply of utility tokens.

As a matter of fact, ICOs have been running out of steam with approximately 46% of last year’s ICOs that have failed[5]. Among the reasons, the limited oversight and regulation had proven to be one of its most significant vulnerability, especially when scammers began to emerge and ICOs’ investors did not benefit from any litigation rights nor protection. Indeed, by its very nature, being non-regulated, ICOs do not provide any legal remedies.

While ICOs have shown there is a massive demand for small-scale investments and that tokenization is efficient to manage large numbers of investors, we believe they lack a predominant component that has prevented ICOs from reaching the mainstream and widespread adoption: a contractual and inclusive link between ICO companies and investors.

Why security tokens are ready to embrace traditional investors

Security Tokens are tradable financial assets, thus securities. Just like financial assets, security tokens are as well back by something tangible, such as equity, real estate, bonds, stocks, revenues, royalties, etc. In overall, anything that has a financial “registered” value. Therefore, they provide the same benefits that traditional financial instruments offer, as they go through the same channel (frameworks, legal documents, and obligations) to achieve compliance.

Where utility tokens do not fit mainstream investors, security tokens are, on the contrary, ready to embrace traditional investors as they provide shareholder rights. Besides of ensuring the same rights securities offer to investors, (i.e., economic, control, information and litigation rights), security tokens are combined with the benefits and capabilities of digital assets. This is where lies the most significant benefits of security tokens.

2. Securities combined with the benefits of digital assets

Security tokens offer the promise of significant benefits to investors by unlocking trillions of dollars of untapped value globally and expanding the range of investable assets. Tokenisation may have the potential not only to turn securities into security tokens but also non-securities into security tokens. In theory, any physical or financial asset which offers an economic benefit to its owner through the appreciation of the asset’s value, through a recurring income/ payment stream or a continued right of usage or enjoyment could be tokenize on the blockchain.

Although different variations exist today, the “tokenization” process involves in the issuance of a digital security token on the blockchain embedded with a smart contract representing ownership rights of the underlying asset collateralized through a generally recognized legal vehicle such as an escrow or trust arrangement. Once the tokens are created on the blockchain and issued to investors, they can then be sold and traded in the secondary market on crypto exchanges globally. Converting a physical or financial asset to a blockchain based digital token presents critical benefits to investors and potential efficiencies that are difficult to ignore:

  1. Security tokens present one digital version of the truth for the asset’s underlying composition and risk characteristics. This could play a significant role in revolutionizing the securitization of more complex instruments such as Asset Backed Securities

As a result, transforming a traditional asset into a tradeable piece of code offers a way to broaden access to investments by lowering barriers such as illiquidity and steep costs. Assets class that will benefit the most from fractionalization, liquidity, and transparency include real estate, art, derivative products and private equity funds.

A practical example to illustrate how tokenizing financial assets could be game-changing is looking back at what has caused 2008 financial crisis: centralized governance and opacity related to traditional derivative products, in particular, Collateralized Debt Obligations (CDO) which backed highly risky subprime mortgage loans. Their lack of transparency and traceability has indeed made it difficult, not to say impossible, for investors to correctly evaluate the credit risk associated with these underlying assets that, furthermore, had AAA-rated CDO investments.

Let’s imagine a tokenized CDO, registered, managed and governed on the blockchain by autonomous smart contracts. This decentralization and open access to trusted information would have certainly brought greater traceability on the ownership’s transfers and therefore visibility on the intrinsic value and risks associated with those assets. That would have avoided assets’ solvency distortions that have led to 2008’s crisis. We could also imagine assets’ rating emanating from this easily auditable information registered on the blockchain.

3. Security token perspective

The big challenges security token platforms will need to take up

As seen discussed in this article, assets’ tokenization offers notable gains in costs, efficiency, transparency, security, and compliance. These potential unprecedented benefits come obviously with specific challenges and risks that security token platforms must fully assess. In particular, the regulatory and technical aspects of operating across all the different stages in the security tokenization lifecycle are key factors.

First of all, since each jurisdiction has its own set of law governing securities, issuance platforms need to ensure they comply with local regulations. A security token offering must indeed abide by the laws of the jurisdiction where the security token offering takes place, which might have specific rules on deal underwriting, capital raise limits, use of general solicitations, market makings, restrictions on resale, investors qualification requirements (KYC and AML), rating assignments, audit reports, etc. Depending on local regulation’s requirements, security token’s architecture will have therefore to be conceived and scaled accordingly.

As of today, countries have taken several positions (proactive, wait-and-see, undefined…) to address security tokens, and by extension security token offerings. Among proactive positions, we can mention U.S. regulators that attempt to fit digital assets into existing frameworks (Regulation D, A+, S and CF) if considered as security by the Howey Test. On the European side, regulators suggest regulating asset tokens by MiFID II, the Prospectus Regulation, Market Abuse Regulation (MAR), if the asset is considered as financial instruments and transferable securities.

In addition, beyond from being compliant with local authorities, security tokens issuance platforms will have to ensure, through the use of blockchain and smart contracts, efficient and reliable interoperability with all different actors intervening in the token’s securitization lifecycle (i.e. underwriters, lawyers, auditor etc.) while maintaining security and compliance at every level. This function won’t be easy to set up, and we believe this transition will evolve to a full-blockchain-based infrastructure in the near future.

Dusk Foundation, a privacy protocol with on-chain compliance, is a good example of achieving this interoperability directly on the blockchain. They aim is to create a decentralized infrastructure with an optimal balance between privacy and legal compliance to issue security tokens with easy and fully compliant onboarding.

Security exchange platforms — representing thus the interface (i.e. marketplace) between tokenized companies and investors, will also have a predominant role to play. The first one, the same as for issuance platforms, would be to ensure investors meet the obligations in each jurisdiction the token are distribute in. Once these requirements have been met, security token platforms will then have to rightly execute and secure ownerships’ transfers, with the rights linked to it (ex. voting rights, information rights etc.) when a security token is being sold to another investor. As companies will want to keep close control on who is detaining their shares and ensure a continuous and inclusive link between shareholders and the company, as the law requires.

This secondary market is today the missing ingredient that would unlock liquidity to the market and thus activity. Security token trading is still in its infancy stage with, as a matter of fact, only one platform is being officially launched and operational (OpenFinance Network, Dec. 2018). Other projects (20+) are currently underway and 2019 should be a landmark year for security token exchange massive emergence. We believe this secondary market will be shaped by cross-border integrations of security token’s protocols (such as ST-20, R-Token, Dusk Token) by well-established platforms (e.g. Binance, Bitfinex etc.) to offer secured and compliant storage and asset ownership transfers.

To conclude, security token platforms’ role would be to offer a set of tools and channels to guide the company through the security tokenization lifecycle — and we believe their success will rely on their capacity to put all necessary aspects of regulation and blockchain technology together in an easy-to-use and streamline manner.

[1] https://www.businessinsider.fr/us/global-financial-assets-2015-2

[2] http://www.worldbank.org/en/news/press-release/2018/08/23/world-bank-prices-first-global-blockchain-bond-raising-a110-million

[3] https://www.coindesk.com/binance-partners-with-malta-to-launch-security-token-trading-platform

[4] https://www.coinschedule.com/stats.html

[5] https://news.bitcoin.com/46-last-years-icos-failed-already/