2018 has been a wild ride for the world of blockchain. The industry began the year at the peak of an unsustainable bubble. As a result, it is now finishing the same year at what many believe to be the bottom of the market – Meaning 2019 has tremendous upside.
Potential growth in the digital securities sector is a major part of that potential upside. 2018 saw a crack-down on ICOs and an amazing amount of fraudulent tokens. However, 2019 promises to deliver functional products that are regulated, liquid, and secure.
A Year in Transition
There was a clear transition away from ICOs throughout the year, despite a record amount of funding being brought in through them. However, it is important to remember that a select few ICOs raised a good chunk of the total money gathered.
This transition can primarily be attributed to the Securities and Exchange Commission. While warnings from the SEC began much earlier, it wasn’t until mid-2018 that they actually began to enforce regulations. For instance, it was here that eyes really began to shift towards security tokens.
There is a race to develop user friendly platforms, for both potential token issuers, and investors alike. While there are many promising platforms that have jumped into the fray, here is a look at the two leading the way – One in North America, the other in Europe.
Securitize (North America)
- This company immediately comes to mind. Led by CEO, Carlos Domingo, Securitize recently received over $12million in funding from industry stalwarts such as Coinbase.
- Services offered by Securitize have seen more adoption than most. Companies such as Spice VC, 22x Fund, Blockchain Capital, and Augmate, have all turned to Securitize in some capacity.
- NeuFund is well poised to continue gaining traction, having just completed their own STO. Figures from their own token sale were double of those expected.
- This platform represents, perhaps, that with the most adoption in Europe. Neufund has at least 10 companies lined up to complete STOs.
One thing is certain – 2018 was a productive year for product development. With this out of the way, 2019 should see the adoption and usage of these services.
An increased focus on security tokens has led to increased scrutiny on the viability of certain protocols to provide the needed security and efficiency. In other words, by recognizing that simple ERC-20 tokens would not work as securities, multiple companies decided throughout the year to develop their very own protocol, tailored specifically towards the digital securities sector. For example, here is a look at a couple of those standards:
- Developed a variation of the ERC-20 token standard, known as ST-20. This standard has seen minor industry adoption, as it provides the necessary security and transparency features necessary in the digital securities sector. As development continues, Polymath finds their protocols evolving with the advent of ERC-1400.
- The Harbor platform has already gone live. This means that token issuers are able to utilize the in-house standard known as ‘R-Tokens’. These regulated tokens represent Harbor’s bid to become the industry standard for protocol use.
2018 was most definitely a year primarily noted for its development of industry infrastructure. With this in mind, there were multiple instances where companies capitalized on this burgeoning sector. Here are a select few STOs that took place, and were successful in 2018:
- Raised $18 million through the sale of digital securities representing equity in a luxury Ski-Resort
- Raised $12 million through the sale of digital securities representing shares within an incubator fund for start-ups working in blockchain
- Raised $134 million through the sale of digital securities representing fractionalized ownership of tZERO. Above all, a company that specializes in integrating traditional finance and blockchain services.
2019 and Beyond
Overall, 2019 is shaping up to be promising for not only digital securities, but for the blockchain industry as a whole. Industry fundamentals have never been better. In addition, infrastructure is rapidly being developed which will support the next boom.
Looking back, we have seen the launch of a variety of platforms, and multiple STOs successfully hosted on them. In addition, we have seen the creation and adoption of various token standards. Furthermore, we have seen a steady increase in excitement towards this burgeoning sector.
Closing out 2018, here are a few words from Brian Armstrong. Speaking at TechCrunch 2018, he commented on the future of digital securities, stating, “It makes sense that any company out there who has a cap table… should have their own token. Every open source project, every charity, potentially every fund or these new types of decentralized organizations [and] apps, they’re all going to have their own tokens,”
How to get an STO approved by German regulators – Thought Leaders
After over 130 security token prospectuses were submitted to BaFin, the German regulator, it was the Bitbond STO that was the first to be granted approval.
In 2016, Bitbond became the first blockchain business to be regulated as a financial institution in Germany. The next logical step was to crowdfund our growth – compliantly – with a bond issued on blockchain technology.
As the first, we had no guidelines to follow, but we learned a lot in the process that followed. Rather than keep these insights to ourselves, we want to share them, in the interests of growing the whole industry and encouraging adoption.
