Security Tokens. What is missing?

Introduction

In 2017 an immense influx of money hit the crypto space generating numerous debates regarding the value of Bitcoin and ICOs. It was at this point when shores of retail investors,  particularly unaccredited ones, began cryptocurrency trading in pursuit of fast and big gains.

Most ICOs back then did not require any KYC verification at all and you would have to rely entirely on the project’s Whitepaper to determine its value or authenticity. It was as simple as sending Ether somewhere into the cryptosphere and waiting for the freshly minted tokens to appear in your wallet, ready for selling on at a higher price.

As risky as it seems, these new methods of investment did open holes for fraud and exploitation; especially with many coins lacking any real utility at all. Regulating authorities such as the Securities and Exchange Commission (SEC) began audits and the introduction of KYC/AML procedures improved safety for investors. By mid 2017, security tokens became a term more frequently used to determine specific tokens and many people predicted 2018 to be the year of mass adoption.

The year is nearly over, so we want examine who the active players in the security token ecosystem are, what hurdles they face, and finally evaluate the future of tokenization and security token offerings.

What are security tokens and how did they emerge?

With all the hype and suggestion that security tokens will be the next ‘big thing’, we ask the question; what essentially are they? And how do they differentiate from utility tokens?

Since 1946, after the United States supreme court handled a monumental case dealing with land investment, the Howey Test has been used to determine security classes. Under these tests, any financial transaction which qualifies as an investment contract is considered a security and should be subject to security registration requirements. There were subsequent tests that followed, such as the “Blue Sky” laws, but the Howey Test proved to be more applicable for blockchain assets.

A significant shift within the blockchain industry occurred after the DAO tokens failed to pass the Howey Test and were deemed securities by the SEC. This was due to a number of considerable reasons. Most importantly, the the nature of its token sale, being a financial investment into a common enterprise with the expectation of profit from the efforts of others, this fell well within the Howey Test criteria. Additionally, the infamous DAO hack, resulting in a loss of over $50 million USD, fostered the SEC’s attention to intervene and protect investors. Since then, regulatory oversight further extended and ultimately resulted in the SEC and FINMA breaking down tokens into utility and security classes.

It was then determined that security tokens are first and foremost financial securities that are compliant with an SEC regulation. Being security compliant, in contrast to a utility token, it gives its holder an array of various rights, which can include: equity, dividends, profit share rights, voting rights, buy-back rights, etc. Hence, these tokens are most often directly connected to an underlying asset, either being real estate, fund holdings, cash flow or even artwork, depending on what was initially tokenized.

The major technical difference of the token structure also stem from regulatory requirements, which primarily deal with the ease of token transferability. As well as different investor rights, other compliance-related limitations, such as investor whitelists, and holding periods are all programmed into the token; hence why security tokens are generally referred to as programmable.

As a result, the token protects itself from illegal actions by enabling features based on legal requirements. According to inner programmable needs, most security tokens are issued as ERC20-based with additional smart contract functions integrated into their structure. Some other security tokens may also utilize various bitcoin sidechains, such as Ravencoin, or simply base themselves on the Stellar blockchain.

To conclude, security tokens don’t necessarily bring technical innovation to the crypto space, but rather utilize the smart contract functions in favor of the need for regulation and compliance requirements.

It is these aspects that make security tokens potentially more attractive for institutional investors, as they now offer a more solid base of investors’ rights and regulation. As for the blockchain evangelists (who see potential in tokenizing almost everything) the real value lies in the ability to replace costly middlemen occupying traditional securities.

But for the evangelists’ misfortune, these security tokens are no longer simple “coins”, they have become a highly regulated asset class, and with more intermediaries and requirements to fulfill, they are slowly resembling centralized and traditional services.

“With great power comes great responsibility” Benjamin “Ben” Parker, or Uncle Ben.

The current security token ecosystem and its major players

As stated above, the classification of security tokens occurred as a result of their intention to become inherently compliant with financial regulations. With this in mind, we have to consider its effect on the structure of the market. Recalling what the markets were like only a couple of years ago, they consisted solely of issuance parties,(either the project’s technical team or a platform hosting the sale) and a cryptocurrency exchange that will list the token after the sale.

Now, the current players in the scene are much more diverse and we can not exclude any of these factors out of the equation: security token issuance platforms, compliance providers, security token exchanges (including additional liquidity providers), global exchanges, utility token exchanges, custody and escrow providers, legal providers, crowdfunding platforms and lastly tokenized funds and assets. Here we take a closer look on these different participants, alternatively you can see our interactive scheme for a visual example.

