As the great cryptocurrency winter of 2018 extends its grip by yet another month, anecdotal evidence at various blockchain conferences worldwide has been rife that a security token wave is on the cusp of forming. This new breed of digital assets is one that seeks to comply with existing regulators, rather than to subvert. Security tokens are are programmatically designed to be compliant with relevant regulations. In the words of influential crypto podcaster and fund manager Anthony Pompliano:
If cryptocurrencies like Bitcoin are considered “programmable money” then you can consider Security Tokens a version of “programmable ownership.”
With recent examples of assets being tokenized ranging from the St. Regis Aspen Resort, to a New York real estate fund, to a Picasso painting (facilitated by a certain John McAfee), to private shares of startups from Germany and Brazil, momentum is clearly favouring this nascent development. Whisper it, but we may even be witnessing the first shoots of a transition from the wild west that was ICO-mania making way for a ‘Security Token Offering (STO) spring’.
Setting The Scene
Before I proceed any deeper — and without suggesting that STOs will necessarily step in to fuel yet another market-wide bull run (out of scope for this piece), I would highly recommend that you revisit this great introductory piece on tokenization:
Followed by this other persuasive piece which lays out the full transformative potential for the security token space:
In short, there are a whole host of benefits driving the security token thesis for mainstream adoption, including 24/7 markets, fractional ownership, rapid settlement, automated compliance and asset interoperability.
The purpose of this article is to provide the reader with an understanding of what we define as the security token value chain — think of it as a series of production line steps which are necessary to create and trade a security token — and an overview on how the ecosystem is shaping up around these layers, especially in markets with more developed regulatory frameworks relevant to STOs such as the United States.
The Security Token Value Chain (aka Yet Another Stack)
The following hamburger provides a layered structure of how we’ve classified the various security token ecosystem players today (from bottom to top):
While the above provides some form of general structure around the process, do note that some of the activities (e.g. auxiliary services) may overlap across multiple other layers, and/or differ entirely in various other flavours as designed by the platform stakeholders.
We begin with the very bottom of the security token hamburger stack.
Simply put, deal-flow origination refers to the process of matching the demand and supply of capital for investments.
The degree of customer accessibility to these investments vary along a spectrum. On one end there are more open platforms such as Kickstarter where the average retail investor Joe may participate in funding the development of cool product ideas; while on the other end there are platforms such as AngeList where only accredited investors are able to join in on equity investments in Silicon Valley-based technology startups.
As a rule of thumb, the general requirements for an aspiring investor to partake becomes more onerous as factors such as deal exclusivity, target capital raise, average cheque size and financing complexity increases. Said requirements usually entail attaining investor accreditation status, more disclosure requirements and sometimes higher fees.
Current notable deal-flow origination platforms involved in the STO space include Republic Crypto, SeriesOne and Indiegogo. Indiegogo — most notable among the examples for having been in the traditional crowdfunding space for about a decade — lent its credible reputation to back the ambitious St. Regis Aspen Resort tokenization project by being the platform through which investors could participate in the initial STO. Most platforms have side-stepped requirements to file for traditional securities offerings by allowing only accredited investors to participate, while some such as Republic allows for regular retail participation via relying on an alphabet soup of SEC regulatory exemptions (more on that later).
Issuance Platforms and Core & Auxiliary Services
Moving along to the meat within the security token stack, we come to the issuance platforms.
These players specialize in providing the technical smart contract know-how necessary for the primary issuance of programmable security tokens.
They provide solutions that handle for things like investor accreditation, KYC/AML requirements, capital raising taxation, as well as the myriad of other more specific shareholder provisions (e.g. first rights to refusal, residency requirements, shareholder ownership concentration rules, etc.). They aim to address as far as possible the common needs of the majority of asset issuers.
The goal for these solutions would be to automate compliance while maintaining immutability and process transparency.
Implemented well, such solutions will ensure that situations such as the Dole Foods case — whereby human error during various ledger reconciliation processes resulted in duplicate shares of Dole Foods being issued on various ledgers — does not wastefully occur.
Most issuance platforms come bundled with services aimed at meeting the common requirements of potential STO issuers in a bid to make up a full-service solution. This would include dashboards for token issuers, and functionalities to allow for them to easily conduct corporate actions such as shareholder voting, rights issue, dividends, interest payments, revenue share distribution and ESOPs, with the aid of document signature tools for token-holders. Examples include Templum, which enabled the tokenization of the Aspen project on Indiegogo, as well as Coinbase-backed startup Securitize, which had facilitated the tokenization of two blockchain investment funds, Blockchain Capital and SPiCE VC.
