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.
HODL Your Hoopla Over SEC Changes For Exempt Offerings – Thought Leaders
Last week the The U.S. Securities and Exchange Commission released a proposal – that has yet to become regulation – to simplify how exempt offerings are done. Shortly thereafter, a flurry of articles and newsletters made their way through the digital asset industry – many of which suggested their platforms were already being modified to fit the new rules. While the SEC has proposed changes, time will tell whether the proposal is adopted – and if so, whether there will be changes to the final draft that will be published to the Federal Register.
The US exempt offering framework includes tools such as Reg D, Reg A, crowdfunding (a.k.a. Reg CF) – essentially everything that is not a public or retail offering. This framework has seen little in the way of changes or modernization since the Securities Exchange Act of 1934. There has been significant public criticism of the current rules for exempt offerings, largely because they reserve access for only the wealthiest Americans to invest in private funds, companies, and other offerings.
If passed, the proposed changes could allow for the average person to invest in earlier stage deals – such as Uber or WeWork – before they reach their lofty valuations and dumped into the public markets. Enabling SPV (special purpose vehicles) and harmonized reporting (ie combing Reg D and Reg CF into one, not two reports), and increasing the total amount that can be raised would help streamline compliance for issuing firms. Additionally, the changes could also enable crowdfunding to become a viable capital formation tool for investing in such asset classes as real estate.
Currently, US offering exemptions such as Regulation CF (crowdfunding) are quite restrictive, limiting the total amount you can raise to $1.07M USD per 12 month period and includes significant restrictions per investor. The US SEC appears to be following the lead of other jurisdictions such as Canada where regulators proposed similar changes, or Europe where regulations were updated last year, increasing the limits for the EGP (European Growth Prospectus) to €8M EUR, a little over $9M USD. According to the new proposal, companies would be able to raise up to $5M USD. While $5M is still a relatively small amount of capital, it does allow early stage companies to build their tribe with a broader investor base.
The SEC proposed similar changes to Reg A, increasing the upper limit to $75M USD. This could make Reg A viable for many later stage companies where larger Series B, C, or even D rounds demand more capital than what is currently available in Reg A.. This also opens up these investment opportunities to the retail investor, previously these deals were only available to the wealthiest corporate venture firms, private equity shops, and high net worth individuals.
Further changes include allowing accredited investors to participate in crowdfunding. Previously, if you used a crowdfunding exemption, you could not accept funds from accredited investors and would actually have to use another exemption, such as Reg D, simultaneously. This typically forces companies into more paperwork, legal fees, and an increased risk of getting something wrong – which could result in regulatory or civil actions. The proposed changes would enable companies to combine accredited and retail investors into one offering.
Aside from accredited investors, the changes also open the doors to institutional and corporate investors, including the SPV (Special Purpose Vehicle).
An SPV is a corporate entity created for a specific purpose – usually for reasons such as limiting liability, tax efficiency, investment, or capital formation. For example: In order to tokenize a piece of real estate, you might form an SPV, and transfer the deed to the real estate into this company. The purpose of that company/vehicle is to hold the deed of this real estate and maintain a accurate record of who the owners are, SPVs are commonly used for investment funds as well.
Combined, SPVs, corporate investors, accredited investors, and major institutional investors can move large amounts of capital. However, they weren’t able to invest in crowdfunding offerings in the US. This created an interesting paradox for companies raising capital, if you could get the big fish interested, you would avoid the crowd – but, if your offering didn’t look good enough for professional investors, your last resort may be crowdfunding. The crowdfunding industry as a whole has faced a lot of criticism from professional investors for low returns and low deal quality, this is likely to change when retail investors have access to the same deals as larger institutions.
Finally, the new crowdfunding regulations propose several major changes to how much each investor can put into any one offering. Currently, investors who do not meet the accreditation thresholds were limited on how much they could invest based on the lower of their income or net worth. The new regulations would change this to the greater of those two. These changes are expected to not only fuel innovation, they are likely to bring in a lot of smart money as well.
