by ALEX VERGÉ
The most optimistic and prophesying minds in the industry are envisaging a future ‘tokenised world.’ A world where anything from traditional financial assets to real estate, public and private votes, and genetic data, will be ‘tokenised’ – which essentially refers to the transfer of the value of underlying assets from paper or electronic form to a digital version.
With the principal obstacles to cryptocurrencies and new financial technologies having made themselves abundantly clear over the past few years, a number of players in the ecosystem think they have found the solution in security tokens. They may just be right, and, as we enter the last quarter of the year, it seems wise to keep an eye out for developments in the security token ecosystem.
The evolution of trade and securities
In order to fully understand what is at hand when we talk about security tokens, or tokenised securities, which is the term some in the industry prefer, a brief reminder of the role and evolution of securities in the way society has conducted business and trade throughout history can be of valuable help.
During the medieval period, Italian merchants began to use what is known in accounting as double-entry bookkeeping. This was in response to the perils attached with travelling with large amounts of money, and what it did is it allowed merchants to avoid taking that risk. Instead, they kept a synchronised record of every accounting transaction.
Eventually, this led to the creation of what we know as banks. Further down the line, as the Portuguese, Spanish, Dutch, French, and English began to conduct commerce around the oceans of the world, mechanisms were put in place in order to allow for investment into costly sea voyages that could last several years. It is in this context that the Amsterdam Stock Exchange was established in 1602 by the Dutch East India Company. The first of its kind, it became a place where merchants from all over would come and exchange and buy and sell bonds and stocks, and where small shares in various companies were available, thus creating an unprecedented degree of flexibility for investors, who could mitigate risk by diversifying their investments. Historians have credited this as the breakthrough in the emergence of secondary markets.
Fast forward to the twentieth century and the Wall Street Crash of 1929 – which was the culmination of a decade of companies selling securities based on promises of large profits backed by inadequate and fraudulent information – and we have what prompted the setting up of what forms the basis of modern securities laws in the United States (US). The Securities Act of 1933 was followed by the Securities Exchange of 1934 and the consequent establishment of the Securities and Exchange Commission (SEC). Regulations and rules have since consistently grown in volume due to recurrent fraud. The financial crisis of 2007-2008 marked another watershed moment, with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 further raising the costs of regulatory compliance. Blockchain has thus emerged in a climate where we are only too aware of the potential dramatic repercussions of operating in an unregulated financial environment.
What all the aforementioned developments have in common is a motivation to make trade and securities safer, more efficient in some cases, as well as, and very importantly, up-to-date with their own times. Security tokens are no different.
The situation today: differentiating utility tokens from security tokens
Unfortunately, events over the past year in the crypto ecosystem have only served as reminders of the dangers of bypassing regulation and being non-compliant. In particular, the boom in initial coin offerings (ICOs) has been marred with controversy.
So far this year, the total amount of funds raised via ICOs stands at over $20bn, more than four times the amount of capital that was raised the same way in 2017. Diar, an institutional publication on digital currency, assets, payments and regulation, has recently revealed that “70 per cent of tokens are now valued at less than what was raised during their ICO.” Considering that there have been hundreds of ICOs over the last couple of years, this is a damning statistic.
With ICOs, companies offer tokens in exchange for funding capital based on the promise of a future product or service. These are known as utility tokens. By avoiding classification as a security – which the SEC defines using the ‘Howey Test’ – companies avoid numerous regulatory constraints on who can invest in their tokens and how these can be exchanged. Ethereum’s ERC-20 token standard has been very important for the proliferation of ICOs, since it allows tokens to be launched without having to build a new blockchain. There is a concern that Ethereum is limited by the number of transactions it can run, and whether or not it would be able to act as a public blockchain that can support an app with a billion users, which is what many hope to see one day.
The bigger concern relates to the ambiguity around ICOs and their so-called utility tokens. Many recognise that most utility tokens are in fact securities, this point has been reiterated time and again by the SEC chairman, Jay Clayton. Back in July 2017, Clayton said the following: “Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasise the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under US law.” Later, in February 2018, the Trump appointee came out with the following remark: “I believe every ICO I’ve seen is a security.”
In spite of these damning statements, utility tokens should not be written off just yet. Efforts are being made in Europe to accommodate them. This summer, Malta published a trial version of its financial instrument test, which is designed to clearly define when assets derived from ICOs constitute securities.
Nonetheless, there is a growing conviction that the future lies with security tokens and security token offerings (STOs). Many in the ecosystem, like Trevor Koverko – CEO of Polymath, a platform that provides compliant and registered security tokens – and Anthony Pompliano – founder and partner at Morgan Creek Digital, a multi-strategy investment firm that provides blockchain technology and digital assets for institutional clients and wealthy family offices – see this as a multi-trillion dollar opportunity. Although the time frame for this is certainly up for debate, considering the immaturity of the crypto-market, there are many aspects of security tokens which suggests they will play no small part in helping the industry on its path to maturity.
