Tokenized Securities
Growing Opportunity at the Intersection of Blockchain Technology and Business Strategy
Jay Derenthal
Below are three examples illustrating how blockchain technology facilitates capital formation and asset liquidity, followed by a look at the securities tokenization process.
☑ 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 $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 $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 Each security token automates 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).
Understanding Security Tokens
In simple terms, security tokens are cryptographic tokens that represent real-world assets such as stocks, bonds, or assets backed by real estate, art, or precious metals. In traditional financial markets, investors enter into a contract when they buy a security. In the case of security tokens, this contract executes on the blockchain, with the consensus mechanism validating ownership rights.
One of the advantages of security tokens is their customizability, allowing them to incorporate utility functions, preferential access to platforms, early feature access, or loyalty benefits. The blockchain’s permissionless nature, coupled 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.
Security Tokens vs. Utility Tokens
Security tokens, such as those offered through security token offerings (STOs), are considered investment vehicles. They give investors a vested interest in a company’s stock, liabilities, profits, or investment fund. Security tokens are subject to regulatory restrictions and require disclosure of information from the issuer. They offer investor protections and trade within regulatory frameworks.
Utility tokens, on the other hand, are primarily used to access a company’s products or services on a blockchain platform. They do not represent ownership in a company or offer dividends. Utility tokens are often issued through initial coin offerings (ICOs) and are unsecured by promissory notes or bonds. They can trade freely with fewer regulatory restrictions.
Security tokens are subject to trading restrictions and can only be purchased by accredited and institutional investors. Parties acquiring security tokens undergo Know Your Customer (KYC), Anti-Money Laundering (AML), and investor accreditation checks.
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 additional flexibility and functionality to STOs.
Determining 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
- 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 significant portion 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 of 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 strong team with a track record 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 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 is expected to 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, leveraging the global reach of online advertising networks and affiliate programs. Moreover, founders can retain 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 worth of 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 can be tokenized through STOs. Additionally, debt securities such as bonds and debentures can be transformed into tradable assets. The possibility even exists for the tokenization of government debt in the future.
Equity fund tokenization offers several other advantages, including:
1. Real-time Cap Table Reconciliation: Computer code allows for the seamless reconciliation of cap tables, providing real-time updates and accurate ownership records.
2. 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.
3. Enhanced Features of Security Tokens: Security tokens offer distinct advantages over utility tokens, such as customizing token lockup periods (vesting) and automating dividend distributions.
4. Investor Protection: Security tokens operate within a regulatory framework, ensuring investor protection through compliance with securities laws.
5. 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
1. 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.
2. 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.
3. Market Volatility and Liquidity: Security tokens, like other cryptocurrencies, can be subject to market volatility. 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 seeking to buy or sell tokens at desired prices.
4. Investor Education and Awareness: Security tokens represent 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.
5. 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.
6. 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 impact the viability of security token offerings.
7. Market Perception and Stigma: Despite the advantages of security tokens, the broader market perception of cryptocurrencies and ICOs may impact 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, such as Polymath, Harbor, Securrency, Securitize, Swarm, and tZero, are specifically designed for security token issuance.
We may soon see a broad array of assets like equity, debt, real estate, and derivatives being 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 provide 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 classifying prospective investors into internal whitelists and blacklists, while additional 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 establishing 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 seeking to transfer funds discreetly across borders.
Token issuers should stay ahead of regulatory requirements, anticipating 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 attempting to onboard.
The API will integrate facial recognition, ID verification, alteration and forgery screening, and GDPR compliance to ensure data protection. 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.
Article by Jay Derenthal
