Tracking ownership of private securities can be a cumbersome process. Reinvested dividends, employee stock option plans, share issues and other events that affect the capital structure of a fund can significantly increase the challenges around record-keeping. Further, making markets for private securities can be quite challenging. Since accredited investors are only able to trade with each other, finding a buyer for your private shares can be tough.
But blockchain technology is revolutionizing the way the private securities market operates in two major ways:
- By incorporating distributed ledger technology, issuers can rest assured that the capital structure is accurately depicted on the blockchain, and accounts for all new transactions.
- Digital tokens can be traded between two parties, so long as they are verified as eligible to hold the investment in their wallets (through KYC procedures and accreditation).
When issuing digital securities, parties have to decide on the right time to mint tokens, thus effectively issuing the securities for good and creating the first public record of ownership.
Let’s dive into some factors that may influence the minting process:
Once digital securities are issued, the record of ownership is public. Issuers create a certain supply of tokens, and equate these to authorized shares utilizing some form of conversion. As a result, future issuances can come in the form of additional tokens, or a separate smart contract altogether (if tokens cannot be further minted).
Some opt to create a large enough supply of tokens to allow room for future equity raises, but this can make investors afraid of the possibility of dilution. By making tokens mintable, issuers can simply create the necessary amount of tokens during the initial raise, and then issue more as needed.
Oftentimes, digital securities pay dividends to investors. In private markets, minimum investment sizes can be in the tens of thousands of dollars, but the periodic dividends that are received are usually much smaller.
In order to minimize capital gains taxes by adding to their adjusted cost base, investors sometimes opt into issuers’ dividend reinvestment plans (DRIP). All dividends are automatically reinvested, and new tokens are minted (or existing tokens are distributed to investors).
Since distributions are usually much smaller than the minimum investment lots, tokens must be of such a size that allows for dividends to be created and reinvested. For instance, if an issuer wants to issue dividends that are 0.5% of the value of the initial investment, each token must be small enough to represent this dividend.
Forecasting of dividend sizes and distribution timelines is an important factor when determining whether to mint tokens, and how many shares / units to make each token worth.
Liquidity and Tradeability
When there is a clear avenue for secondary liquidity (that is not an IPO), issuers usually opt to mint tokens if they haven’t already done so. In this case, much like in public markets, the size of each share / unit of investment will determine the amount of liquidity available.
When token sizes are too large, an issuer may opt to do the equivalent to a share-split, usually by minting more tokens and distributing them to existing investors. If token sizes are too small, tokens can be consolidated via a new token issuance.
A Note on Gas (Transaction) Fees
Gas fees on the Ethereum mainnet have been a trending topic over the past year. As the NFT boom took place earlier this year, many noted that the increasing price of Ether and high levels of network congestion led to a spike in gas fees – the cost paid to issue a smart contract.
In the digital securities market, unlike in the NFT world, gas fees are not as much of an issue. This cost is usually paid for by the registered dealer brokering the securities transaction.
Those who choose to raise capital by issuing securities on the blockchain are willing to pay the gas fees even when they are at their highest, as this cost is still a fraction of traditional methods.
In short, gas fees represent a larger burden for an individual trying to sell art for $500 (20% transaction fee) than they do for a securities issuer raising $3,000,000 (0.007% transaction fee).
To Wrap Up…
Minting tokens is a decision that is carried out by both issuers and broker-dealers. When issuing digital securities, one must consider how future capital raising events will affect the token supply. Then, dividend reinvestment plans must be incorporated into this structure. Liquidity may also affect the token supply, with split or consolidation events to improve marketability of securities. Once more infrastructure (such as decentralized exchanges for digital securities) is available for wallet-to-wallet regulated transactions, minting tokens will become increasingly necessary.