Specialised issuance platforms provide a number of solutions to achieve compliance while conducting an STO. The services provided by these platforms differ from simply offering a specially designed token infrastructure to a more rigorous solution with inbuilt management tools needed throughout the token’s life cycle. These issuance platforms usually market themselves as “compliance platforms” that take care of technical aspects, but do not conduct the offering itself, as a broker-dealer licence or an ATS is required for such actions. Additionally some may also provide KYC/AML services.

The most popular platforms in this field include Securitize, Harbor and Coinlist. Another form of issuance platforms are arising as hybrid solutions with services in conducting the issuance itself as well as offering newly minted tokens for sale on their own websites. They are considered  “hybrid” because they offer more than just issuance, with some platforms offering managing tools, KYC/AML and even secondary trading. Most popular hybrid platforms include Polymath, Swarm Fund, Templum and Securrency.

Compliance and legal providers are currently finding themselves in a favourable position, as now both investors and project leaders are seeking either partnerships (so that they can offer white-label hybrid solutions), or to simply undertake the process to become a compliant investor. Therefore, many players in this field are watching the security token offering (STO) scene intently.

The most popular STO oriented compliance providers include Vertalo, Prime Trust, VerifyInvestor, IdentityMind and a dozen of other minor players. The KYC/AML marketplace is extremely crowded, as the barriers of entry are not relatively high, but it is the one in the most “straightforward-winning” business position, as everyone would anyway require their services.

Liquidity, being a cornerstone feature of the new tokenization structure, has brought specialised security-token exchanges to the scene. The most prominent of which being OpenFinance Network and tZero. Apart from these, we found a number of utility-token exchanges and even global traditional exchanges looking to join the security-token space in the near future.

The list of interested parties includes: NYSE, Six, Malta Stock Exchange, Binance, OKex and Huobi and a list of others. Aside from these, there are also specialised liquidity layers/providers which function as decentralized exchanges: Bancor, BnkToTheFuture and AirSwap.

Custody is also increasing in demand, primarily due to the regulatory aspect of interaction between issuers, broker-dealers and ultimately investors. The list includes: PrimeTrust, Bankex and a number of exchanges with the required licenses.

Crowdfunding platforms that previously specialised in equity crowdfunding as a Reg CF under the JOBS act of 2012 are also looking to utilize STOs for their needs. Active platforms include: Indiegogo, StartEngine and Republic Crypto.

Last of all there are tokenized funds, such as Blockchain Capital, SpiceVC and more specific tokenized assets, such as Maecenas (art) or Slice (real estate).

As it can be seen from the current market structure, new players, generally speaking middlemen, are establishing themselves and becoming ubiquitous throughout the industry. They cannot be ignored as they offer valuable compliance services much needed in the STO sector. Therefore, launching a project has become more laborious and complicated than it was, due to more limitations and more procedures to follow.

As a result, there is a tendency for hybrid and white-label solutions that offer all-in-one services for the clients’ convenience. What began as a decentralized movement, bypassing third parties and middlemen, is slowly becoming the opposite. They supply a demand and offer solutions to existing problems, but the question remains – at what price?

Expectation

Apart from full compliance and the protection of investors’ rights and interests, there are also a myriad of other advantages associated with tokenization and security tokens:

• Increased liquidity via tokenization of illiquid asset classes such as VC, real estate or art funds, which would usually suffer from long holding periods of up to 7-10 years. With the help of security tokens the funds invested stay under management, while investors gain an opportunity to buy additional or sell their shares if needed.
• Security tokens also enable fractional ownership of any asset being tokenized, which can then be traded.
• As all operations occur on the blockchain, accounting and auditing processes are simplified by removing traditional back office and greatly reducing costs.
• As all transactions are happening on-chain, the complexity and paperwork required is greatly reduced when managing settlements (e.g. collecting signatures, wiring of funds, mailing of distribution checks etc.)
• More transparency and a more accurate and fair asset valuations once all fund operations are kept on-chain.
• Tokenization promises lower issuance fees by removing investment banks and underwriters.
• Decreasing the reliance on middlemen ( e.g. lawyers) through smart-contracts to control the rights of parties and their interactions.
• Faster secondary market settlements, as with traditional crypto coin transfers.
• Automating dividend payments on the smart-contract level.
• Programmable tokens enable each investor with voting rights or alternatively an ability to delegate their voting power to a proxy to vote on their behalf by staking their tokens.

