Security Tokens: 20 Important Things you need to know (Detailed Guide)

What is a security token?

Security Token Offering can be best defined as a “Public-Private” security offering that utilizes regulatory body framework such as Securities and Exchange Commission ( SEC ) or Ontario Securities Commission ( OSC) to offer investment products via blockchain technology.

Preface

A securities offering (or funding round or investment round) is a discrete round of investment, by which a business or other enterprise raises money to fund operations, expansion, a capital project, an acquisition, or some other business purpose. A securities offering (or funding round or investment round) is a discrete round of investment, by which a business or other enterprise raises money to fund operations, expansion, a capital project, an acquisition, or some other business purpose.

STOs would be a process to move traditional assets to blockchain & evolving the way assets are issued, traded, held & transferred. It’s a work in progress with blocks built around it to support the ecosystem.

Background of Security Tokens:

Blockchain, cryptocurrencies, bitcoins, smart contracts aren’t alien terms anymore. Information is at all time high but there is a fair bit of noise on the benefits with thousands of companies finding the use cases for this revolutionary technology. While there has been interesting technical progress, there hasn’t been a killer case which would attract industry wide adoption. Exciting news on how the industry is progressing is a weekly affair but it rarely has put a dent on world economy more than pure speculation. Bitcoin did emerge as a libertarian movement with a promise of banking the unbanked, revolution against the status-quo, decentralized system with no manipulation but so far there is very little to show. Despite all of these there isn’t any reason to write-off this industry, because we’re still in infant stages. It’s a work in progress for last 10 years & it may take maybe a decade before utopia dream is fulfilled. Digitisation had a lot of impact on our daily lives in multiple sectors but financial industry is far from perfection when it comes to frictionless banking. I still have to go to bank to do a wire transfer & it takes couple of days for funds to get to other end at a exorbitant cost. Counter-argument would be that the banks are already digital & majority of the people don’t go to the bank anymore, so we’re on the right track. I take cryptocurrencies as an experiment lab or a sandbox where ideas can be tried, tested & could be launched into masses if successful. Current regulatory environment is fairly conservative when it comes to investment product or any other financial instrument. It’s either due protection of consumer or status-quo, that’s a different discussion, but it is what it is.

We’ve seen the exponential rise in cryptocurrency valuations, institutional interest through acquisitions & whopping billions dollar of raise in Initial Coin Offerings ( ICOs). ICOs could be simply explained as pre-prepaid credits in a game that was sold before the game was launched. It was fine till recently there were issues with this model.

  1. The game was never launched
  2.  these credits were trade-able way-before game launch leading to speculations & hype.

That ended about 10,000X returns in few cases & 99% loss in value from All Time High(ATH) in extreme cases.

Fear of Missing out ( FOMO) is a common term in which a person gets into a deal without due diligence because time clock is kicking in. Majority of the time it doesn’t end well. This FOMO lead to retail investors buying useful tokens of every kind. Doge currency was created to make fun of these tokens but that lead to 1.5B in valuation while the creator clearly mentioned that it’s a joke. In an another case a person clearly mentioned that he is creating a useless token with no use however people still bought them. Around that time Ripple CEO was worth more than
CEO of Facebook. While these tokens were marketed along the lines of prepaid tokens, they clearly weren’t. This is where Security Exchange Commission (SEC) & other regulatory bodies jump in.

Despite the legal language used in building analogies around network usage, setting up non-profit foundations in friendly offshore jurisdictions, taking shelter behind fancy buzzwords such as open-source software movements, decentralisation, blockchain 99% of them are securities & I’ve doubt about the remaining 1%.

There is a famous duck test,

“If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck”

This term was popularised in the US during the cold war in 1950 when Richard Cunninghand Patterson Jr, US ambassador to Guatemala at that time accused Jacobo Arbenz Guzman government of being Communist. These were the exact words
“Suppose you see a bird walking around in a farm yard. This bird has no label that says ‘duck’. But the bird certainly looks like a duck. Also, he goes to the pond and you notice that he swims like a duck. Then he opens his beak and quacks like a duck. Well, by this time you have probably reached the conclusion that the bird is a duck, whether he’s wearing a label or not”
In 1946, Supreme Court heard a case that set the precedent on what’s a security

  • It is an investment of money
  • There is an expectation of profits from the investment
  • The investment of money is in a common enterprise
  • Any profit comes from the efforts of a promoter or third party

If either of the above points satisfies during a financial transaction, whole new set of requirements kick-in. Entity is bound to register with the Security Exchange Commision ( SEC) regardless of whatever they think they’re. SEC only however generally looks over cases that involves US entities but other countries follow similar guidelines in their jurisdiction. Despite billion in funding ICOs have very little to show. Lack of investor rights, governance structure & geographical restrictions people are left with these useless tokens, but SEC has intervened in multiple cases leading to fines, capital return & other punishment. I expect them to rise, however despite all this drama, there is a very good case for issuing tokens that are actually securities but still have the benefits that a token provides. There is where Security tokens come into play which will have the legitimacy of a Initial Public Offerings (IPO) but flexibility of ICO ( Initial Coin Offering ). Welcome Security Token Offering (STO).

