Tokenized Securities

Growing Opportunity at the Intersection of Blockchain Technology and Business Strategy

Mar 10, 2021

Introduction

The intersection of blockchain technology and business strategy has opened up a growing opportunity in the form of tokenized securities, including Security Token Offerings (STOs). These securities, represented by cryptographic tokens on a blockchain, provide a unique approach to ownership and transactions. By encoding ownership in a token, commonly known as a "security token," tokenized securities offer advantages in capital formation and asset liquidity.

A security token represents real-world assets such as stocks, bonds, or assets backed by tangible items like real estate, art, or precious metals. Unlike traditional financial markets, where contracts are entered into by investors, security tokens execute contracts on the blockchain, with ownership rights validated by the consensus mechanism.

What sets security tokens apart is their customizability, enabling them to incorporate utility functions, preferential platform access, early feature access, or loyalty benefits. The blockchain's permissionless nature, combined with the flexibility of security token development, means that the benefits offered to token holders are limited only by the issuer's imagination and risk tolerance.

In this article, we will delve deeper into the concept of tokenized securities, including Security Token Offerings (STOs), exploring their potential, benefits, and the implications they have for both investors and businesses. We will examine the role of blockchain technology in facilitating this innovative financial approach and discuss the evolving landscape of tokenized securities, highlighting STOs as a significant opportunity for businesses at the intersection of blockchain and traditional finance.

Use Case Examples

☑ Private REIT Liquidity

· Old Thinking ¯\_(ツ)_/¯ ❝Illiquidity makes private REITs hard to buy and harder to sell in an industry still running on spreadsheets and fax machines.❞

· New Thinking 📈 ❝Asset tokenization transforms REIT shares into security tokens that facilitate paperless trading among LPs. Cap table automation saves time. Broker disintermediation cuts costs. Security tokens can serve as loan collateral for stablecoins and cash liquidity.❞

☑ Early-stage funding ─ Reg D 506(c) STO (Security Token Offering)

· US & foreign issuers can raise any amount from accredited investors.

· Typical raise of $500,000 to $2 million

· Low costs for legal fees, audits, investor onboarding

· Multi-year fundraising window

☑ Reg A+ STO (aka ‘tokenized mini-IPO’)

· US & Canadian issuers can raise as much as $50 million from accredited and ‘Main Street’ investors.

· Typical raise of $8 million to $15 million

· Significant costs for legal fees, audits, investor onboarding

· 1-year fundraising window

The Securities Tokenization Process

➊ Asset tokenization converts traditional shares into tradeable digital assets known as security tokens.

➋ Smart contracts automate investment contracts, shareholder caps, and lockup period compliance.

➌ Cap table automation simplifies administration tasks like disclosures, consents, distributions, and voting.

➍ Paperless trading among LPs can be authorized case-by-case or allowed more broadly.

➎ Listing on an Alternative Trading System (ATS) may increase exposure and reduce illiquidity discounts.

➏ A well-timed listing on a security token exchange can facilitate price discovery and support Net Asset Value (NAV).

Security Tokens vs. Utility Tokens

Security Tokens:

Bridge the gap between blockchain and traditional investments.
Represent a tangible stake in a company’s assets, granting investors a stake in a company’s stock, liabilities, profits, or investment fund.
Provide investor protections.
Align with securities laws and regulatory restrictions.

Limited to accredited and institutional investors

Buyers undergo KYC, AML, and investor accreditation checks.

Issuers disclose information via documents such as a prospectus.

Lockup, trading, and transfer restrictions

Utility Tokens:

Primarily used for crowdfunding and attracting startup funding
Appeal to a broader market
Provide access to a company’s products or services on a blockchain platform
Do not represent ownership or offer dividends
Have few regulatory restrictions
Lack the same level of investor protections
Often trade outside regulatory oversight

Advantages of STOs

Within the cryptocurrency realm, “STO” has become the latest buzzword. Security token offerings (STOs) are an effective method for raising substantial amounts of capital and a more cost-effective alternative for venture capital and private equity groups to issue shares. Tailored security token protocols, such as dividend tokens, tokens with limited transferability, and non-fungible tokens linked to physical assets, provide added flexibility and functionality to STOs.

Deciding if an STO is Justified

While STOs offer the potential for significantly larger fundraising than ICOs, they come with legal and regulatory requirements. Therefore, an STO is typically justified if the issuer meets one or more of the following conditions:

High-growth
Generates $10 million or more in revenue in one year
Operates internationally
Seeks institutional funding
Prefers a transferable asset over a utility token
Desires high liquidity

Key Considerations for STOs:

Cost: Costs range from $150,000 to $500,000, excluding salaries. Allocating a sizable part of the budget to marketing is crucial for building a trustworthy brand. Brand management, website development, roadshows, PR, investor outreach, influencer outreach, and social media marketing typically consume half the budget.

