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The Need for Interoperability in Security Token Protocols – Thought Leaders

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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.

Regulatory Compliance

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.

The Protocols

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:

 

  1. How do authorized parties update on-chain information about users?

 

Harbor

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

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

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.

 

  1. How this information about users is then stored and accessed on-chain?

 

Harbor

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

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

 

Polymath

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.

Exchanges

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.

Investors 

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.

Solutions

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.

Conclusion

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.

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Alice Henshaw is a smart contract engineer at Fluidity. Fluidity are a New York-based company working on DeFi, and are best known for creating decentralized exchange Airswap. Previously Alice worked at ConsenSys where she designed and implemented smart contract systems responsible for over $100M USD in transaction volume. She is a graduate of Oxford University with a degree in Computer Science.

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5 Major Takeaways from SEC’s New Investor Protection Rule – Thought Leaders

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5 Major Takeaways from SEC's New Investor Protection Rule - Thought Leaders

It seems that the controversies surrounding SEC’s newly adopted Regulation Best Interest rule (Reg BI), would continue to take center stage, even though it goes into effect next summer. The regulation is the culmination of a decade-long process that started in 2010, immediately after the great recession. The Dodd-Frank Act passed that same year authorized the SEC under section 913 to enact a fiduciary standard and best of interest rule to govern broker-dealers and investment advisors when engaging with private investors.

In the aftermath of the introduction of Reg BI, stakeholders, state regulators, investment advisers and broker-dealers have weighed in on various factors that could undermine or aid its effectiveness.

5 Key Takeaways 

  1. Brokers Dealers required to adhere to new “best interest” standard
  2. Sets up U.S. Department of Labor (DOL) to synchronize rule-making (later this year)
  3. Big win for broker dealers  → even bigger for financial services
  4. The New Common Reporting Standards (CRS) Says Broker = Advisor → confusion between  broker vs fiduciary advisor
  5. Reverse focus on protecting brokerage role than consumer = more confusion 

However, before we highlight these takeaways, let’s first take a look at the substance of the fiduciary standard clarification rule.

The Takeaways from SEC’s Regulation Best Interest Rule

SEC intends to subject broker-dealers, who currently are only required to meet suitability standards, under fiduciary standards.

On one hand, fiduciary standards presently govern the relationship between financial advisors and their clients. And it expects the former to only offer services that are in the best interest of the latter. On the other hand, suitability standards require brokers to ascertain that the investment they recommend suits their clients.

In essence, the rule looks to extend the fiduciary rule on broker-dealers who are increasingly taking up the roles of financial advisors, when their primary duty is to sell an investment product for a stipulated commission. Under the suitability standard, it is legal for a broker to recommend an investment product that avails him a good commission, so long the product is suitable to the customer.

While this is a given, it also presents a conflict of interest. It’s possible that there are cheaper investment products with similar features to the one the broker recommends, but with a less attractive commission. This conflict of interest is what the Reg BI looks to eliminate, as it requires brokers to place the client’s interest above theirs.

To do this, the rule would enforce brokers to explicitly disclose important information such as incentives and commissions that could influence their recommendations. More so, it would, to an extent, ban industry practices, like incentives in the form of vacations, that could spur brokers to betray the interests of their clients.

Knowing fully well that brokers could find a way around this requirement by disclosing conflict of interests with technical terms or in a voluminous document, the SEC also introduced another requirement that could counter such practices. The requirement states that brokers must outline conflict of interests and their compensation structure in plain English and in a concise manner on a document called form CRS.

Also, brokers would document the history of legal or disciplinary actions taken against the firm offering the investment product or its financial professionals. Another vital feature of the rule is Care Obligation. This requirement entails that financial advisors to make sure that they diligently and carefully ensure that their recommendations are in the best interest of their clients.

The last requirement is the Conflict of interest obligation. It requires the management and mitigation of commissions that could represent a financial conflict of interest.

