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Wednesday, July 17, 2019

Security Token Offerings: They’re Not Just the New ICO


Security token offerings (STOs) are now being widely talked about in the cryptocurrency marketplace. One measure of the clamor surrounding them? Globally, in the first quarter of 2019, there were approximately 135 blockchain industry conferences. The vast majority featured one or more panels and talks on STOs.

The following is a primer on STOs and looks at how assurance is the linchpin to wider issuance and true liquidity.


STO Overview

Cryptocurrencies and blockchain technology remain outside the comfort zone of many finance professionals. The theory and technology are complicated, and the practicalities of using cryptocurrencies require a departure from comfortable finance and accounting processes. New terminology, like “cryptographic keys” and “digital wallets,” can be mystifying.

The same is true for issuers of — and traditional investors in — private securities offerings. Whether private company ownership or income-producing real estate vehicles, issuers and investors are comfortable with the processes they have, and most remain skeptical about this “new thing.”

Basic concepts

Let’s start with a few foundational concepts. STOs are, by their nature, no different from traditional private placement securities offerings. The tokenization part of the issuance can be thought of simply as a digital wrapper.

With this digital wrapper, traditional securities offerings can be transformed. Not necessarily in the sense that the underlying investment structure changes, but rather that securities can become “better, faster, and cheaper.”

Let’s take photographs as an analogy. For most of the twentieth century, photographs required film and expensive development processing. (This is like private placement securities now, which live on paper and require expensive, time-consuming “processing” to issue, maintain and trade.)

Enter digital photography. We still take pictures of our dogs, cats and vacations, but now we take many more pictures than before. We send them to friends and family through apps and upload them to social media. And we back them up to cloud storage in droves.

Securities, like old photos, are typically locked in a physical form, and they are illiquid owing to the need for manual documentation of transfers, etc.

Could securities offerings benefit from blockchain technology in the same way that digital photography and internet connectivity unshackled traditional photography? We think so. We also think that blockchain and tokenization, as enabling technologies, will eventually transform traditional securities offerings and allow for the development of new products.

Indeed, there are already projects today that are working on technology to allow a holder of a security token to take a margin position or a hedge against another security or basket of securities or assets, as well as technology for STO derivatives.

Tokenization

Next, let’s clear the mud around tokenization. There’s a lot of talk about it, and all the buzzwords can make your head spin. So let’s focus on three main points:

  1. The value of tokenization is highest when applied to private securities.
  2. There are generally four categories of private securities at play.
  3. There are specific benefits for both issuers and market participants.

The Focus Is on Private Offerings

Private and public securities are both investment contracts, but they issue, trade and settle in the real world in different ways.

Although blockchain technology and tokenization will be applied to public securities to increase administrative efficiencies, the paradigm-shifting value will be realized when the tech is applied to private securities offerings and secondary markets.


The Four Main Buckets of Private Securities

Orange bucket icon

Shares & share-
like securities

Green bucket icon

Asset-backed
securities

Purple bucket icon

Bonds & debt
securities

Red bucket icon

Venture capital



Shares and share-like securities

These include private company ownership. Share-like STOs have great potential to create immediate liquidity for an issuer, and to alleviate significant administrative burden for things like cap table management and tax compliance.

Managing the cap table, now a burdensome and time-consuming process, could be done by a management consultant with the right skills and technology to read from a blockchain node.

Other ongoing operations, such as vesting schedules, governance rights and dividend distributions, could be automated and controlled using wallets and smart contracts.

We see great potential in our business to welcome these changes. We are already laying the groundwork through our Blockchain Lab to solve problems like cap table management on public blockchains.

Asset-backed securities

These represent a large category of offerings that include trust, partnership and corporate legal structures to hold underlying assets and associated tax structuring for dividends and capital gains.1 One asset in particular jumps out as a perfect application for tokenization: income-producing commercial real estate.

Armanino has a large real estate practice, providing tax strategy, compliance, and assurance and audit services to large funds and owner-operators, as well as lenders. We are hearing mixed feedback from this group about tokenization.