What makes an STO an attractive option?
The institutional mismanagement of money that triggered 2008’s global financial crisis has had profound effects on investor appetite for alternative products. Crowdfunding and micro-lending have been growing, which has enabled a new frontier: decentralized financial products.
Relying on no bank or centralised authority, decentralized finance encompasses cryptocurrencies and blockchain-powered financial products that are decentralized, relying on less middlemen or intermediaries.
Security Token Offerings (STOs) – where a company creates a digital asset that represents a tradable stake or asset, which it sells to investors in return for capital – have been a natural progression from the crowdfunding boom launched by Kickstarter in 2009 and crowdlending movement initiated by Topa and LendingClub.
The sale of a digitized version of a security, STOs have become an onboarding point for non-crypto investors to learn about digital assets. At the same time STOs are a cheaper, and more efficient tool for businesses to fundraise, with the added benefit of a compliant structure to adhere to.
So, what does it take to launch a regulated STO?
Step One: Get your business, and your story, in order
Obtaining regulatory approval for any financial product is not easy. It shouldn’t be. With emerging technology like an STO, the barriers become even steeper.
Before embarking on the road to regulation, you need to clarify your motivations within your business. What makes an STO the most efficient method of fundraising for your goals? How will a diverse pool of international investors offer more value to your business than a smaller pool of sophisticated investors or experienced VCs?
For Bitbond, it made sense to launch an STO to the public, as the core product is about creating access to finance for underserved demographics, in a compliant way.
Similarly, when Blockstack, a decentralized computing ecosystem, was looking to raise money in a decentralized and accessible way, it made sense for them to make use of the SEC’s crowdfunding regulation, Reg-A+.
When a business is built on the idea of decentralization, using a fundraising method that encourages wider participation and access is the logical route to take.
Step Two: Talk – and listen – to regulators
In Germany, regulators have defined cryptocurrencies and other blockchain-backed tokens as units of account, so they have to be treated as financial instruments. This means any kind of service for third parties in relation to cryptocurrencies or crypto tokens must be authorised by BaFin.
Whilst they judge on a case-by-case basis, any token or cryptocurrency project looking to facilitate the issuance, exchange or other services around tokens must make their case to BaFin.
When BaFin are presented with a prospectus, they must give feedback within 20 days, which is a short time, even when they are assessing a product they already know.
With emerging technologies, a different tactic is needed: the blockchain industry needs to talk to the regulators, not just on the products we’re building, but on the ecosystem at large.
In April 2018, Bitbond reached out to BaFin, to present a legal framework of the Bitbond STO. By opening the conversation with something tangible to build from, we could tailor our prospectus around their concerns.
Over the next months, we went back and forth with the regulators; much of conversation centred on how blockchain transactions work, what additional risks and opportunities stem from them, the unique features of the Bitbond offering and how the proof of ownership in the security works if there is no central clearing.
We took things back to basics, when talking to BaFin to provide a crash course in the fundamentals of blockchain. We answered numerous questions on how the blockchain works, what Ethereum and Stellar are and how transactions work on these protocols.
This gave them the language to interrogate our project – and helped us identify the main areas of concern and the risks BaFin wanted to see addressed in a prospectus.
By teaching them the context, including the fundamental pillars of blockchain technology, and the way tokens facilitate the use of that technology, we can help regulators make more informed decisions, and ask better questions.
Step 3: Prepare a prospectus that addresses concerns and regulations
They may bring administrative hassle, but regulators play an important role in the financial ecosystem. They hold businesses like us to account to maintain the stability of the financial system and protect consumers.
In Bitbond’s case, the idea for the STO came in February 2018, conversations began with the regulator in April, a prospectus was submitted at the end of October, with approval being granted in January 2019: nearly a year later.
This took longer than a standard securities application, but that was because the concept we were presenting was so new – there was nothing the regulators could compare it with.
Investing this time was worthwhile, as we now have the first mover advantage with the first regulated STO in Germany.
More than that, we have the privilege of paving the way for more German and European businesses to launch compliant STOs.
An STO remains a more efficient way of fundraising than going through a private VC fund or accredited investors: there is only one prospectus to prepare, rather than having to tailor many proposals to individual institutions or investment banks.
