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How Security Tokens Will Transform Traditional Finance

by Adrian CiaffonciniJune 4th, 2018

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By <a href="https://twitter.com/adrianciaff" target="_blank">Adrian Ciaff</a>

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By Adrian Ciaff

The Bitcoin network allows users to access a censorship resistant ledger, with its native coin offering properties that align to ‘digital gold’. For distributed ledgers like Bitcoin and Ethereum, there are a myriad of use cases emerging that will change a wide range of industries. For this article i’d like to focus on a specific use case that promises a complete overhaul to traditional finance — ‘securities’ as a digital token.

If you don’t know anything about smart contract platforms like Ethereum, watch this first: Ethereum Tokens Explained

What is a Securities Token?

Securities tokens are digital tokens that represent ownership of an underlying asset or security — subject to a nation’s federal securities regulations. These digital tokens will soon be issued on public networks like Ethereum or Bitcoin with in-built compliance features.

Examples of securities in the real world include Public Equity, Private Equity, Real Estate, Managed Funds, Exchange Traded Funds, Bonds, the list goes on…

It’s projected that securities tokens will dominate the majority of the cryptocurrency market by 2025. This is why financial regulators and Entrepreneurs such as Polymath and Harbor are quietly designing critical infrastructure that will pave the way for securities to be established as digital tokens. In Australia, the ASX are building their own ‘private blockchain’ to tokenise securities for Australia’s public equity market. This is similar to creating a private ‘intranet’ where users can only send emails to each other within that closed network. More on this below…

Importantly, securities tokens are not to be confused with ‘utility’ tokens — which have gained a lot of attention recently for potential non-compliance with U.S Security laws. Security tokens are compliant, and legally represent ownership of an asset.

Why ‘Tokenise’ Securities?

Unlike paper based ownership, digital ownership can be programmed

Think dividend payments, vesting periods, distributions, shareholder voting, and more… These are tasks that teams of accountants, bankers, and lawyers would often be enforcing and instead will be automated with code in the token itself. The security becomes a computer program that can interact with its shareholders and other organisations without middlemen, significantly reducing the cost of governance and issuance.

Take Private and Public Equity as an example — Issuing equity will become as easy as clicking a button on the internet. As securities tokens mature, software will enable securities to perform functions from as simple as paying dividends, to more complex securities such as convertible debt or even credit default swaps; where the terms of the contract are hard coded into the token itself and is completely self executing.

Regulators will also be able to mandate laws or standards inside the code of the tokens themselves, allowing securities regulation to become proactive, eliminating the need for middlemen to enforce such regulations. Anthony Pompliano put this nicely:

If I am an accredited investor in the US, I can purchase a Reg D security offering but am not allowed to trade it within 12 months of purchase. The new tokenized system, specifically the protocol, knows who I am (my wallet is KYC/AML verified), what security I hold (all properties such as regulation exemption status, jurisdiction & date of issuance, etc is written into the token), and anyone that I am trying to transact with (their wallet is KYC/AML verified).

If I attempted to trade my Reg D security within 12 months or with an unaccredited investor, the protocol would instantaneously identify the trade fails compliance criteria and the trade would be rejected. The security would be returned to my wallet, along with information on why the trade was rejected.

Tokenised Public Equity will be tradeable 24/7 and instantly settled

Major securities markets around the world generally close in the afternoon on weekdays and on weekends or public holidays. Settlement for assets often occurs between the usual hours of corporate office workers. By definition, a blockchain has no downtime and as a result, 24/7 trading and settlement will be the new default.

Take Australia’s de facto stock exchange as an example — The ASX operates settlement in T+2 business days. That’s 2 business days after trading before the asset finally settles and ownership changes hands. In contrast, blockchains settle ownership from one entity to another almost instantly. At the time of writing, Ethereum’s average settlement time is currently 15 seconds, and you can easily do a search online to confirm if an asset has successfully changed hands from one entity to another in real time. Other blockchains like EOS sacrifice decentralisation for speed, boasting up to 50x more transaction capacity per second than Visa’s global payment network.