Business Case

There is a capital scarcity when it comes to private markets for small & medium business (SMBs) . Just to talk in terms of numbers, there are 28 Million small business in the US vs 3671 publicly traded companies. Number of public companies is decreasing year over year & this trend will continue to drop due to complicated nature of managing public market listings. SMBs are the backbone of any country economy & 70% of new job creation is due to them, but still they suffer growth due to lack of capital available. There are Venture capitalists, predatory lenders, angels & limited public after JOBS act, but that’s still a very limited segment. If they are able to access debt in return for a fractional ownership in the firm, that can be traded back & forth, it will get them out of the capital drought. It could be debt, equity, convertible note or combination of these but important point is access. This could lead to trillions of dollars in economic benefits.

Real estate is considered to be the best & safest asset class however it’s expensive to own. We’ve Real Estate Investment Trust ( REITs), but they’re still fairly out of reach for the masses. Real estate globally is worth around 265 Trillion but only 1% is accessible through these complex REIT structures. Security Token offering can remove lot of overhead making it flexible, simple & convenient for average investor to participate in an potential economic upside event. Lot of investments currently require the investor to have an accredited investor status despite there isn’t any relationship between IQ & wealth, but net worth does serves as a barometer for qualification of investor acumen. There is an argument that it’s not an acumen test but more of a ability to sustain loses. If that’s the case why isn’t a test before entering a casino or any high-end luxury store. No one gets inquired of his/her financial health at the gate while entering these establishments. If these high-risk or luxury establishments aren’t bound to do a background test on the consumer ability, why should a potential upside event be restricted ? Regardless of whatever I think, it’s a law which I respect & abide. This is where I think Security Tokens will make a lot of sense since they can solve major issues around public markets abiding with the current financial structure yet flexibility of tokens.

Here are the 20 major reasons to make a business case for Security Tokens to exist

No.Content
1.Liquidity
2.24/7 markets
3.Fractional ownership
4.Immediate settlement
5.Elimination of 3rd party services
6.Real-time ownership reconciliation
7.Cost reduction
8.Compliance automation
9.Expansion in the offering options
10.Custody
11.Vested Stocks
12.Pedigree proof
13.Preferential treatment
14.Infungibility
15.Debt restructuring
16.Global Assets
17.Larger investor base
18.Stability
19.Front running avoidance
20.Ownership Proof/ Title

1.  Liquidity

90% of the assets in the world are illiquid. It’s not possible to get in/out quickly without accruing significant slippage and/or paying a significant fee.Though liquidity is referred to as speed at which you can trade an asset, however it’s much more than just the speed in practice. Another parameter is also cost. Example is that you may be able to sell your house within 24 hours but that’ll be generally classified as a distressed sale & will lead to a loss in comparison if you wait. Price difference delta between distressed sale & regular sale is the liquidity discount that you’ve to offer. Other impact of these sale is that it lowers the bar for fair market value ( FMV) of similar houses in the vicinity.

In comparison you can trade Microsoft stocks at market value during business hours without having any major impact on the market prices by paying a very small fee. Now there are fractions if you’re a whale and cause market crash. Take this further with cryptocurrency which you to trade even a fraction round the clock.

Total world assets are 700T, but less than 10% of them are liquid. If Security Tokens are able to turn them liquid, there would be trillions dollar worth of economic activity generated.

2. 24/7 markets

Majority of the traditional exchanges operate between business hours such as 8 – 4:00 am in the morning with respect to local time zones. They’re closed during the holidays so if you want to make a move while having Saturday dinner, that’s not possible. Tokens on the other hands are tradeable 24/7. Due to the nature of STOs, it would be possible to trade them round the clock even on Christmas eve.