The remaining funds cover white paper drafting, tokenomic design, token coding, security audits, test-netting, legal fees, and KYC/AML compliance auditing and reporting. Established companies can fund these costs internally, while growth-stage companies may need to raise funds in a seed round before the STO launch.

Team Formation: A dedicated team with a history of successful business plan execution is essential, drawing from diverse professions such as accounting, blockchain development, legal, sales, and marketing.

Legal Services: Legal services play a critical role in an STO project, including white paper review, employment agreements, private-placement memorandum (PPM) drafting, advisory agreements, compliance, and due diligence provisions.

KYC/AML: STOs must comply with KYC/AML regulations to ensure regulatory compliance throughout the token lifecycle. Crosschecks for politically exposed persons (PEPs) and sanction lists are essential. Resale restrictions encoded in smart contracts can prevent covert token redistribution for at least one year.

STOs for Growth Companies

The capital provided by Wall Street and Silicon Valley is often insufficient to meet the funding needs of all growth-stage companies. However, security token offerings (STOs) are emerging as a viable solution for online capital formation in the remaining growth funding marketplace. As a result, the number of startups surviving and thriving on STO funding will increase.

Advantages of STOs for Founders

Security token offerings provide access to institutional capital previously limited due to regulatory constraints. They enable traditional capital to flow into the blockchain sector. STOs also offer a new way of marketing offerings, using the global reach of online advertising networks and affiliate programs. Moreover, founders can keep control and avoid short-sighted decisions often driven by venture capitalists seeking quick exits. Additionally, security token offerings generally attract higher valuations.

Asset-Backed STOs

Tokenization presents a significant opportunity for established companies that hold trillions of dollars in assets. The global value of public and private equity assets is approximately $90 trillion, while real estate assets amount to around $270 trillion worldwide. Most of these assets are tokenizable. Additionally, debt securities such as bonds and debentures are tokenizable. The possibility even exists for the tokenization of government debt in the future.

Equity fund tokenization advantages:

Real-time Cap Table Reconciliation: Computer code allows for the seamless reconciliation of cap tables, providing real-time updates and accurate ownership records.
Asset Interoperability: Through the ERC-20 standard, equity tokens can be easily exchanged and integrated with other platforms, enabling 24/7 market trading with fast settlement times and minimal transaction costs.
Enhanced Features of Security Tokens: Security tokens offer distinct advantages over utility tokens, such as customizing token lockup periods (vesting) and automating dividend distributions.
Investor Protection: Security tokens operate within a regulatory framework, ensuring investor protection through compliance with securities laws.
Global Accessibility: Security tokens trade globally, enabling companies to access a larger pool of investors and increase liquidity.

By leveraging these functionalities, equity fund tokenization provides improved transparency, liquidity, and efficiency in the trading and management of assets.

Drawbacks of STOs

Regulatory Compliance: Security token offerings are subject to regulatory compliance, which can be complex and time-consuming. Issuers must navigate various legal requirements, such as registration, licensing, and disclosure obligations, to ensure compliance with securities laws in their jurisdictions. Compliance can add significant costs and delays to the STO process.

Limited Investor Pool: While security tokens have the potential to attract institutional investors and expand the investor base, they may still face limitations in terms of accessibility for retail investors. Regulatory restrictions, accredited investor requirements, and the need for digital wallets or specialized platforms can limit the participation of smaller investors.

Market Volatility and Liquidity: Security tokens can be subject to market volatility like other cryptocurrencies. The liquidity of security tokens may also be lower than traditional securities, especially for tokens issued by early-stage companies or those operating in niche markets. Low liquidity can pose challenges for investors looking to buy or sell tokens at desired prices.

Investor Education and Awareness: Security tokens are a relatively new investment instrument, and many potential investors may need to become more familiar with the concept or the underlying blockchain technology. Educating investors about security token benefits, risks, and mechanics is essential but challenging.

Limited Secondary Market Infrastructure: While the blockchain provides the potential for more efficient and accessible secondary markets, the infrastructure for trading security tokens is still developing. Traditional stock exchanges are exploring the integration of security tokens, but widespread adoption and liquidity in secondary markets still need to be fully realized.

Security and Regulatory Risks: The digitized nature of security tokens introduces cybersecurity risks and vulnerabilities. Hacking attempts, smart contract vulnerabilities, and other security breaches can result in financial losses and damage to investor confidence. Additionally, evolving regulatory landscapes and potential security law changes can introduce uncertainties and affect the viability of security token offerings.