As noted earlier, many don’t see a need to change what works. Others are very excited by the potential to improve the ease and cost of capital formation while reducing some administrative burdens. Even the enthusiastic ones, however, see hurdles that remain before this promise can be fully realized.

Bonds and debt securities

The Securities Industry and Financial Markets Association (SIFMA) categorizes bonds into treasury bills, corporate debt, mortgage-related notes, municipal bonds, money markets, agency securities and asset-backed securities.

In 2017, the overall U.S. bond market was an estimated $39 trillion. Generally, the U.S. bond markets dominate internationally and represent about 45% of global markets.2

Here again, the distinction between public and private securities is important. For this analysis, the focus is on privately issued instruments, not federal, state or municipal bonds.

Within each category of debt security there are myriad considerations about whether tokenization can make the security “better.” For instance, bonds on company debt could be an attractive area for tokenization for investors and corporate issuers.

Private companies would be able to undertake capital formation while reducing issuance and underwriting costs, and lock in favorable terms, thus allowing bondholders to trade freely in and out of the investment. In some instances, however, the liquidity promise of tokenization may not offer a paradigm-shifting value.

Indeed, private bonds with fixed terms offer the repayment of principal and interest on a predetermined payment schedule, allowing an investor to lock in returns and avoid interest rate exposure. If a corporate bondholder were to take their coupons to trade on the secondary market, the market would apply discounts (or premiums) depending on the prevailing interest rate.

Therefore, on average, private company debt may be a class of debt securities that generally doesn’t need liquidity if investors are holding to realize par value return. But if one were to assume a rich marketplace, perhaps supported by a technology platform that allowed investors to assess and trade in bond tokens, then the conclusion above could be proven wrong.

Currently, retail investors make up about 10% of bond market participants. The other players are large mutual funds, as well as institutional investors who buy and sell through brokers and decentralized over-the-counter (OTC) desks.

Venture capital

While venture capital (VC) funds could probably fit under the umbrella of share-like securities described above, we’ll look at them separately, as there has been some interesting activity in this area.

Specifically, a number of crypto-native VC funds have tokenized. The tokenization of these funds has been instructive and exciting because it shows us what is possible, but we don’t think the funds have achieved the promise of STOs generally because there is very little liquidity.

There are many possible reasons for this. One is that VC, in general, is not the best use case for tokenization because capital recipients are actually interested in locking up not only the capital, but also the investors themselves.

Admittedly, tokenization can allow for frictionless voting or deployment of capital in the VC use cases. The other use cases mentioned above don’t rely on investor identity to derive any value.

This leads to the question: Can tokenization work well in VC scenarios at the fund level? We think so. Indeed, this is perhaps a better model altogether, as the purpose is simply to generate and deploy capital, not necessarily to obtain the most influential and connected VCs (i.e., lock in the identity of the investor).

In today’s market, at the fund level, low liquidity would seem to be the result of two factors: first, market depth (not enough kids in the pool yet), and second, time to returns (VC has a long life cycle and these funds aren’t likely to pay strong dividends regularly).


Benefits of Tokenization: The Promise

Clay Collins of Nomics, a crypto asset data company, has done a lot of work on STOs and their implications for the future of securities. Collins breaks the benefits of tokenization into nine categories. We think there are a few more, which round out our list below.3

Graph Icon 1. Increase liquidity and market depth Fingerprint icon 8. Maintain the cap table for private companies
Networking icon 2. Remove liquidity discounts, realize liquidity premiums Table icon 9. Reduce the cost of tax compliance and cap table reporting
Gear head icon 3. Open the door for new products People search icon 10. Provide cap table analytics to public companies
Checklist Icon 4. Automate tax compliance and dividend payments, allow for “compliance in the code” Building icon 11. Allow for fractional ownership of property like paintings and fee interest in real estate
Smiley icon 5. Give control back to security owners Stopwatch icon 12. Reduce settlement times from days to minutes
Cash Icon 6. Increase the number of liquidity options for security owners Dollar icon 13. Make it cheaper to go public
Bitcoin icon 7. Remove rent-seeking intermediaries Handshake icon 14. Increase opportunities and reduce cost of capital formation

Below we examine some of these benefits in more detail.

