2019 is widely anticipated by blockchain bulls to be the year of the security token. In Instalment 1 of this 4-part series, we described how security tokens are created through strong cryptography, able to digitally represent ownership in an asset, such as shares in a company or fund, real estate, rights to cash flow or financial instruments. In Instalment 2, we looked at how security tokens are generated on Ethereum-based platforms employing blockchain technologies. In Instalment 3, we observed how new regulatory frameworks for these new securities called “security tokens” do not yet exist – that the issuance and exchange of security tokens is being conducted under existing, traditional securities laws of registration and exemption, while complying with comprehensive, overlapping, global anti-money laundering/sanctions regimes. Today’s concluding segment previews what lies ahead in the coming months for security tokens.
Exchanges, Trading and Liquidity.
Markets can only operate effectively with liquidity. The creation, i.e. issuance, of a security token is a preliminary step, giving birth to the token. But for securities markets and security tokens to live meaningful lives, there must be robust secondary trading via exchanges which is fully-automated, reliable, inexpensive, scalable, rapid in trade and settlement, compliant, always-on, global. Just as company stock issuance boomed with the development of centralized stock exchanges, so too the security token industry would flourish as decentralized security token exchanges develop. “Build it and they will come” is the mantra that is usually mocking engineers who build nifty technology and assume without any basis in market reality that everyone will want to buy it because it is nifty. However, if people want to trade security tokens, this mantra is in fact true for security tokens exchanges: demand will follow supply. Building security tokens exchanges and secondary markets requires enormously complex business, legal and technical collaborations married to massive amounts of capital, but in the coming months we will see beginnings of this integration of blockchain markets into traditional finance.
In Europe, most notably Switzerland’s stock exchange owned and managed by SIX Group is building a fully-integrated trading, settlement and custody infrastructure for digital assets, known as a ‘digital asset ecosystem’ – SIX Digital Exchange. SIX (acronym for Swiss Infrastructure and Exchange) operates the infrastructure of Switzerland’s financial center. In USA, the Boston Stock Exchange and subsidiary BOX Digital Markets have announced a partnership with token platform tZero to launch the world’s first regulated security tokens exchange Q2-19.
tZero is championed by super crypto-bull, Patrick Byrne, CEO of parent company, Overstock.com. Byrne is committed to integrating blockchain capital markets into the US National Market System (NMS). Byrne is, in effect, staking Overstock’s future on tZero, which is burning at least $2 million per month. “I don’t care whether tZero is losing $2 million a month, “Byrne was quoted yesterday in the Wall Street Journal. “We think we’ve got cold fusion on the blockchain side.”
This is the creed of blockchain True Believers, which is powering the development of security token infrastructure. Like other blockchain-related infrastructure companies, Overstock raised capital from the sale of its own security tokens: $134 million to be exact. Mr. Byrne is not alone, as investors and blockchain pioneers charge ahead. The Wall Street Journal reports in its article that, according to Overstock, Hong Kong-based GSR Capital has agreed to invest up to $270 million in tZero equity that would value tZero at $1.5 billion. GSR would not confirm this claim to the Wall Street Journal.
Security Tokens Issuing Platforms.
Security tokens issuing platforms are daily becoming faster, cheaper, smarter. Decentralized applications (DApps) with back-end code are being developed in every part of the globe where there is a developer-grade internet connection. Several outstanding, mostly USA-based, Ethereum platforms issue tokens, and manage the investor process and the tokens through the lifetime of the asset, such as Securitize, Harbor, Securency, Swarm and Polymath (Canada). tZero expects to be handling token transactions by Q2-19, beyond issuing and managing, as well as offering an alternative trading system moving into other investment sectors such as debt, real, estate and other tokenizable asset classes.
European platform, Token Market, based in Gibraltar, [disclosure – client of the writers]has this week become live as the first security tokens issuing platform offering to public retail (as distinct from private) investor markets. Token Markets was selected by the UK regulator to assist in carrying out security tokens offerings to test, measure and develop issuance of digitized equity in UK. Lithuanian platform, DESICO plans in 2019 to launch a securities exchange that will provide immediate listing and liquidity for security tokens, operating in conjunction with the Bank of Lithuania.
Impressive platforms with breakthrough architecture/technology may move beyond Ethereum technology. EOS is believed by many in the longer term to eclipse Ethereum with higher scalability and lower cost. Distributed platform Cardano claims to be more scalable and more decentralized than Ethereum, as it scales through side-chains/horizontally. Cardano, administered by the Cardano Foundation in Switzerland, was created in Hong Kong, and is led by Charles Hoskinson, co-founder of Ethereum.
Financial services represents about 15% of the world economy; inevitably, significant portions will be digitized and integrated. Though counter-intuitive to some, in financial services industries intensive regulation and strict enforcement are key to establishing confidence, orderly operation and mass adoption. The stringent regulation and enforcement governing financial markets in the USA have helped make the USA financial markets the envy of the world, the model to emulate. Securities industry regulators are the critical partners in any development of the security tokens industry. All stakeholders, aware of this, – cheer regulators on to action, or condemn their inaction.
In coming months, there will be significant step-up in activity by issuers and investors under existing global securities regulation, smart contract-auditing procedures and disclosure practices, and evolving regulation of the blockchain-related ecosystem. Enormous investments of time and acquisition of domain expertise are required for regulators to understand sophisticated systems, methods of capital formation and investor interfaces, and the complex financial services implications that flow from their deployment and development. The SEC, for example, by its FinHub is committing considerable resources to engaging ecosystem players. In addition to being a resource for the industry providing information about the SEC’s views and actions in the FinTech space, FinHub is a forum for SEC staff to engage the public
UK has shown aggressive innovation in crowdfunding by providing exemption for equity offerings up to EUR8 million, stimulating the crowdfunding industry. It came as no surprise when UK regulators (Financial Conduct Authority) recently launched a dedicated regulatory sandbox which includes exchanges for security tokens. Successful applicants benefit from lower regulatory thresholds and receive direct guidance from the regulator, while the FCA gains confidence and understanding working with new financial technology and processes.
Gibraltar, a first-mover in legislation for digital assets, is the world’s first jurisdiction to license distributed ledger technology for blockchain and fintech businesses. Next month, Gibraltar is publishing shovel-ready legislation for security tokens compliant with all EU directives, the fruit of unified efforts of Gibraltar regulators and local industry experts.
Security tokens are theoretical game-changers for financial and ownership models, allowing any asset or fund to offer equity, debt, full or partial ownership or revenue share. Bulls and bears abound. For investors security tokens are secure, virtually incorruptible, and accessible to trade by anyone with an internet connection. In the longer term of three to five years, comprehensive fintech banks will have to emerge to conduct the securities token industry to act as traditional investment banks performing funding, underwriting, compliance, retail distribution, analysis, legal and advisory functions to manage processes, because the development of the security tokens industry going forward is about 20% technology, and about 80% regulatory/business. If security tokens will continue to provide access to compliance features for issuers, signs of liquidity for investors and a framework for oversight to regulators, then 2019 could belong to the security token.
Omri Bouton co-wrote this. We are both at Hassans.
Recommended reading for further research:
- The Security Token Thesis Professor Stephen McKeon (Advisor to Harbor, Inc.)
- What are Securities and Security Tokens? Mikko Ohtamaa (CTO Token Markets)
- StartupEngine Summit – Tokenizing the World, with excellent panels from StartEngine conference October 19, 2018 Los Angeles
- Overstock Founder Bets on Blockchain, Not Bedsheets, Wall Street Journal November 23, 2018
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