Similar to traditional security, a security token performs the same function except that it confirms ownership through blockchain transactions and also make fractional ownership possible. Federal laws that govern securities also apply to Security tokens with the intention of protecting investors on some levels. Security tokens are programmable. Tokenizing securities, in theory, remove the need of a third party by using smart contracts. For example, a loan “tokenized” on a blockchain could automatically make payments without the use of a traditional middleman like a bank. A detailed article on STO was written by Moonwhale Ventures that discussed deeper on the various regulatory requirements around security tokens.
Let’s take a look at three commonly known types of security tokens:
- Equity Token
- Debt Token
- Real Assets Token
Equity tokens represent the value of shares issued by a company on the blockchain. The difference between an equity token and a traditional stock lies in its method of recording ownership. A traditional stock is logged into a database and the records are then represented by a paper certificate. For an equity token, however, it is recorded on an immutable blockchain essentially digitizing the traditional means of recording. Owning an equity token entitles the investor a portion of the company’s profits and a right to vote. It is important to note that these tokens are not limited to only the early stages of funding though it is more common to find companies offering its tokens during seed round. There are three benefits to this system:
- Enables investors to invest in blockchain companies while staying in compliance with securities law
- New fundraising model for early startups
- Framework for regulators to evaluate the project’s fundraising
ICOs provided an opportunity for early startups to seek funding through utility tokens. However, it came under major scrutiny by authorities as utility tokens do not represent ownership to the company. An STO ensures their fundraising efforts are compliant with securities law. One example of an equity token offering is Documo. They will be launching one of the world’s first equity token offerings to fund its business initiative to drive the mass adoption of paperless document technologies. Their tokens DCMO represents actual equity ownership in Documo.
Debt-based security tokens represent debt instruments such as real estate mortgages and corporate bonds. The prices of these tokens are dictated by two factors: Risk and Dividend. A medium risk of default in a real estate mortgage cannot be priced the same way as a bond of a pre-IPO company. Therefore, modeling the price of a security token after risk and dividend is key. In blockchain terms, the smart contract representing a debt security token should include operations such as repayment terms that dictate the dividend model but also incorporate the different risk factors of the underlying debt.
The benefits of tokenizing debt include:
Fractionalizing debt vehicles brings new opportunities to a larger scope of investors
Tokenizing futures contracts and derivatives could open up a whole world of new opportunities. As a result, they can bring massive liquidity into the tokenized market, thanks to its highly leveraged nature. It also provides a great way of hedging portfolios.
- Market Size
The current public market that includes bond and debt security is worth $100 trillion dollars. Should tokenization be the next evolutionary step for financial instruments, the potential for debt-based tokens can be massive.
The difference between dividends from equity and from debt is its regularity. Dividends from bonds are typically more frequent than equity because dividends from equity heavily depend on the underlying companies’ performance.
Real Asset Tokens
This type of token represents ownership to a certain asset such as real estate or commodities. Commodity-backed tokens address issues of trust, their inefficiencies and the complexity of transactions, which typically involve multiple parties. Blockchain technology allows a transparent record of complicated transactions, track goods, and reduce fraud, which seems to make it a natural fit for the commodity business.
Tokens can be used as virtual currencies, which have the same characteristics as any commodity (like gold) that can be traded with profit-making intentions. Commodity-backed cryptocurrencies included tokens linked to gold, silver, and oil . And each of those commodity has its own advantage and disadvantage.
Commodity-backed stable coins are one of the most exciting developments in the crypto world. Commodities such as gold or diamonds giving the tokens stability and value.
- Bananas — a cryptocurrency backed by bananas.
- Cannabium — backed by liquid cannabis extracts from legal sources
- PowerLedger —backed by renewable energy of the sun.
- “El Petro” — Oil-backed. Venezuela’s economy has been plummeting.
- Diamonds are an easy-to-redeem commodity with a good potential of a soon-to-be unlocked market. Among commodities, diamonds are one of the most stable in value. While gold, silver, and other commodities are exposed to financial markets and speculators’ whims, diamonds have remained steady for over three decades (enjoying a positive appreciation).
The STO Market Today
With regards to these three types of security tokens, the majority of projects that offer the token is lacking in quality. There are several great examples of real asset tokens such as the project led by Inveniam Capital Partners to tokenize $260 million worth in real estate and debt transactions. However, buyers have to hold at least $10 million in Crypto to participate and purchase a minimum of $500,000 worth. It is clear that the world of security tokens are fundamentally geared more towards institutions.
It will take a considerable amount of time to incorporate the true beauty of initial coin offerings into security tokens. Initial coin offerings democratize the fundraising process which was only open to larger institutions and accredited investor. Imagine a world where a student living in Argentina being able to own equities to a company based in Russia simply from their phones. But for now, the Argentinian student has to wait and proceed with the current ways to invest in security tokens. The STO market is definitely one to watch for in the next coming years as we attempt to revolutionize the financial markets.
