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Three Types of Security Tokens To Know – Thought Leaders

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Three types of security tokens you should know about

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:

  1. Equity Token
  2. Debt Token
  3. Real Assets Token

Equity 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 Token

Debt securities that includes bonds, notes, debt instruments

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:

  • Fractionalization

Fractionalizing debt vehicles brings new opportunities to a larger scope of investors

  • Futures

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.

  • Dividends

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

tokenizing commodities in agriculture, metals, livestock and energy

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.

Some examples:

  1. Bananas — a cryptocurrency backed by bananas.
  2. Cannabium — backed by liquid cannabis extracts from legal sources
  3. PowerLedger —backed by renewable energy of the sun.
  4. “El Petro” — Oil-backed. Venezuela’s economy has been plummeting.
  5. 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.

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Iliya Zaki is the Head of Marketing & Business Development for Moonwhale Ventures. Moonwhale Ventures is an STO Financial Advisory offering companies strategic advice on STO process & structure, as well as token issuance incl. lifecycle management and secondary market on-boarding for their projects.

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The Howey Test: The Fine Line Between a Security Token and a Utility Token – Thought Leaders

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The Howey Test: The Fine Line Between a Security Token and a Utility Token - Thought Leaders

The Securities and Exchange Commission’s recent barrage of crypto-related firms and investments with enforcement actions tells a story that has long been a mystery to many. Two of these prominent cases made headlines in June. The first, a case against a social media platform, Kik, and Kin foundation – the foundation governing the operations of the Kin ecosystem. The second was against Longfin Corp, a fintech company that “offers commodity trading, alternate risk transfer, and carry trade financing services.”

While many expect more of such crackdowns, the back and forth between the SEC and these companies have somewhat opened fresh controversies surrounding the viability of the regulatory framework governing digital securities and tokens. In light of this, it is important to examine the arguments from both sides of the divide to fully acknowledge the critical nature of the situation and its implications on America’s investment landscape. But first, let’s explore the actions/inactions of Kik and Longfin that might have forced the SEC to sue them.

SEC vs Longfin

In April 2018, the SEC froze the trading profits generated from the sales of Longfin’s stock, which the regulator accused of selling unregistered shares after acquiring Zidduu.com (a crypto trading company). In June 2019, SEC filed fraud action against the same company and its CEO, Venkata S. Meenavalli. The released complaint claimed that Meenavali had “conducted a fraudulent public offering of Longfin shares” by misleading investors on the financial standing and mode of operation of its company’s crypto-related business.

SEC vs Kik

On June 4, 2019, the SEC officially took legal action against Kik Interactive Inc. for conducting an illegal $100 million securities offering of digital tokens back in 2017. If you will recall, Kik was one of the many companies that capitalized on 2017’s ICO boom to raise money for its blockchain ecosystem. SEC asserted that Kik’s fundraising campaign was illegal because the company sold $55 million worth of tokens to US investors without registering the offers or sales.

Secondly, the complaint alleged that at the time of the fundraising campaign, none of the products and services that Kik had implied would drive the demand for Kin tokens did not exist. Also, the watchdog claimed that the revenue-sharing clause that featured in the Kin offering campaign established that the Kin token is a security. This is true since the campaign failed the Howey test as it  promised profits “predominantly from the effort of others” to build an ecosystem and drive the value of the token.

And so, SEC based its case on Kik’s failure to comply with the registration requirements under U.S. securities law and the omission of information that would have helped investors make informed decisions. It is worthwhile to note that Kik had released a strong response to SEC’s initial claim.

Although there was no clear framework to guide the conduct of ICOs or digital security offerings in 2017, that has not stopped SEC from litigating companies that had sold digital tokens years before regulators issued guidelines.

 

The Howey Test Controversy

From the details of the highlighted charges, it is clear that funding a business or company through fabrication or manipulation of information is, by the standard of current securities law, a punishable act. This is also true for investments that do not comply with existing required financial disclosures. However, as argued by David Weisberger (co-founder and CEO of CoinRoutes), the current financial disclosure requirements are not effective when it comes to giving investors insights on the viability of the investments.