• With the aid of programmable tokens, the KYC/AML requirements are often becoming wired into the token. Therefore, with the lapse of time compliance operations they can be automated through smart-contracts features.

Reality

Today’s reality is however falling far behind expectations for a number of reasons:

• The primary hurdle facing the proposed ecosystem is the limited amount of projects adopting the securitization route due to the level of regulatory requirements, the associated time and costs. The first option is to conduct a registered STO, which is a full equivalent of conducting an IPO, which will be available for both accredited and unaccredited investors with public advertising and other benefits. On the flip side, the cost has been estimated at an average of $4M, including a 12 month waiting period for filing the application and an SEC review. Blue sky laws also mean an STO should be registered in each state.The second option is to become exempt, this can happen if the offering falls into either Reg D, Reg A+, Reg CF or Reg S exemptions. This process is generally cheaper, but depending on the exemption, the security will be limited to certain restrictions which can include some of the following: a cap on the amount to be raised, only specific types of investors (mostly accredited), a more stringent KYC, obligatory 12 months holding period, no marketing/advertising, blue sky laws to be applied to secondary trading, and other reporting obligations.

• Very limited liquidity options available in the market. There exists a deficit of security token exchanges currently in operation as more platforms are held back due to broker-dealer or ATS licensing. This has become the second biggest hurdle facing the ecosystem and as a result, the secondary market is simply inexistent as of now.
• The 12 month holding period for accredited US investors reduces the flow of trading between parties.
• Questionable level of demand from accredited investors, especially during the current US stocks bear market as the  crypto industry as a whole is not considered a safe haven.
• High dependence on middlemen at every stage of the asset’s lifecycle; including legal, compliance, custody, issuance and secondary trading (need to either acquire ATS or partner with somebody) aspects.
• Questionable transparency of asset valuations of currently tokenized SPVs (special purpose vehicles), as funds are not disclosing full information of their holdings and therefore there is no clarity on profit distributions after exit events.
• Constant frictions within the community on regulation vs. decentralization and identity vs. anonymity, as both big investors and issuing parties are not willing to disclose all information.

Taking into account all of the aforementioned hurdles it is clear that the process of an STO is at least not easier or more affordable than a direct public offering or an equity crowdfunding. Hence, unlike ICOs, no garage startups will be able to conduct an STO for its capital raising needs. When examining ICOs and STOs, we could compare the first with digital crowdfunding with low barriers of entry and the latter with more serious IPOs with additional gimmicky features and possible advancements to asset liquidity.

What is crucial for further market development is an understanding of which parties gain from the additional features and who would be in favor of taking on the cost to arouse the market. What has become clear is that neither the blockchain nor any other type of token advancement will facilitate this process as at the moment it is compliance and regulation taking the lead.

Final thoughts

When attempting to foresee the future of security token offerings, too much attention is paid to either their features or the current state of the ecosystem. But a more profound analysis is required, specifically of the various parties’ interests involved.

It appears the regulating authorities are the only parties involved who are fulfilling their interests in terms of financial market regulation and protecting investors from fraudulent activities. For everyone else, who could be driving the market, the corresponding pros-and-cons analyses are very vague.

Lets take for example all the financial institutions that are currently involved in the securities market; banks, exchanges, brokers, dealers and other intermediaries. The costs associated with implementing such a technological move currently leaves too much speculation and not enough answers.

Even if we take into consideration the investors, who are in favour of such liquidity-related advancements, these benefits can still only be utilized by investors who are not afraid of dealing with the risks involved in blockchain-based assets and who have previous experience with crypto trading or investing (a small percentage of the market).

The companies looking to raise capital do not benefit from any cost-cutting, because the legal process is the same as with other traditional fundraising methods, hence it can be used only for marketing purposes by those who can afford it. Therefore, this alternative for fundraising is mostly suitable for established companies, who are likely to be already active in the crypto space and have current investors interested in technological improvements, creating additional incentives for investors to take part in a new investment round.

With this in mind, this mechanism is mostly suitable for crypto VC or hedge funds, which have already a strong record, but this ones again represents a very limited share of the market.

Summing up, the potential of a first mover advantage incentivizes companies to enter the STO market. Some are better-suited at the current market condition, such as KYC providers, who already specialize in that category and regardless need their job to be done.

Others, such as security token exchanges and issuing platforms, are failing to acquire required trading licences, and need to undertake a much larger risk. The only party involved currently achieving their goals are the regulation authorities. Ultimately, what is most pertinent and crucial for all markets, is a sufficient level of both supply and demand; and at this point in time the token security market is limited in both.