When any Asset Becomes a Digital & Immutable Proof of Ownership – Thought Leaders
The regulatory scrutiny has morphed into a permanent reality in the crypto space. This much had become clear in early 2018. Regulators from all corners of the globe are looking to ﬁt the crypto phenomenon into some regulatory rules or framework. The main question however is to discern what crypto assets are? And whether crypto assets are securities? If they are, then the relevant law must be applied.
In the US, Securities and Exchange Commission (SEC) had announced that all crypto assets are investment contracts or – securities. This later corrected that all, except for Bitcoin and Ethereum (in its present stage) are to be deemed securities. 1https://coincenter.org/ ﬁles/2019-03/clayton-token-response.pdf
The reality is the American legal system largely still relies on the 86 year old Securities Act, with exceptions made available with enacting the JOBS Act in 2012. And within this amendment, there is a place for security tokens to be issued as well. Small issuances of up to USD 1m can be effected as crowdfunding projects. Larger deals can be done as private placements or public offerings limited to accredited (professional or high net worth) investors. Either way, the registration of the issuing security is mandatory. It is likely that the Securities Act may see a major revamp to exclude most cryptocurrencies from the scope of federal securities law. 2https://cryptovest.com/news/bipartisan-bill-proposes-to-exclude-crypto-from-us-securities-law/ In the meantime, the most recent discussion identiﬁes guidelines on how to assess if the publicly offered or sold digital asset is an investment contract and therefore a security. 3https://www.sec.gov/ﬁles/dlt-framework.pdf
In Europe, on the other hand, the European Securities and Markets Authority (ESMA) has called to extend Europe’s revised Markets in Financial Instruments Directive (MIFID II) to include cryptocurrency products such as initial coin offerings with securities features among transferable securities or other types of ﬁnancial instruments. 4https://www.esma.europa.eu/press-news/esma-news/crypto-assets-need-common-eu-wide-approach-ensure-investor-protection European Prospectus Regulations will apply in full from 21 July 2019 and replace the current directive. Under the Regulation each EU member state will be able to set its own limit between 1 and 8 million EUR when the mandatory prospectus requirement applies.
On the brink of Brexit, the UK’s Financial Conduct Authority (FCA) published an extensive consultation paper on the classiﬁcation and regulation of crypto assets. 5https://www.fca.org.uk/publication/consultation/cp19-03.pdf The paper seeks to provide regulatory clarity for ﬁrms and consumers, when certain activities around “cryptoassets” or tokens themselves fall within the FCA’s regulatory perimeter. The FCA reminds that the breach of authorisation regime is a criminal offence and carries a maximum penalty of 2 years imprisonment or an unlimited ﬁne, or both. Following the consultation period, FCA intends to publish the ﬁnal Policy Statement in relation to cryptoassets by summer 2019.
Other pioneering jurisdictions, such as Switzerland, Malta, Estonia, Lithuania, Liechtenstein have reviewed the types of crypto assets and proposed a classiﬁcation thereof.
All the above mentioned jurisdictions offer more-or-less similar classiﬁcation of tokens. Largely separating tree or four types. It is a matter of not so distant future, when every national regulatory body will be compelled to put out their opinion or guidelines on the subject.
Tokenisation – digital and immutable proof of ownership
The rise and fall of the ICO exuberance has resulted in setting a ﬁrm precedent in demand for tokenisation. It has also set an example for how the future of securities will likely look. There will always be a law governing securities issuance. But there also will be a decentralised reﬂection of the issued securities on the blockchain. With transparent protocol implementation, everyone should be able to access smart contract speciﬁcations and assess overall market interest.
The IEO or initial exchange offering appeared to remedy some of the most lacking aspects of a typical ICO, such as reliability, custodianship, vetting, transaction speed, cost, and sales channels. But it is yet to be seen, if it turns out to be the most appropriate utility token issuance method. After all, tokenisation is adding to a healthy competition amongst issuers and issuance platforms.
A legacy exchange listing cannot be applied to tokenised securities. Legacy exchanges lack understanding of the underlying technology and regulatory clearance. This is why there are many new technologically advanced initiatives, looking to set up a regulated space for security token listing and secondary market.
For a small-capital company a KYC/AML compliant STO campaign can be considered as an alternative way to access funding. Tokenising businesses by offering equity tokens, revenue sharing or raising capital with debt tokens may become an inevitable part of a company funding life cycle. A security token offering may be equaled to initial or subsequent equity or debt offering in the form of a digital token.
When asset becomes a digital and immutable proof of ownership to a global community, that is when we have created a democratic access for everyone to participate in the growth of the global economy. Today, not all countries have harmonised securities laws. But we are well on the way to lowering barriers of entry for both investors and issuers.