3. Fractional Ownership

It’s impossible for 95% of the world population to diversify into more than 2 investment classes due to high unit costs but if there is a mechanism to buy a small ownership, it’ll attract a whole new set of investors effectively increasing liquidity & raising premiums. Now in case of equities, there are options to buy them from public markets & similarly you can buy publicly-traded or private market RIETs but an estimated 99% of the real estate assets isn’t available through either of these tools. There would also be ability to make profits when the markets are going down rather than just buy & hold strategy and capture the gains with appreciation. Retail investors are unable to balance their portfolio to de-risk their investments across multiple assets, but availability of vast set of liquid assets would allow them so. Ultimately, it’ll lead to more efficient markets

4. Immediate settlement

There is a time difference between when the actual trade is executed & settled. Example is buying a house today but paperwork, transfer of funds & ownership might take 4-6 weeks. Even in stock exchanges, though you’re able to trade immediately, it’s usually 2 business days (T+2) before the owner get his hands on the purchase. It used to be 3 days but reduced to 2 in 2017. With STOs there should be a possibility of execution & settlement at the same time.

5. Elimination of 3rd party services

Blockchain has the potential to increase settlement speed for securities, but it’s more complicated than a comparison to cryptocurrencies. The degree to which these processes can be automated through interoperable smart contracts will determine the gains in settlement speed. There is a moral hazard with the usage of these companies since they can manipulate with insider information & little oversight on governance matters. With an open system, there’ll be a more transparent, fair & balance playing field.

6. Real-time ownership reconciliation

Even though the trade Trading books are balanced by the end of day. It’s costly & not optimistic. After stock issuance, there is a bundle of paperwork that goes in producing friction that leads to inefficiency. Contractual features including but not limited to liquidation preferences, depositories and depository participants management and drag-along rights etc could be easily calculated making it simple for the participants to decide their risk-reward ratio. Through STO, there would be a chance to have a real-time asset reconciliation in a transparent manner.

7. Cost reduction

There are massive costs associated with operating the exchange which could be reduced by having a lean-operated STO exchange. These smart contracts will reduce the complexity, costs and paperwork with managing securities (collecting signatures, wiring of funds, mailing of distribution checks, collection of W-2s, Sending K9s, etc).

8.  Compliance automation

KYC & AML policy are the two most basic compliance things any financial institute has to take care of. There are two major frictions in the current system

  • Legal Restrictions
    Financial institutes have to filter out the people who’re ineligible to be involved in the transaction mostly due to regulation. These restrictions could be due to buyer financial profile, industry, jurisdiction of transaction/seller/buyer or past history etc. Failure to abide can lead for serious repercussions. It slows down the onboarding process.
  • Complex chain of stakeholders
    There is a chain of stakeholders who’ve to be on the same page during the transaction. Lawyer, government, accountant, exchange is to name the few and all of them have their own of reconciliation which leads to inefficiencies in terms of cost & time. Unless & until all of them can match up their record, it doesn’t go through.

With blockchain, every transaction can be downloaded or broadcasted in a standard format in real time which should be able to make this process more efficient. Customers can get an ID that is verifiable by any party in real time at time of settlement. Currently, you’ve to create an account in every exchange that you use but in future you only provide ID if requested.

9. Expansion in the offering options

Currently there is a very rigid set of requirements to be listed on these exchanges, but in future it might change because companies would be able to innovate on compensating their investors. Staking, proof of work, token burn, forks are few of the unique innovations that has been used to reward investors by the current token offerings.

10. Custody

Financial institutes are generally a storage for your assets and issue you I Owe You(IOU). This increases the risk just if incase a FI goes into default. Beauty of cryptocurrency is that owner can hold the private keys & no 3rd party can seize them. With STOs, investor would have ability to control and take custody of the tokens. He isn’t obliged to store them with any 3rd party if he doesn’t want to. In unforeseen condition such as war, he can transport them himself.

11. Vested Stock

There might be interesting structure for the long-term holders if they lock up their tokens. This effectively reduce the sell-pressure & encourage the company to thing big & focus on long term strategy. Firms can issue more stock in shape of interest to vested folks where if you lock the token for suppose 12 months, you can 2% in extra tokens towards end of year.

12. Pedigree proof

It’s really tough to invest into the top funds or private REITs because they keep it private. Mostly it’s because they don’t want to deal with the headache of onboarding & dealing with new Limited Partners or backers. It’s a relationship play. In regular markets, it’s hard to establish trust & have inroads if you’re trying to get into these funds. Through STOs an investor would be able to prove that he already owns ABC stock for 5 years & that might break the ice. As an investor, I do have to sell companies on taking my money if there is a good interest. I usually do that by telling about my portfolio or testimonials from the founders I’ve worked with. Through STOs I can just show proof of ownership to build the pedigree. A company can also put a restriction to raise money from people who own specific tokens already to maintain the pedigree. Ferrari is a good example of maintaining the exclusivity since they don’t generally sell it to anyone & in few cases you’re required to show a track record of ownership before getting special editions.