Rounding off the list of services necessary are trust companies and custodians — a category of companies that are absolutely integral to making tokenization tick, especially in the case of most assets that are not natively-digital (i.e. today’s “real-world” assets such as stocks, real estate and art). Their jobs as custodians are to ensure that these assets — be it the stock certificate, property title deed, physical painting — are being held in a secure location, with token-holder ownership rights being clearly defined and legally upheld, and that the tokens in issue that represent them are always counter-balanced in a 1:1 ratio by the underlying asset. Key players to have established this niche for themselves are PrimeTrust and BitGo.
Secondary Market Trading
Finally at the very top, secondary market trading is the layer which provides security tokens with their much-heralded benefits of liquidity and 24/7 trading & settlement.
An intuitive, easy-to-use trading interface constitutes table stakes for any form of digital asset exchange product these days. For any STO exchange to materially value-add to the user experience, they will have to be cognisant of the rules of the legal jurisdiction that they operate in, as well as that of its customer clientele. For instance, they may automatically facilitate reporting on capital gains taxes applicable for American users who have profited through trading on the secondary market, but not for Singaporean users (where capital gains taxes do not apply for retail investments).
Other differentiating factors relate to the user experience journey. Exchanges can be set up such that they give users the option of self-custody of their own digital assets, or — for those who are less savvy technically with managing private keys — provide them with just a simple, user account plus password system. Exchanges can also help reduce the time taken for trade settlements on their platforms through the use of stablecoins. Stablecoins will allow for such trades to happen atomically, which implies that I receive my sales proceeds the moment that my sell order gets paired with an interested buyer, with my security token going the other way in one single, simultaneous action. This is an exponential improvement over the settlement speed for securities trading in existence today, where T+2 represents the gold standard (cross-border stock trading settlement sometimes require T+5 days even!).
A couple of juggernauts have already made their mark. OpenFinance Network has raced ahead on the partnerships front, forming a whole slew of collaborations to list the tokens issued by an assortment of niche issuance platforms. tZERO, a blockchain subsidiary of NASDAQ-listed company Overstock, has built up a sizeable war chest after the conclusion of its own US$134M STO round in August. Purchasers of their tokens are promised regular dividend payouts tied to the profits generated by their exchange business.
The Land Grab Race Is On
The current landscape remains largely fragmented with players finding their niches and gradually establishing partnerships. While there are unique cases of projects such as Neufund that are seeking to provide a complete end-to-end solution for potential STO issuers — or rather ETO (equity token offering) issuers, as they have chosen to term it, most are specializing within a certain layer within the stack , before partnering with other projects that complement them. For example, SPiCE VC — a tokenized fund specializing in investing in blockchain startups (deal-flow) has partnered with Securitize for the issuance of their tokens, and also with OpenFinance Network to enable the future subsequent trading of their tokens.
Another observation to make would be that the structure of most of these blockchain startups are rather akin to that of a “traditional” tech startup, operating on a service revenue-based business model. Exceptions include those which have made use of STOs to coordinate platform incentives and/or raise capital (e.g. Neufund, SPiCE and tZero) from investors in exchange for the promise of future dividends, along with several others which have done ICOs (e.g. Polymath, Rate3 and TrustToken) or have distributed their tokens via mining incentives (e.g. Ravencoin).
Finally, it is also noteworthy to mention that the large majority of these players are based in the United States, highlighting the immaturity — as well as the consequent potential — of the asset tokenization space in other markets.
Still Early Days On The Regulatory Front
While acknowledging that there have been several forward-thinking, ‘real-world’ tokenization projects that have made news headlines recently, one cannot stress enough on the infancy of the entire security token space as a whole. Most of the marquee, flag-bearing tokenization proof-of-concept projects so far are just that — PoCs that are being sold to a small, select group of accredited investors only, in order to stay on the right side of regulators. Mass retail adoption are still some significant way off.
Having said that, it is apparent — and heartening — that the clarity of regulatory exemptions available within the United States has resulted in many security token ecosystem projects and partnerships flourishing there. Ken Nguyen, founder and CEO of Republic was recently interviewed in a great podcast, in the process demystifying the various US regulatory exemptions which STO projects could seek:
It does not appear long before other Asian ‘pro-crypto’ jurisdictions such as Singapore and Japan start embracing STO innovations on their shores as well, allowing for the retail investor masses — not just accredited investors — portfolio exposure to security tokens serving as proxies for investments which they may never have got the access to otherwise.
This is a thought which truly excites me; imagine the multi-fold returns of having been able to invest in one of the early rounds of equity fundraising for startups such as Grab or Gojek. Think of the whole new design space which issuers could work with to increase customer engagement and loyalty, such as, for example, allowing for priority booking for token-holders.
With jurisdictions like the United States laying the groundwork for others to observe and adapt, what was once solely the domain of the rich and connected may soon become within touching distance of the masses within the near future.
Disclosure: I work at Rate3 Network, a protocol that handles asset-tokenization and identity management across both Ethereum and Stellar blockchains.
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