This prospectus must cover all conceivable risk factors that exist for investors. These range from unexpected rises in transaction fees reducing the profitability of the bond, through to the tax risks associated with holding an emerging asset class that is subject to legal changes.
Projections must be made, and justified. Assets and liabilities must be declared and broken down in a balance sheet. The target market must be identified, and characterised.
An extensive history of the issuer and its business activities must be laid out, in language that the investors will understand.
Once all the details have been laid out, there are far fewer intermediaries needed between the business and investors, which makes the raising process significantly leaner, more efficient, and easier to manage.
With these future savings, educating the regulators is a worthwhile investment.
Conclusion: Education and open-mindedness will improve access to alternative forms of finance
It is in the interests of all stakeholders in this space – from regulators to businesses to customers – for emerging technologies to operate within a compliant structure. We have already started working with other companies looking to gain the regulator’s approval and use our technology for the issuance process.
As well as a fundraising method, an STO has become a vehicle to teach investors about digital securities.
It is exciting that the process of getting approval for a prospectus can become an extension of this educational process, which can act as a catalyst for regulatory engagement.
BaFin’s willingness to interact, and learn from the industry is an exciting opportunity for Germany to step up as world leaders of innovative financial services and products.
If the industry continues to invest time and resources to educate and work together with regulators, we can create a framework for compliant STOs, which in turn provides a welcoming environment for the next generation of compliant digital securities.
The Need for Interoperability in Security Token Protocols – Thought Leaders
A Short History of Tokens
It’s been over 10 years since Bitcoin first introduced blockchain technology to the world. In that time, the list of potential use cases for distributed ledgers has expanded rapidly, from digital currencies, to supply chains, to identity management. At their core, however, many of these uses cases take a similar structure: they enable users to hold and transfer digital assets on a peer-to-peer basis. Put simply, we can now trade and track digital assets without needing a central trusted authority to manage the process.
This evolution of the space naturally led to the invention of “tokens” – digital assets on a blockchain that are ownable and transferable between individuals. Tokens are split into two main categories: those that represent a natively digital asset, and those that represent an underlying real-world asset. Leveraging this new paradigm, hundreds of thousands of different tokens have already been created on Ethereum alone, with a combined market cap of over $15 billion at the time of writing.
One of the most promising applications of tokens is the representation of real-world securities on-chain, which allows traditionally illiquid assets like commercial real estate to be fractionalized and transferred peer-to-peer. This process, known as “tokenization”, has gained significant mindshare from both legacy institutions and new start-ups, due to its potential to alleviate many existing pain points within the capital markets.
While blockchain can make it easier to transfer ownership in a technical sense, security tokens are still subject to the same laws and regulations as traditional securities. Ensuring security tokens are compliant with regulation is therefore critical to any potential tokenization, and has been a barrier to adoption to date. As seen in the chart below, regulatory uncertainty is widely considered the largest barrier to blockchain adoption.
Numerous projects have emerged in the blockchain space, each designing a protocol that attempts to simplify and standardize how security tokens are regulated, traded, and managed. Looking at Ethereum alone, projects that have published standards tackling this problem include Securitize, Harbor, Polymath, and more. However ultimately, without modifications to how these protocols are currently designed, investors and exchanges will continue to experience significant friction when buying and selling tokenized securities. Why is this? Interoperability.
Interoperability is Crucial
Interoperability is one of the most significant benefits of tokenization. It allows an entire ecosystem of capital markets applications and products to integrate with one another because they share common software standards. However to enable interoperability at the application and product level, it needs to begin at the lowest level with the tokens themselves. In the security token space, interoperability is essential for two key parties: exchanges and investors.
As an exchange, you want to be able to authorize investors for the purchase of any security token that they are eligible to buy – no matter the company that created the token. This means not having a bespoke integration with each security token, but a simple and generic integration that is uniform across all security tokens.
As an investor, you want the onboarding process to be as simple and frictionless as possible. Currently when an investor wants to purchase shares from multiple places, they have to provide their personal information time and time again in a process called Know Your Customer “KYC”. Blockchain has the potential to transform this process by storing this information immutably on-chain, where it can then be referenced by all security tokens. This would mean not having to repetitively provide the same personal information every time you wish to purchase a new token, instead only supplementary or updated information would be required after the initial registration. However, this process will only be possible if interoperability between security tokens is designed into the standards that govern the system.