Trustless Ownership

Ownership of tokenised securities is managed entirely by the blockchain. Owners of securities will no longer need to trust third party intermediaries to hold custody of their assets for them. Instead, they are empowered to hold the asset themselves online, with wallets that only they have access to. Assets can’t be stolen even if their password is compromised as the token itself is programmed so that it can only be transferred between specific people or entities.

Only identity linked digital wallets are allowed to own security tokens. Once an identity has been linked to a wallet, it can ‘in theory’ invest in any type of security that it meets the requirements for. This will allow securities to be traded peer to peer between eligible wallet addresses on the open market.

The need to store and secure tokens is actually a potential disadvantage for those that prefer to trust third parties to hold their assets, however there’s an argument to be had that people will slowly remove expensive custodians and pay less fees as a result. Either way, custodial services for financial assets will evolve from ‘required’ to ‘opt in’.

Take investment funds as an example — where ‘units’ (or in this case ‘tokens’) in the fund are issued and managed transparently on a blockchain. This is in contrast to the legacy approach of having each investment fund KYC check each investor upon application, and manually manage ownership of the fund’s units in some centralised database (outsourced companies such as Unit Registries that provide these services to Investment Funds will likely be disrupted). Dividends or distributions from the investment fund are completely transparent and go directly from the fund to the end investor (no intermediary is required to facilitate payment). Dividends and distributions can be paid with stablecoins like TrueUSD or Maker Dai into the same digital wallet that the principal investment is secured in, thus simplifying payments for both funds and investors.

Fractional Ownership

Security tokens are divisible, and a security can be split into multiple tokens. This means high value single unit investments (such as real estate or art) can be fractionalised, providing further liquidity from investors that were previously priced out.

Take Real Estate as an example — You might decide to sell some equity in your family home to investors, or even own a piece of the corner shop down the road. Property exposure in one’s asset allocation will now be managed at a more granular level. Millennials will finally be able to afford their property and avocado toast too!

Securities Tokens — Public Blockchains vs Private Blockchains

Progress is being made in the U.S. to allow securities to launch on public networks such as Ethereum, allowing public blockchains to serve as shared infrastructure for a global financial network.

As organisations in other countries begin to launch securities on public networks, regulators might find that companies won’t want to list on centralised exchanges like the ASX. Instead, they will prefer to list where their company can benefit from global ‘interoperability’; this is the ability for their security to interact with other programs in an open network, allowing for smart contracts that automate execution of trade deals (derivatives), use of existing stablecoins (pegged to USD or Gold), and things called zero-knowledge proofs that use smart cryptography and allow users to interact privately.

Metcalfe’s law states that a network’s benefit will increase exponentially for every new user in that network.

For public equity, information required by regulators such as top shareholders will automatically be exposed to the public in real time, eliminating the need for one-off ‘static’ disclosure in Annual Reports and further increasing transparency for shareholders. In fact, as more services migrate to distributed ledgers, public reporting will evolve from static disclosure in PDF documents to real-time web based disclosure that will completely revolutionise financial transparency — Forcing public companies to become more accountable whilst regulators and investors can be more proactive in the way they interact with financial information.

Lastly, no one knows which public blockchain will be the platform of choice to launch securities on, however I argue that private blockchains will slowly become irrelevant as privacy features on public ledgers improve. Public blockchains offer bleeding edge open-source software development and private companies simply can’t compete with open source software — i’m yet to learn about a private blockchain that hasn’t borrowed its technology from existing public blockchains.

Conclusion

If you work in finance it’s important to understand what’s coming. Our industry is about to be disrupted by a force bigger than most currently realise. This is an order of magnitude larger than the Uberisation of the taxi industry and will be just as brutal to incumbents.