Dissecting the Implications of The Regulation Best Interest Rule

As expected, critics left and right have dissected SEC’s Reg BI, and the prominent argument that many have brought up is the fogginess of the rule. For one, some critics have condemned SEC’s reluctance to clearly define what it means by “Best interest”, the actions that would suggest that an investment advisor is not compliant, and how to mitigate financial conflict of interest.

Chances are that broker-dealers would look to find a way around this rule, at least until SEC starts enforcing disciplinary actions against non-compliant investment advisors. Besides, Reg BI does not seem to have enforcement muscle. It is unlikely that non-compliance would lead to class action lawsuits and litigations.

Furthermore, there is an outcry that SEC’s rule has done nothing to clarify to investors the roles of Investment advisors and broker-dealers. Note that a majority of brokers-dealers are registered with the SEC. Technically, this means that they could assume the roles of Registered Investment Advisors (RIA), and yet, they are not fiduciaries.

More concerning is the fact that the Form CRS requirement would do little to change the status quo. This notion stems from the fact that studies showed that consumers found it difficult to understand the contents of CRS forms.

While responding to many of the criticisms leveled against Reg BI, SEC’s chairman, Jay Clayton stated that “differing views were expressed regarding whether the standard should be more principles-based or more prescriptive — and in particular, whether to provide a detailed, specific, situation-by-situation definition of ‘best interest’ in the rule text.” 

As such, after careful consideration, the agency concluded that the principle-based approach adopted for the rule “is a common and effective approach to addressing issues of duty under law, particularly where the facts and circumstances of individual relationships can vary widely and change over time, including as a result of innovation,”

Judging from the details of Reg BI discussed above, there is no doubt that the rule has elements of the fiduciary rule that the Obama administration proposed through the Department of labor. The difference is that the latter was looking to classify all investment professionals as fiduciaries. In other words, a client could decide to sue his investment advisor or broker once he notices any discrepancies that would suggest that his interests were not best served by the actions of his investment manager.

Recall that this rule hit a roadblock under the present administration, as the securities industry challenged its viability in court. And while DOL has also indicated that it is pushing for a new fiduciary rule, there is no guarantee that its future proposal would have the same grit as the previous one. This assertion is probable, considering the likelihood that Eugene Scalia, the attorney that led the case against DOL’s previous fiduciary rule, would emerge as the new Labor Secretary.

Also, it is important to note that the Certified Financial Planner Board of Standards plans on enforcing an ethics code that would entail that its 84,000 members adhere to fiduciary standards, irrespective of the regulatory frameworks that govern them. Interestingly enough, this code’s implementation date coincides with that of Reg BI’s.

More importantly, some states are contemplating on taking matters into their own hands by imposing separate fiduciary rules that would correct the apparent flaws of Reg BI. For instance, New Jersey’s security bureau has released a rule proposal that explicitly classifies brokers- dealers as fiduciaries. Other states that have taken a similar path are Nevada and Massachusetts.

In response to this development, SEC’s chairman, Jay Clayton, stated that “I and many others believe a patchwork approach to the regulation of the vast market for retail investment advice will increase costs, limit choice for retail investors and make oversight and enforcement more difficult. I am hopeful that our regulatory colleagues will continue to work with us to minimize inconsistencies and maximize the effectiveness of our collective efforts.”

However, regardless of the loopholes of Reg BI, and the controversies that spurred responses from state regulators, I believe that the SEC’s proposal is a step in the right direction in order to protect investors. 

For investors, it is a matter of asking the right questions: 

  1. Who pays your broker’s commission?
  2. How much he gets paid for encouraging you to buy an investment product. 
  3. Are you a fiduciary?
  4. How does a broker apply investor protection rules? 

 

The information provided here is personal opinion and provides only a subjective opinion of the rules and regulatory guidance provided by the SEC. It should not be read as legal or compliance advice. Consult with your compliance professional for further details.

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Top 5 Equity Crowdfunding Websites – Opinion

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Top 5 Equity Crowdfunding Websites - Opinion

Crowdfunding has been around since 2008 with the launch of indiegogo, followed by Kickstarter which launched in 2009.