Three of Ethereum’s leading security token protocols were published by Securitize, Harbor, and Polymath. All three of these protocols are built upon Ethereum’s ERC-20 token standard, which they then extend to enforce compliance into the trading of the security token. This is achieved by querying a second contract on the legality of each trade at the time that it happens.
Whilst named differently in the protocols, the use of a second contract is consistent throughout all three, achieving the same result: preventing non-compliant trades. This second ‘Regulator’ contract is kept up to date with users’ KYC and accreditation information by off-chain services that are authorized to do so – for example an exchange, or the token’s issuer.
Although these three components may seem like everything you need to regulate a security token (and in the simplest form, they are), it is how the components are programmed that really determines interoperability. Sadly, the protocols lack interoperability in two key areas, which will continue to cause friction and slow adoption of this technology:
- How do authorized parties update on-chain information about users?
Harbor declares in their whitepaper that they will be the only party authorized to update user information on-chain for the time being. The centralization of this role means that exchanges would not update any data referenced by the Regulator. They therefore will not be able to approve new recipients of the token, preventing tokens from being easily traded outside of the Harbor platform.
Securitize have already implemented a system whereby multiple parties can be authorized, meaning investors can register their compliance information in multiple places and are not required to go through Securitize themselves. The on-chain data is then updated directly by the authorized party, and can be viewed by all of Securitize’s tokens. Furthermore, to prevent investors from having to provide information multiple times, Securitize have designed an API to allow authorized parties to access the private information about investors that is stored off-chain, enabling them to easily determine whether an individual is compliant or if more information is needed.
Polymath has a native digital utility token called POLY that is required throughout their platform to perform various tasks, including to get an authorized party to update your on-chain data. In order for an individual to KYC themselves, they first must purchase POLY tokens, which does not have a liquid fiat to POLY market. Instead the individual must purchase another cryptocurrency such as Ethereum’s “ether” (ETH) using fiat, and then exchange this for POLY. The tokens can then be used on Polymath’s KYC marketplace to make a bid to a KYC provider. If the KYC provider approves the offer, they are paid in POLY tokens to perform the KYC check for the individual. This process is clearly a significant onboarding friction to the Polymath platform, and makes the process more complex than necessary.
- How this information about users is then stored and accessed on-chain?
From looking at the whitepaper and smart contracts on GitHub, it is technically possible for many of Harbor’s tokens to all share one common Regulator contract, and share one common source of user data, however this is unlikely due to the differences in regulation between different tokens. The lack of live Harbor’s tokens on Ethereum has not clarified whether it is their intention for this to be the case, or whether each token will be deployed with its own Regulator.
Securitize’s protocol is designed such that their Regulator contract queries a third smart contract which stores user information. This enables each token to have unique regulations encoded in their own individual Regulator, whilst still sharing a common source of user data in the third contract, meaning when a user KYCs for one Securitize token their information is stored ready for them to buy future tokens
It’s not explicitly stated in their whitepaper whether Polymath has a central source of compliance data stored on-chain that each Regulator then interacts with, or if tokens have their own local source of information. However, based on Polymath’s sample contracts, it appears that each token uses a local source of information, which is not shared between different tokens. While this may have advantages, this setup risks data redundancy and inconsistencies.
Take the following example: Bob has expressed interest in two Polymath security tokens, ABC and DEF, and has been approved as an investor for each of them. This information is sent to the Regulator contract for each of the tokens. A month later, Bob tries to purchase further DEF tokens but it is found that he is no longer accredited. This information is sent to DEF’s Regulator to update Bob’s investor status to be non-accredited. Now, on-chain, there is conflicting information: ABC thinks that Bob is a verified investor, however DEF disagrees. It is easy to see that having a central source of information would prevent such discrepancies from occurring.
Interoperability of the Protocols
As discussed previously, there are two main parties involved in the issuance and exchange of security tokens to whom interoperability will matter greatly: exchanges and investors. Both of these parties desire a smooth experience when interacting with different security tokens. So, if using the protocols as-is, let’s take a look at how exchanges and users will be affected.