In its true sense, existing securities laws only require the disclosure of information about the issuer and its finances. As such, Weisberger argues that there is no way investors would use such information to judge the prospect of digital tokens. Using Kik’s travail with the SEC as a case study, he explained that if Kik had followed due process and complied with registration requirements, it still wouldn’t have given investors a hint that the price of the token would today worth far less than what it had sold for in 2017.

Nevertheless, as SEC puts it in the complaints, before the commencement of the Kin promotional campaign, Kik was in dire need of funds, as its expenses had consistently trumped its revenue. If Kik had informed prospective investors about its financial predicament, many would have had a rethink. As such, there is no doubt that such information would have helped investors to make informed decisions.

The Howey Test: The Fine Line Between a Security Token and a Utility Token - Thought Leaders

Also, SEC’s released a clarification on the Howey test, which explains the factors that determine whether a digital asset is a security or not, showed that many of the tokens out there are securities. Perhaps, the most interesting piece of information in the 13-page document is the one that revealed that companies must have working products before embarking on fundraising campaigns.

Again, this clarification implicates Kik and many of the organizations issuing digital tokens, as it is common practice for startups and established companies to base their ICO campaign on fictional products.

Some history 

To fully appreciate the controversy surrounding the “security” and “utility” conversation, one must take a look at the origin of the Howey test way back in 1946. Back then, a company, the Howey company, introduced an investment scheme that would allow investors to buy a fraction of its orange groves, with the hope of making returns on the profit made from selling the cultivated oranges. 

Following the introduction of this scheme, the SEC, while claiming that the terms of the investment meant that it was security, moved to block the sale. What ensued next was a hard-fought legal battle that dragged to the supreme court. Eventually, the supreme court ruled in favor of the SEC. And so the definition of securities established in this case has since been the de facto framework for defining securities till this very moment. 

The Howey Test: The Fine Line Between a Security Token and a Utility Token - Thought Leaders

No respite for digital (utility) token issuers

The commitment of the SEC to establish a standard and enforce securities laws on firms that had once found a way around regulatory structures will undoubtedly change the outlook of the digital asset markets. While some crypto firms have taken up the defensive stance to fight the imposition of these new directives, others are working closely with regulators to establish clear rules and to guarantee investors protection.

There is no doubt that the present regulation narrative is stifling the growth of the crypto sector in this part of the world, as established companies like Coinbase are yet to find their footings. It does not help that even after complying with the SEC’s regulations, companies have to deal with the various regulatory provisions of each state.

But it is also true that things would have deteriorated had regulators chosen to stay on the sideline. For one, the surge of scams that punctuated the ICO era of 2017 would have continued as investors had no means of ascertaining the legality of tokens. Only now some cases are becoming public, such as notorious ICOBox violating securities laws with its 2017 token sale and further activity promoting other initial coin offerings (ICOs) or an extortion case Nerayoff and Hlady. There are many more cases like this that are yet to become public. The SEC’s primary goal is to protect investors. And as argued by CEO and co-founder of Symbiont, Mark Smith, it is up to firms to look for ways to work with regulators to define the fine line between utility and security. This right here is the step forward, rather than the common practice of bypassing existing laws. 

Nonetheless, if the SEC were to change its stance and introduce new securities laws, creating a subclass of tokens issued to investors to fund for-profit organizations will go a long way to help the watchdog update the 70 years old Howey test. In turn, the establishment of such an asset class will help the SEC to formulate an adequate framework to govern the exchanges and dealers that trade them.

Interestingly enough, the US House of Representatives has taken the initiative to reintroduce a taxonomy act that would exclude digital tokens from the broad definition of securities. To achieve this, the legislators plan on amending the security acts of 1933 and 1934. Having said that, the implication of such a development, which will be treated in a separate article, would kick-start a domino effect. 