About the author
Liza Aizupiete, the Managing Director of Fintelum, which serves the crypto industry by carrying out a technically sound and KYC/AML compliant token sale process, crypto funds co-custody, transfer agency, secondary token OTC desk and corporate actions.
Previously Liza was a founder and the Managing Director of a cyptocurrency exchange Globitex, as well as the General Director of Lithuanian e-money institution NexPay UAB. A Latvian native, Liza graduated from the University of Geneva, Switzerland, majoring in Philosophy. Liza is experienced in the ﬁnancial industry, including trading, fund and portfolio management. Since 2012, she has become passionate about Bitcoin and later crypto industry at large, as a proponent of a decentralised and sound monetary system.
Fintelum is a comprehensive ICO/STO token launch platform for businesses looking to tokenise their assets in the form of utility, equity, debt and other asset or revenue sharing token. Fintelum suite of services comprises a regulated KYC investor onboarding, and continuous compliance with the EU AML laws. The token sale process can be followed through a tailor made dashboard. The backofﬁce system allows data access and management as well as on-demand reporting. In addition, to help mitigate token sale process risks, Fintelum acts as a crypto currency co-custodian. The system incorporates an integrated multi signature cold/hot wallets. To serve the security token industry, Fintelum acts as a transfer agent, ensuring security token ownership amongst whitelisted investors. Fintelum is also able to provide secondary token OTC exchange desk functions, with ongoing corporate action services, such as voting, dividends and announcements.
Learn more at https://www.ﬁntelum.com
This is part 5 of a 5 part series.
Evolution in Capital Markets – Thought Leaders
From the traditional private equity or debt to less conventional crowdfunding. The most recent tokenisation method is the next step in the evolution of the capital markets.
Often ICO token issuers made public promises regarding future increase of value of their token. Such claims are deemed to be promoting securities, according to regulators. There were additionally cases where ICOs blatantly disregarded their roadmap commitments. Around the same time as some bad ICO apples were falling, and regulatory scrutiny was increasing, STO or security token offering ideas became vocal, as the natural continuation of the ICO industry.
Indeed, STOs make more legal sense, but much less retail buzz. The times of raising hundreds of millions for a white paper idea are deﬁnitely gone. But it is the contention of the author of the present article – that does not mean all ICOs are dead. There still can be cases of utility represented by a smart contract token.
However, if there is no utility or service on offer, then it is likely a future proﬁt distribution, or outright corporate rights exercise. In other words – a security.
A security is a legally deﬁned ﬁnancial asset that can be traded or exchanged. A legal deﬁnition however varies by jurisdiction. The main categories are equity or debt, or derivatives thereof. Securities are offered by an issuer. The primary offering of a security today can be done either through crowdfunding, private placement, or full- ﬂedged public prospectus offering. Depending on the amount and jurisdiction, either option would constitute an issuance of a security.
A tokenised security offers a combination of advantages of both the ICO practice as well as the existing securities laws. On the one hand, an STO complies with the law to the letter. And on the other hand, an STO offers a similar promise of an immediate (or delayed in case of legally required lockup periods) liquidity.
There are no “securities token exchanges” to date (April 2019). But there are quite a few initiatives looking to obtain regulatory authorisation to run a securities exchange for the modiﬁed securities asset class – security tokens. Potential way of exchanging security tokens would be OTC desks provided by ownership transfer agents such as Fintelum. See more below.
The main difference that sets security tokens apart from non-token securities is the actual blockchain aspect. Now in stead, or rather in addition to regulatory requirements, such as registration of certiﬁcates, shares, bonds and debentures – a smart contract is issued representing the registered rights and obligations of the issued security, whereas bearer securities could be most effectively tokenised.
Investors or participants of an STO are typically cryptocurrency users, but not necessarily. STO practice will continue the path carved by the ICO industry in setting the use cases for cryptocurrency at large. The STO offer is not so democratic than ICO used to be. Security token offering is much less frictionless than it used to be with utility tokens.
Today, the potential buyer of an STO will need to overcome burdensome KYC/AML proﬁling process to be compliant with the sales of a security. And often try providing the impossible – the accredited, sophisticated or professional investor status. And depending on the jurisdiction and the project offering, the pain levels may vary. This is why, an STO issuer should have an attractive proposition on the table to be able to attract investors.
Security token or tokenised securities?
As a note of importance, not to confuse the two concepts, well posted out by Noelle Acheson in her piece 6https://www.coindesk.com/security-tokens-vs-tokenized-securities-its-more-than-semantics. Security tokens are the subject of our present article. Whereas tokenised securities are a token representation of an already existing security. For example, an Apple stock may be tokenised and traded on a separate exchange than the original stock is traded (eg.: APPL ticker, traded on the New York Stock Exchange). Although it is questionable, but there seem to be attempts at listing tokens that allegedly represent an Apple stock 7https://www.ﬁntelum.com/blog/digital-securities-tokens-based-on-share-of-10-nasdaq-listed-companies/.