As an exchange, integrating these protocols for purposes of transfer is easy: all of the tokens utilize the ERC-20 token standard, providing a uniform interface to invoke transfers, approvals and balance checks. However further integration with the compliance aspect of every protocol becomes far more complex. You’ll remember it’s not currently possible for a trusted party to become authorized on Harbor’s protocol – they will instead have to direct users to Harbor to KYC themselves. To then integrate with Securitize’s protocol, the trusted party must be authorized by Securitize, which will then allow them to access investor KYC data through the off-chain API, and to update on-chain information stored in the on-chain data store.
To integrate with Polymath’s protocol is likely the most complex. The trusted party must register themselves as a KYC provider on Polymath’s KYC marketplace and set themselves up to receive bids in POLY tokens in return for providing KYC services. In providing KYC services to investors the trusted party must then organize a way to ensure that the duplicative on-chain data stored about a user in each security’s Regulator④ does not become inconsistent.
Not only do the protocols have different interfaces that the trusted party must integrate with, each protocol also has a different way to provide error reporting to the exchange. When building an interface it is important to be able to translate any errors that occur into something that is understandable by users. For example, if a user cannot purchase a token this could be for a wide variety of reasons: the security may have a holding period that has not yet been satisfied, or may restrict the maximum number of permissible holders. To be able to communicate these messages to users, the exchange would have to integrate with a different method of error reporting for each protocol.
The different methods by which onboarding of investors is currently designed in the protocols means that investors will likely have to provide personal information many times to different platforms and in different ways. This is caused by the fact that Harbor have not authorized any other parties, and Polymath require investors to bid for KYC processes using POLY tokens. The friction caused by the enforcement of these compliance methods may render investors unwilling or unable to purchase securities they would otherwise purchase.
The scale of this protocol-induced friction on investors may be somewhat alleviated by the manner in which exchanges go about integrating each of the protocols. For example, if an investor chooses to KYC on an exchange to purchase a Polymath token, that exchange, if authorized, could choose to update Securitize’s data storage at the same time. This would mean the investor’s information is on-chain in case it is needed in the future. However, if no changes are made to the current protocol designs, then the process of registering and purchasing securities will remain daunting.
The solution to this problem need not be complex. In fact, it is possible to introduce certain solutions without changing any tokens that are already live on Ethereum. An ideal solution that results in minimal friction for both exchanges and investors, and that prevents data inconsistencies caused by having many different sources of compliance data would closely resemble Securitize’s centralized on-chain data store; however, any such a set-up must then be adopted on an industry-wide scale.
By having a central source of information on-chain, the risks of data inconsistencies is removed, and investors are able to purchase different securities through just one compliance verification. This central contract would carry out the verification that the transfer was compliant for all security tokens, and the transfer would continue or revert. The off-chain API that is accessible to all authorized exchanges means that investor compliance information can be communicated to exchanges and reduces the number of times investors must be asked to provide data. These aspects together also massively reduce the amount of integration work required by exchanges.
The introduction of a new system like this clearly causes some complications, and a number of issues would still have to be ironed out. For example in the design of how each exchange becomes authorized: who makes the decision that an exchange should be trusted? Time has to be taken to design a system that allows a consensus to be reached.
The tokenization of securities is still an area that is early in development and adoption, which is in-part due to the complexities of regulatory compliance. While the publication of protocols simplifies the compliance with many of these regulations by enabling them to be enforced in the execution of every transfer, there is still a long way to go before this is a seamless process. Until we have an agreement between protocols on how investor information is stored and updated both on-chain and off-chain, there will remain significant friction throughout the registration and investment processes for all parties involved.
Top 5 Security Tokens to Invest In – Opinion
Below are the top 5 security tokens which I personally believe have the most potential for liquidity and future growth. As a disclaimer, I’m a token holder in all the investments listed below. No financial compensation was given for this article. This is based exclusively on my personal opinion.
#5 – Lottery.com
This was one of the earliest STOs in the space. The vision is to raise billions of dollars to help solve the most pressing humanitarian needs across the globe using global charitable raffles. They offer token holders 7% revenue share on all ticket sales.
Some of the notable investors behind this project include:
- Pantera Capital – Joey Krug (co-chief Investment officer).
- Paraag Marathe (Chief Strategy Officer EVP, SF 49rs).
- Bruce Gibney (Founders Fund, seed investor of PayPal).