For example, an investor with a net worth of $750,000 and an income of $150,000 couldn’t qualify as an accredited investor. This person has a Phd in bioscience and finds a startup with a revolutionary innovation in the field of bioscience – they are not qualified as an accredited investor and barred from investing. Ironically, they can be an advisor to any institutional investor on why this particular startup is so hot – but under the current rules, they are not qualified to risk their own money.
While these changes are welcomed by most market participants, they are not a sure thing. This proposal for a new exempt offering framework is not yet regulation, it still has to make it’s way through the government and be entered into the Federal Register. Looking back at the proposals for crowdfunding in the US we can see how different a proposal can be from the regulation – and there are still a lot of lobbying dollars that want to see the status quo maintained. It is important to not make important business decisions based on this proposal – rather, look at these changes as a larger trend among securities regulators globally.
We’re seeing securities regulators trying to make easier for distributed capital formation. Crowdsales and crowdfunding are actually becoming something that the regulators across around the world are working together to harmonize their frameworks. By combining the crowdfunding regulations from jurisdictions around the world, early stage companies would be able to access global capital and build a global investor base, without being forced to break the rules like most of the ICO and STO issuers are doing today.
Perhaps the most exciting thing about the SEC’s proposed changes is how they demonstrate a very coordinated effort among securities commissions globally. As this new era of capital formation emerges, businesses will be able to combine and leverage the regulatory frameworks of multiple countries. That being said, for US based offerings, we still have to wait for the new regulations before knowing what they will look like, or their impact on the digital securities industry.
Why EU blacklisting the Cayman Islands matters for the STO industry – Thought Leaders
On February 18th the European Union added the Cayman Islands to its tax haven blacklist. While this has not made the news in the security token industry, it has had major implications. Due to the strict demands of AML & KYC in many jurisdictions, regulators are focusing more resources on beneficial ownership, tax transparency, and enforcement.
For companies raising capital, the blacklisting means you should not take money from a Cayman fund if you’re a European issuer. In the EU, a lot of the investment in security tokens, real estate, and private equity comes from or through Cayman fund structures. Cayman is also where a large portion of American VC funds are domiciled.
The current tax haven blacklist also includes American Samoa, Fiji, Guam, Oman, Palau, Panama, Samoa, Trinidad and Tobago, US Virgin Islands, Vanuatu, and Seychelles.
Any company taking funds from a Cayman domiciled fund, or working with a platform/issuer/bank in that market should be aware that being associated with a blacklisted country could create significant new risk exposure for your project, and possibly yourself. These changes are effective immediately. Until recently, most firms could fly under the radar but the EU is also rolling out a public registry of corporate ownership. This will not only make non-compliance much easier to spot but also increases the ability for regulators in the EU to investigate and enforce.
The regulation could impact people working at (including directors, officers, or significant shareholders) a company that received funding from a Cayman source after the blacklist date. Enforcement severity changes by country but can include criminal charges, company seizure, and known associates may end up on a variety of sanctions and watch lists. Not to mention the reputational damage.
This is a good example of why a good AML program does not only consist of face matching a document and pinging an API to name match a sanctions list – you are opening up your venture, and most likely yourself, to massive liability. Your legal and regulatory obligation is to take a risk based approach. What that looks like can change by country, transaction value, activity history, etc., so AML program needs to be dynamic, robust, and comprehensive enough to catch things like narrative sanctions.
For example: The most popular security token platforms today only use KYC for digital onboarding of natural persons – not corporate entities. However, when you look at the investors in their previous token issuances you can see that most of the funds are coming from corporate accounts, corporation owned wallets, but the on-chain transaction and KYC is done by an individual. These platforms are missing the technical capabilities to spot transactions coming through blacklisted jurisdictions such as Grand Cayman.
iComply recently helped a virtual asset exchange pass the audits needed to offer their users the ability to spend virtual assets, such as Bitcoin and Ethereum, with a Visa card. This process involved independent audits from Visa, their banks, and regulators – each wanted to see the client demonstrate how they would be able to identify these risks and fulfill the requirements of a whole web of regulations.