The benefits of security tokens
Security tokens are built to work within traditional finance, and thus to be compliant and regulated, whilst retaining the many advantages that are offered by blockchain and tokenisation. Below is a non-exhaustive list of some of the advantages that security tokens offer:
Liquidity: Liquidity can be defined as the degree to which assets can be bought, sold, and exchanged, whilst maintaining a stable price. Many of the evolutions referred to in the opening section of this piece directly aimed at offering greater liquidity as the markets of the world became larger and more interconnected, thus showing the potential place of security tokens in the evolution of the world economy. Jeffrey Sweeney, Chairman and CEO of US Capital Global echoed the sentiments of many when he wrote in a piece for The Fintech Times that security tokens “promise even broader participation [than IPOs or secondary market trading in private securities] and greater liquidity through more efficient primary and secondary market trading.” Many of the benefits associated with security tokens fall into the broader category of liquidity.
Automation and smart contracts: Smart contracts are programmable computer codes that are self-executing and built into tokens. They can automatically decipher who is qualified to purchase or repurchase a security, depending on their credibility or on their country of residence. They also embed directly within the token itself your rights and preferences as a shareholder. Effectively, they make your tokens ‘smarter’ and thus carry a host of implications, like faster settlement times. But, as a research report by EY into ICOs last year commented, the programme code of smart contracts “can contain errors or latent terms.”
Fractionalisation of ownership: Fractional ownership is nothing new, however blockchain and tokenisation certainly make it easier for assets to be divided up into shares, which can be affordable for people in society who have less investable wealth than others.
Lower fees: A significant number of the fees associated today with financial transactions are due to ‘middlemen’ (bankers, lawyers, regulators, etc.) Thanks to smart contracts, many of the costs and complexities that come with dealing with securities may be greatly reduced.
Larger investor base: A significant benefit of security tokens is that they enable 24/7 trading, with asset owners being able to trade with any individual with an internet connection. For example, this removes the constraints imposed on Asian investors who wish to invest in US private companies and real estate, but are limited by the fact that the New York Stock Exchange closing-bell rings at 4pm during the week and is closed during the weekend.
Important players in the security tokens ecosystem
In consideration of the potential of security tokens, a number of companies are aiming to be at the forefront of this aspect of the crypto-industry’s development. Old-timers of the financial sector are also paying close attention.
As mentioned earlier, there are concerns with how many transactions Ethereum can handle and how this might prevent the scalability of security tokens. Polymath is addressing this problem by building a platform to accommodate STOs, in effect trying to be what Ethereum is for ICOs. To that end, they have built a token standard, ST-20, with KYC and AML built-in and which, like ERC-20, simplifies the operations of creating and investing in security tokens.
BlackMoon has built a similarly impressive product which supports fund investment tokenisations (see BlackMoon interview in this issue of The Fintech Times). Also, tZero, a subsidiary of online retailer Overstock, which is aiming to become the first SEC-licensed security token trading platform, ended its STO in early August , but it is unclear how much of the $250m target was raised.
Another promising sign is that Coinbase – a digital currency exchange which became the first billion-dollar company from the Bitcoin boom – is looking to incorporate into its system an alternative investment market for security tokens. Its CEO, Brian Armstrong, has made no secret that he wants his company to be the foremost exchange in the world for people to exchange fiat currencies and get into cryptocurrencies. Speaking at TechCrunch Disrupt in San Francisco at the start of September, Armstrong declared that Coinbase could host hundreds of tokens within years, possibly millions, and that he felt “a substantial subset of these tokens will be securities.”
Finally, it goes without saying that regulators and stock exchanges across the world will play vital roles in terms of the rate at which the use of security token systems spreads. Both the Zurich-based SIX Swiss exchange and the Börse Stuttgart (SWB), the second largest stock exchange in Germany, are working towards building infrastructures to accommodate the trading of crypto assets and digital (tokenised) securities. Also, the London Stock Exchange and the UK’s Financial Conduct Authority are working with blockchain experts and startups in order to test a decentralised platform for issuing security tokens.
The variety of profiles and companies looking to test and accommodate security tokens appears to be a positive omen.
Further down the line: the ‘tokenisation of everything’?
Though the focus of this piece has been on the tokenisation of securities, some in the industry are casting their nets further and are envisaging a future society where not only the financial sector will be revolutionised by blockchain and tokenisation, but also the public and civic sectors. One of them is Jeremy Allaire, who declared at MoneyConf in Dublin, in June of this year, that the world is at the beginning stage of ‘tokenising everything’. The co-founder and CEO of payments company Circle explained that: “Once you have an open global immutable record-keeping system, transaction-processing system and a secure computing environment, you can re-conceptualise on a global basis every aspect of finance, corporate and commercial law, the intermediation of contracts, and crucially all of the systems we use in both corporate and civic decision making.” He further added the following: “With crypto-assets, you can tokenise your house, car or art, and establish open global financial relationships around any physical property.”
In Allaire’s mind, there are four principal obstacles in the way of the ‘tokenisation of everything’: regulation, scalability, the need for a more mature marketplace, and stable coins – digital assets that seek to maintain price stability by being pegged to the value of a stable asset, like fiat currencies – in order to allow prices to be consistent.
Considering the above, although it may take more time than some would like, what is certain is that tokenisation and, especially, security tokens are presenting a viable possible next step in the evolution of the way in which our economy operates. Perhaps one day, as Anthony Pompliano commented this summer, we might eventually all be referring to security tokens as simply securities. •
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