What’s impressive with this project is the current progress that they have made which includes:
- The world’s largest lottery results and information provider to the digital media sector for U.S. and North American lottery games, including Google and Amazon Alexa.
- Provider of lottery results in more than 30 countries worldwide.
- In the US Lottery.com is a premier mobile lottery play service with multiple state approvals.
This token can be purchased on the OpenFinance platform.
#4 – tZERO
tZERO is working on building a regulated exchange for trading security tokens and digital securities. They are taking their time on developing this platform as they wish to ensure that they are fully legally compliant. Think of tZERO as the Binance of regulated security tokens.
If they succeed in their stated mission, they will become a market leader in the digital securities space. Being fully regulated institutional investors and banks will be able to use this platform for all their exchange needs.
We have reported on tZERO frequently including the painful due diligence process which is slowing the launch of the platform. Being fully legally compliant is a positive thing, and we prefer that they take things slow to ensure full compliance and legality.
This token can be purchased directly on the tZERO platform.
#3 – 22x Fund
22X Fund invested in 30 pre-vetted start-ups that were part of Batch 22 of the 500 Startups early-stage venture fund and seed accelerator program. 500 Startups have invested in over 1200 companies, some of these notable investments include Udemy, Visual.ly, Canva, Twilio, talkdesk, & ipsy.
All 22X Fund companies are part of Batch 22 from 500 Startups which took place in San Francisco in summer/fall of 2017. The 500 Startups Accelerator has a ~2% acceptance rate. The majority have raised previous funding and are revenue generating.
Batch22 focuses on FinTech (9 companies), Data (7 companies), and Digital Health (4 companies). The list can be found here.
Investors receive tokens in 22X which will own between 2.5% to 10% of the equity in each 22X portfolio company.
This token can be purchased on the OpenFinance platform.
#2 – Blockchain Capital
Blockchain Capital really needs no introduction when it comes to blockchain. They were founded in 2013 and have such notable investments as ABRA, Augur, Bancor, BitFuty, BitGo, Block.one, BlockStream, Coinbase, Ethereum, Harbor, Kraken, Ripple, Securitize, & Templum.
The BCAP token was launched in April 2017 and raised $10M in six hours.
In June, 2019 Coinbase Custody announced support for the BCAP token. The importance of this news cannot be understated, as this is the first security token to be supported by Coinbase.
This token can be purchased on the OpenFinance platform.
#1 – SpiceVC
My personal favorite is SpiceVC and this token is managed by an experienced team that are heavily involved in the digital securities space. They are investing in the future of security tokens and digital securities. Their most notable investment is in Securitize. Securitize is the token issuer that has shown the most traction when it comes to tokenizing security tokens. They have directly tokenized, or offered tokenization services to the bulk of the companies on this list.
Other notable investments by SpiceVC include:
- SAGA – An upcoming stable currency
- Slice – The tokenization of real estate
- ROX – Tokenization of commercial real estate.
- Archax – A digital securities exchange to be launched in London, UK.
- Lottery.com – An online lottery security token.
- Bakkt – A digital assets security exchange company created by ICE, the owners of the New York Stock Exchange. Bakkt is one of the most anticipated exchanges in the cryptocurrency space and has the potential to bring in institutional grade investments into Bitcoin and cryptocurrency.
This token can be purchased on the OpenFinance platform.
Securities.io is not is not licensed by or registered with the U.S. Securities and Exchange Commission, FINRA, or any other financial services regulator. Specifically, Securities.io is not a FINRA registered Broker Dealer and does not offer or sell securities, or engage in any other Broker Dealer activity. Nothing in this website constitutes an offer, distribution, solicitation, or marketing of any security.
Furthermore, Securities.io is not an exchange, alternative trading system, escrow agent or transfer agent. Securities.io does not provide legal, accounting, tax, or regulatory advice, or hold custody of any cash, virtual currency, security token or other digital asset for or on behalf of any third party.
- BitBond Finance BmbH STO Hits €2.1 million July 17, 2019
- How to get an STO approved by German regulators – Thought Leaders July 16, 2019
- DigiMax & Entoro to Collaborate as Advisors on Digital Security Offering July 16, 2019
- Will Facebook Subsidiary, Calibra, See the Light of Day? July 15, 2019
- Mikko Ohtamaa, CTO at TokenMarket – Interview Series July 15, 2019