Market Perception and Stigma: Despite the advantages of security tokens, the broader market perception of cryptocurrencies and ICOs may affect the perception of STOs. Skepticism, regulatory concerns, and past instances of fraudulent ICOs create a stigma that issues must overcome to gain wider acceptance and adoption of STOs.

It’s important to note that while STOs have drawbacks, they also offer significant potential for fundraising, liquidity, and asset tokenization. As the technology and regulatory frameworks evolve and issuers address these challenges, STOs will become a more attractive option for companies and investors.

STO Infrastructure and Platforms

Infrastructure to support security token offerings and the public trading of security tokens is under development. Dedicated STO platforms include Polymath, Harbor, Securrency, Securitize, Swarm, and tZero.

We may soon see assets like equity, debt, real estate, and derivatives tokenized and sold via STOs. A private equity fund can tokenize its assets into tradable coins, thereby locking in investor capital without locking in the investors themselves. The resulting increase in market depth yields a liquidity premium in place of an illiquidity discount.

ICO launch platforms like Ethereum, Neo, EOS, and Hyperleder are not well-suited for STOs.

Platforms specifically designed for security token offerings include Polymath, Harbor, Securrency, Securitize, Swarm, and tZero. These STO launch platforms strive to offer an intuitive GUI to code smart contracts for offering start/end date, KYC/AML whitelisting, payments interoperability (ETH or other), soft and hard cap, and token holder rights.

Hybrid STO platforms will enable both security tokens issuance and trading. Security tokens can be trialed on the Ethereum testnet before the STO goes live. APIs and abstraction layers can supply the smart contract “plumbing” to extend an STO project team’s vision onto various blockchain standards.

KYC/AML Infrastructure

KYC/AML procedures typically involve collecting and verifying identity information and cross-checking against PEP and sanction lists. Security token offering platforms can manage the classification of prospective investors into internal whitelists and blacklists, while added risk mitigation may require human-reviewed assessments.

Establishing a robust KYC/AML infrastructure involves balancing maximizing investor acquisition and minimizing regulatory and internal risks. Rather than considering KYC/AML as an operational obstacle, project teams should recognize its importance for the project’s long-term health and fundraising success.

Poor execution of KYC/AML can lead to regulatory scrutiny, damage the project’s reputation, and discourage potential investors, partners, and advisors. Compliance with KYC/AML ensures not only regulatory adherence but also provides valuable insights into investors and customers, enabling informed business practices and decisions.

Security token issuers should proactively implement KYC/AML protocols to reduce operational and regulatory risks. Even if they operate in jurisdictions with lenient ICO KYC/AML requirements, they must prepare for retroactive compliance mandates imposed by regulatory bodies. Regulators currently overlooking certain ICOs may eventually classify their tokens as securities.

Implementing a best-in-class KYC/AML system helps onboard investors who meet risk appetite parameters and compliance requirements. This semi-automated system efficiently routes low-risk prospects to a whitelist, subjects unknown individuals to extended due diligence on a gray list, and flags high-risk individuals such as politically exposed persons (PEPs) or those on sanction lists as blacklist candidates.

While many regulatory jurisdictions are still setting up rules for token offering KYC/AML auditing and reporting, token issuing companies must adhere to KYC and AML audit reporting requirements imposed by an increasing number of regulators. Without such measures, token sales and cryptocurrency markets would remain vulnerable to criminals looking to transfer funds discreetly across borders.

Token issuers should stay ahead of regulatory requirements, expecting that KYC/AML standards will align with securities issuance regulations and potentially apply retroactively to previously issued tokens.

Automated KYC/AML Compliance

In the future, crypto projects may have access to turnkey launch platforms that facilitate the creation of web-based KYC/AML interfaces. These interfaces can seamlessly integrate with the project’s main website, maintaining brand alignment and carrying over legal requirements, disclaimers, and social media feeds. KYC/AML APIs will enable real-time risk scoring, dissuading potential fraudsters from trying to onboard.

The API will integrate facial recognition, ID verification, GDPR compliance, and alteration and forgery screening. Admin dashboards will allow calibration of risk profile tolerance, while smart filters will efficiently sort token sale buyers based on reputation scores.

Conclusion

The token sale industry is entering a phase of maturity and regulation. With the rise of “security ICOs,” more commonly known as Security Token Offerings, a new era is upon us.

The increasing emphasis on compliance and investor protection signifies a positive shift towards a more regulated and trustworthy market.

As the industry continues to evolve, token issuers, investors, and regulatory bodies must work together to shape a sustainable and secure ecosystem for token sales.

By embracing these changes, we can unlock the full potential of blockchain technology and realize the benefits of tokenization in various asset classes.

The golden era of STOs is now within reach, and it holds great promise for the future of finance and investment.

Jay Derenthal