Conclusion

SEC’s reinvigorated approach to digital tokens and security laws has not come as a surprise. The ICO abuse of 2017 was just an anomaly brought about by the change of guard in SEC’s leadership after the swearing-in of President Donald Trump. For this reason, digital token issuers must ensure that all their operations fall within the confines of the law, as there are no more free passes. 

We now have 2 great examples of SEC approved Reg A+ compliant offerings: Blockstack and Props

P.S. IT’S OFFICIAL!.Ether is a commodity.

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Binance IEOs Outperform Competing IEO Projects – Thought Leaders

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Binance IEOs Outperform Competing IEO Projects - Thought Leaders

Over the past 12-month IEOs (Initial Exchange Offerings) have replaced ICOs (Initial Coin Offerings) as the fund-raising method of choice for blockchain companies. There are undeniable advantages to IEOs compared to ICOs.

One of the biggest advantages is there’s a reduced risk of investment funds being siphoned from a hacked website. One example of this happening to an ICO is the Etherparty hack whereby hackers discreetly modified the Ethereum address displayed on the ICO website to reroute incoming investments to a Hacker’s Ethereum address.

The barrier to entry to launch an IEO is also significantly higher than an ICO, which is beneficial to investors. Trusted exchanges will (in theory) only list reputable projects after they perform extensive due diligence. Compare this to ICOs, many of which copy and paste existing whitepapers, create fake founder LinkedIn profiles, and then advertise to unsuspecting investors using Google Adwords.

In this sense, IEOs are a much better alternative to ICOs. Investors have a much easier time both accessing the fundraising opportunity as well as funding the investment. This is provided in a safe (but unregulated) environment as provided by the exchange. Different exchanges offer differing parameters for listing an IEO. For instance, we noticed much higher quality IEO listings with market leading exchange Binance, and Kucoin, versus some of the smaller exchanges such as LAToken and Yobit.

While IEOs provide financial benefits to both the host exchange and startups, the same cannot be stated for the financial benefits that are offered to investors. From crunching the numbers IEOs have to date performed poorly.

In researching this article we reviewed IEOs from all major exchanges. Over 50% of the IEOs on smaller exchanges were not listed on CoinMarketCap.

Nonetheless, there were some surprises. While the majority of IEOs performed poorly and provided negative returns on the majority of exchanges, Binance was the odd exchange which actually had a higher number of tokens outperform the market. This was especially true for IEOs launched in 2019.

Below we track the launch date of several IEOs on the Binance exchange, the amount raised, as well as the IEO sale price of each token and the current market value of each token. The reason we do not use market map is that this number is very misleading for investors, as the total market cap includes the entire value of a token project, versus the IEO tokens which were initially sold to investors.

These numbers are based on publicly available data and may not be 100% accurate.

Binance IEOs:

Company:IEO Date:Raise:Initial Token USD:Current Token USD:
BreadDec 201732M0.8550.223078
GiftoDec 20173.4M0.10.017310
BitTorrentJan 20197.2M0.00012 0.000634
Fetch.AIFeb 20196M0.0867 0.061525
Celer NetworkMarch 20194M0.0067 0.005940
MaticApril 20195M0.002630.014397
HarmonyMay 20195M0.00650.008229
ElrondJuly 20193.25M0.00050.001945
WinkJuly 20196M0.000066730.000245
PerlinAugust 20196.7M0.07743 USD0.060321

Unfortunately, other exchanges did not fare so well. Some exchanges performed so poorly with the IEOs that they offered, that we could not find the market value of the tokens listed anywhere.

In conclusion, what is currently more important than the actual project being listed, is where the project is listed. We anticipate that once regulated security tokens increase in popularity, that IEOs may be an enticing option to list these security tokens on regulated exchanges. This would be similar to how stock exchanges currently operate.

Disclaimer: While I have previously held BRD & BTT tokens, in September 2019, I did not hold any of the IEO tokens as profiled in this article.

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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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