13. Preferential treatment

There is a big disconnect between company stock holders & customers. If you work for a company they generally have perks for using their own products, but in case of stockholder no such perks exists. Now, through STOs it would be easy to establish proof of ownership & be entitled to some perks which can be restricted by how long you had them & point. I may buy stocks of airlines I travel on to get into the line first or utilize a dedicated lane at grocery store. Through STOs, businesses will be able to encourage their users to hold onto their tokens which results in stronger brand following.

14. Infungibibility

In private capital, there are different classes of shares with “common” & “preferred” as being the most popular however there is option to have exotic stock structure. In public markets, it has to be the same but through STOs, there is an option to create different STOs for the same asset well suited for the investor type. Commonly investor is either looking at appreciation play or seeking dividends. Ideally he wants both but that isn’t possible in a practical world. Company can separate both type of assets by issuing two types of STOs at different price. You may want dividend so you can purchase stock at a different price than someone who just want to hold for long term. At the moment, it’s somehow built into the price but a clear separation would make much easier for retail investors & help company with their growth plan.

15. Debt restructuring

Debt financing have sunk ships for many businesses. Delay in permits or any other hurdle that temporary caused borrower to default on payment has lead to disaster for many. It’s not an ideal outcome for neither the borrower nor a lender however options are limits. Through tokens debt can be restructured very easily automatically. Imagine you gave someone a loan but he is unable to pay the payments such as in house cases. In this case the bank takes over the entire asset, but what instead of that, bank keeps on adding the default payment towards the loan. In STOs, upon debt issuance, tokens of the assets are pledged towards the loan & in custody of the lender. Effectively borrower is buying back those tokens. If borrower is unable to buy back token at a scheduled time, lender will repossess tokens worth that missed payment providing better breathing space in tough times. It’s fairly complicated in current scenario but through smart contract all of this enforceable & Security Tokens would be really effective at this.

16. Global assets

Access to majority of the assets is limited by geographical limits. It’s impossible or very difficult to invest in Africa from Asia for a retail investor. Approximately 97% of the global assets are inaccessible for entities outside the geographical limits. Security Tokens do eliminate that by empowering companies globally to build an STOs and raise capital. There would be less requirements to issue STOs.

17. Largest investor base

In order to trade on New York Stock Exchange ( NYSE) or NASDAQ investor has to go through a set of stringent requirements which crypto exchanges on the other hand are able to onboard customers globally with excluding sanctioned countries of course. STOs will be able to open doors to these assets to investors globally. This’ll lead to more healthy competition.

18. Stability

Every company wants to list in NYSE or NASDAQ despite them US not being their biggest market. This being said, US economics has impacts on the company valuation which is totally uncorrelated to company’s operating jurisdiction. With Security Tokens, there would be a global set of investors with different sentiments leading to more stabilized markets.

19. Front running avoidance

Front-running also referred to as tailgating is the practice of a broker or trader stepping in front of large orders to gain an economic advantage. It’s a prohibited practice of entering into an equity (stock) trade, option, futures contract, derivative, or security-based swap to take advantage of a confidential information that has impact on price. Multiple times bad actors get away with it due to lack of data availability required to establish a proof. Another reason for this is unfair access to market for different participants. Blockchain treats everyone the same & the books are open, reducing the chances of front running.

20.  Ownership Proof/Title

Whenever you’re acquiring an asset, you generally go for a title check or get a title insurance to make sure the asset is free of any liens or disputes. Blockchain can track back the ownership transfer from inception without the fear of record being forged.

Conclusion:

Majority of the ideas here are not solely linked to tech but also are restricted due to regulation. I consider STOs as being the sandbox for next generation of Securities. They might eventually be offered by traditional exchanges or can operate totally separately where companies graduate from these STO exchanges into the top exchanges.

If Bitcoin is programmable money, then Security Token is a programmable ownership. They do add improvement to current security industry which may be frowned upon status quo but eventually be able to prove it’s worth & get institutional support.

Security tokens would new way to build, fund & grow companies & it’ll happen quicker than many people anticipate.

2018-12-08T17:20:06+00:00December 3rd, 2018|Categories: Security Tokens|Tags: , |Comments Off on Security Tokens: 20 Important Things you need to know (Detailed Guide)