Now that they have passed the audit, they are first to market with a very compelling offer compared to their competition who still have months of development on their AML systems before their applications will go through. Using iComply to get ahead of the regulations has also put them ahead of their competition.
We can expect the same for the security token market. Token issuers need to pay close attention to their AML compliance – Telegram had to refund over $1B USD over AML, has spent millions in court with the SEC, and the OCC has not even started with them yet…after that, how many of their “not investors” will be ready to jump onto an investor class action lawsuit? We have already seen this with the recent OCC case against MYSB in New York, or with the SEC and AirFox in Boston.
Regulated Digital Assets Take Over in 2020 – Thought Leaders
2018 was the highwater mark for initial coin offerings (ICOs), when 1,253 new coins raised $7.8 billion. In 2019, this “Wild West” market went from boom to bust. Dollars raised in ICOs plummeted 95% compared to 2018, and the Securities and Exchange Commission (SEC) continues to announce new actions against various ICO players for fraud and unregistered issuances. The sheriff has come to town.
Regulation, my old friend
It’s no consolation to investors who lost millions in ICO scams, but they were part of a natural market evolution. The laws governing traditional securities were also originally inspired by bad actors like “bucket shops” that emerged as another new technology, the telegraph, was changing financial markets. The SEC’s decision to crack down on digital assets and apply those same laws to blockchain securities is good news for market participants.
Blockchain securities have the potential to increase efficiency, lower costs, provide greater transparency and mitigate risk. However, the financial industry can’t fully realize the potential of blockchain securities without a public market and regulated ecosystem to support their full lifecycle. That means fully compliant issuing, investing, trading, settlement and custody.
Governments around the globe are working to establish the necessary frameworks in their own jurisdictions. This is lowering the risk of investing in blockchain securities by introducing investor protections associated with traditional markets. Although different jurisdictions have different requirements for regulated entities, investors, traders and users, there are four common areas being addressed:
- Distribution – how are security tokens created and why, and how are they delivered to their owners?
- Custody – where is the ultimate record of ownership kept and by whom?
- Reporting and Record Keeping – what additional regulatory requirements are placed on participants such as transfer agent services?
- Specific Processes – what additional processes are required, for example, in order to move security tokens between personal and master wallets?
The SEC and the Financial Industry Regulatory Authority (FINRA) have established guidance in all four areas through a series of communications including the report on The DAO and a joint statement on broker-dealer custody of digital assets. The necessary U.S. framework is finally in place to allow regulated, public trading of blockchain securities to blossom.
If the juice don’t look like this
In parallel with these regulatory developments, companies have rushed to create the necessary market infrastructure. Critical components are in place and more are coming this year. The question for those considering whether to participate: is the juice from this 2.0 version of digital assets worth the squeeze? The answer will be yes if the blockchain securities market looks like an upgrade of traditional markets, which would require that it offers two key benefits to investors and companies looking to raise money.
The first is efficiency. Blockchain securities need to eliminate the cumbersome data systems and manual paper-based processes of traditional securities trading. The potential is there but execution is everything as the saying goes. Implemented correctly, blockchain can efficiently support the entire lifecycle of digital assets from issuance and investing through trading, settlement and custody.
The second benefit is smart oversight. To be viable over the long term, the blockchain securities market needs to be fully compliant not only to satisfy regulators, but to create liquidity. It needs to supply investors with convenient access to transparency, account safeguards, and regulated trading. This will require integration with traditional brokerage accounts as well as intuitive user interfaces.
I’ve become so numb
I was hoping to get through this article without using “disruption” because I know we are all numb to the concept. Unfortunately, I keep hearing that blockchain securities will disrupt financial markets. I’ve said it myself! But the reality is that blockchain securities are an evolution not a revolution. The same year that ICOs peaked at $7.8 billion, the traditional US securities industry raised $2.4 trillion. For blockchain securities to become a mainstream asset class, they can’t remain on the island of personal wallets. They need to be bought, held and sold by retail investors, institutions, and advisors through traditional trading systems and brokerage accounts. That could happen as early as this year.
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