This is part 4 of a 5 part series.
STOs vs Crowdfunding, ICOs & IEOs – Thought Leaders
Crowdfunding and ICO – a step in evolution of capital markets
ICO acronym abbreviates to “initial coin offering”. But the practice stems from small capital funding method known as the crowdfunding.
In 2009 a US company called Kickstarter launched and successfully continues today to promote and facilitate funding of creative ideas and products. The idea is to pre-sell some product that a creative team pledge to develop or mass produce and deliver to its backers. The practice had no clear legal foundation back when it started. It was only three years later, in 2012, the US law was amended to regulate the new practice of easier access to small capital ﬁnancing, by adopting Jumpstart Our Business Startups (JOBS) Act 8https://www.sec.gov/spotlight/jobs-act.shtml.
Similarly, ICO phenomenon sprung up from the burgeoning crypto community. The ﬁrst ICO is widely accepted to be the Mastercoin blockchain project in 2013. It set itself apart as the ﬁrst crypto crowdfunding case. The idea was to presell a blockchain coin/token as a service that the team pledged to develop in future. To purchase interest in the project, one was able to pay in bitcoin cryptocurrency. All of a sudden, a new practice was born.
A new use case for cryptocurrencies was forged and started to unfold rapidly. By 2017, not only many new cryptocurrencies emerged, but there were hundreds of ICO projects,
pre-selling their services, often, but not exclusively blockchain-based business applications. Indeed, raising funding in less restrictive way was the prime goal of the practice. Selling a token as interest in the project that had some utility or representation. Hence the new expression – utility token.
By deﬁnition, investing in a nebulous utility token (typically Ethereum EIP-20, also known as ERC-20 compliant) had very loose legal obligations, only those pledged by the issuing entity. The investment was not an equity purchase, nor it was a loan, rather – a voluntary contribution. The attraction was an almost immediate liquidity of the newly minted token. After the initial offering, a bubbling secondary market developed and offered easy entry and exit to all participants. Selling a token was selling a promise of a non-existent yet service, not dissimilar to the age of discoveries of long sea voyage ventures.
Similarly, the beginning of 17th century introduced the ﬁrst permanent joint stock form, where the investment into shares did not need to be returned, but could be traded on a stock exchange. 9https://en.wikipedia.org/wiki/East_India_Company
The crypto investment practice unfolded into a wave of ICO projects, culminating in 2017. Thus many startups and mostly white paper ideas got funded. Most were real projects. Some were bad apples. But the most attractive aspect of the ICO were the returns on investments. According to one source, the ROI yielded in excess of 10x, even if you had invested in both the winners and losers alike over the 2017 year. The whole industry was on a steep upwards pressure, with strong interest from the institutional sector. Such returns are unprecedented in the normal trading environment. Fortunes were made and lost.
The year 2017-2018 went down in history as the ICO hype unfolded. It culminated with several major events that occurred at the same time. One was Bitcoin blockchain forking and the subsequent nose dive of most cryptocurrency value. There were other notable events that coincided and contributed to the overall price fall.
From peak to trough the crypto asset market value was at times suddenly and later gradually reduced from over USD800B to little over USD100B. The so called crypto winter had set in. The bittersweet mass interest receded and an immediate ﬂight away from all things crypto ensued. See chart below. 10https://coinmarketcap.com/charts/
IEO – initial exchange offering
Similarly as with Slack and Spotify exchange listing, there are some ICOs that have listed directly on token exchanges. This way projects can leverage token trading venue client base to showcase their projects directly, without active promotion of the offering through other, often ineffective, marketing channels. This has prompted many token trading venues to start issuing utility token IEOs on behalf of token issuing start-ups.
For the contributors, exchange listing adds trustworthiness, security and vetting, knowing that a reputable exchange, such as Binance will have done certain due diligence before listing an unknown project. Indeed, for utility tokens IEO may prove to be a safe, if not cheap way to gain community trust. It is yet to be seen, however, if the initial listings continue to persist over a longer stretch of time, and what regulatory requirements may be imposed as to listing requirements. This also is a piece of history in the making.
This is part 3 of a 5 part series.
- Security Token Standards – Factom Asset Token- FAT May 23, 2019
- Vertalo Releases V-Token Software for Usage during Tokenization May 23, 2019
- TokenOro to Offer Security Tokens backed by Gold and Mining Operations May 22, 2019
- Smartlands to Tokenise Nottingham Real Estate through STO May 20, 2019
- PCF Capital to Host $250 milllion DSO through KoreConX May 19, 2019