The early crowdfunding websites offered users free perks, and goods in exchange for funding their business venture. Most of these start-ups fizzled out after a few months but some of these were widely successful. One of the most notable success stories is the virtual reality headset Oculus which raised over $2.4 million on Kickstarter in a campaign that also caught the attention of Mark Zuckerberg. Shortly thereafter Oculus was acquired by Facebook for $3B. This was a monumental acquisition for a start-up with a great vision and zero profits.

Unfortunately, while the Facebook acquisition of Oculus was life changing for the Oculus team, the early backers of the project on Kickstarter received nothing, as no equity was offered for their initial backing of this project.

In 2012 the JOBS Act passed which opened the doors to crowdfunding websites offering early investors equity. Now investors from all over the world have the opportunity to support start-ups who are too small to access traditional venture  funding.

These equity crowdfunding websites serve an important purpose as they are directly responsible for nurturing entrepreneurs while offering investment opportunities to investors who are not based in Silicon Valley.

Below are in my opinion the top 5 equity crowdfunding websites.  As a disclaimer, I’m an equity owner in 3 of the companies listed below (WeFunder, Microventures, StartEngine).

#1 – SeedInvest

SeedInvest differentiates themselves by focusing on only having handpicked start-ups in upcoming industries. If you want to invest in the future of tech this is one of your best options. The industries that are often featured include:

  • Augmented Reality
  • 3d Printing
  • Artificial Intelligence
  • Robotics
  • Space Technologies

They’ve helped over 150 companies raise capital, and the team is great at filtering out most companies that apply, to offer investors a curated list of world class companies to invest in.

#2 – Microventures

This website is different than the rest of this list as they offer two different focuses and they target accredited investors only.

The main focus is on Late Stage companies. Some of the late stage companies which have been featured include:

  • SpaceX
  • LYft
  • Pinterest
  • Honest Company
  • Robinhood

This offers the easiest possible route to investing in phenomenal late stage companies which are often only a few years away from going IPO. The minimum investment is often in the $5000 to $50000 range, with the minimum depending on the interest level and the company.

They also offer investment opportunities in Early Stage companies with minimum investments in the $3000 to $5000 range. These companies are often in Fintech, robotics, 3-D printing, etc. The quality of these Early-Stage companies is high and is also handpicked.

 

#3 – WeFunder

They were responsible for helping to write the JOBS Act, and are one of the oldest companies in the crowdfunding space. There’s been some huge success stories on this website.

In April 2013 Zenefits raised at a $9M valuation, and only 2 years later in May 2015 they raised an additional $500M and were valued at $4.5B. This means if you had invested $10000, you would have received a cool return of $500,000 in a 2 year period.

WeFunder came out of the Y Combinator accelerator program, which is the most famous and successful accelerator program in the world. Some success stories from here include AirBNB, DropBox, Stripe, coinbase, etc.

The reason this is important is that Y Combinator companies support each other in what is a giant ecosystem. Many of the start-ups on WeFunder are Y Combinator graduates (such as Zenefits).

#4 – Fundable

One of the oldest platforms on this list, Fundable launched on May 22, 2012. Since then they have been offering access to a notable list of companies in every industry that you can conceive of. I’ve seen everything from solar power fields to revolutionary 3D printed prosthetics.

Fundable is a crowdfunding website which offers an extensive live of companies to choose from.

#5 – StartEngine

Over 90M has been raised by 265+ companies. They even recently successfully raised a$10M STO for themselves.

While this is a great platform they are not as selective as the rest of the equity crowdfunding websites on this list, so you do have to be more careful and perform extreme due diligence in who you invest in. That being said there are some gems to be found. Hackernoon recently successfully completed a $1.07M raise. I do find that they have too many companies listed, which makes perusing the list a bit exhausting.

Summary:

These are the top 5 crowdfunding websites which I believe offer investors the best access to investment opportunities. You should always perform proper due diligence, and understand that Early Stage investing is high risk, and that you are more likely than not to lose access to all of your capital.  You should also expect that it takes 7 to 10 years to earn a return on any of these investments.

Disclaimer:

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.

 

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How to get an STO approved by German regulators – Thought Leaders

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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.

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