Graph Icon 1. Increase liquidity and market depth

Liquidity — an often used and sometimes abused term — is an imprecise measure of whether a given security can be bought and sold easily and quickly. What qualifies as “easily and quickly” is not always clear. In some cases, private securities can be harder to sell or liquidate than a piece of real property (such as a single-family home) because of “market depth.”

If there is enough supply and demand to allow a current market participant to sell, or a new market entrant to buy, then there is market depth, and thus some level of liquidity.

Real property is not typically categorized as a liquid asset, nor are private securities, because — even where there is market depth — matching buyers and sellers requires marketing and searching, deal assessment and pricing, and intermediaries, as well as transaction costs and settlement or closing costs.

Tokenization can make illiquid assets and ownership structures easier and quicker to buy or sell. Blockchain technology as an enabler is incredibly powerful in this regard. But wrapping an asset or an ownership structure (security) in a digital wrapper does not itself create the market depth needed for liquidity.

You can count the number of security offerings on your hands and toes at this point, so we can reasonably say that there is not yet significant market depth. The order books for secondary trading are thin. Thus, subscribers to a tokenized security offering may be able to trade “easily and quickly” with other existing/whitelisted subscribers, but this fact is more about ease of transferability than true liquidity.

In addition to market depth, liquidity of securities in secondary markets is partly dependent on the historical performance of those securities, the valuation of underlying tangible and intangible assets, income streams, etc. Therefore, assurance plays a key role in market depth.

We can make a simple analogy to public markets and imagine today’s markets without quarterly and yearly filing of audited financial statements with the SEC. Market depth would drastically reduce — as would prices for public stocks. Investors seeking returns would instead look for vehicles with higher levels of assurance.

Networking icon 2. Remove liquidity discounts, realize liquidity premiums

Within the billions of dollars of private securities, there are incredibly valuable investments, from trophy real estate to equity in profitable business ventures.

But when investors want to move their principal and deploy that capital for other means, they face an uphill climb. While it is possible for an investor to liquidate their position in private placements, this liquidation price is often discounted by the buyer to account for transaction costs and risk.

Even when a great deal is given a digital wrapper, lowering transaction costs in some measure, there remains the buyer’s calculation and pricing of risk. In our estimation, much of the risk calculation stems from many private placements lacking reliable, transparent, third-party assurance in the form of audits or reviews.

If the digital wrapper were combined with more available information (net asset value, real estate valuation, validation of income streams, expenses, etc.), then the liquidity discount problem could truly be solved.

Here again, assurance is key to realizing the promise of tokenization of security offerings. But another fascinating issue is at play: interest in transparency. There are a multitude of use cases, specifically with share-like tokens, where an issuer or business may be very wary of creating transparency into their strategic roadmap, or their margins, or other financial performance.

Gear head icon 3. Open the door for new products

When the motive is profit, human ingenuity abounds. The products that have been developed as complements to the STO market are still nascent, but many are interesting. From derivatives to hedging, insurance, and even margin offerings, the ability to digitize a private security offering opens the door to a host of new financial instruments.

Checklist Icon 4. Automate tax compliance and dividend payments, allow for “compliance in the code”

In today’s non-tokenized private securities world, the calculation and payment of dividends, the calculation and remittance of tax withholdings, and compliance with U.S. securities laws for issuance and secondary transfers, are all intensive and mostly manual processes.

One area in particular — regulatory compliance with secondary transfers — consumes many hours and dollars for issuers, fund managers and counsel. So, is “compliance in the code” a reality, a potential future, or just a buzzword?

Compliance in the code is already here, and while there is only as much compliance in the code as there are actual STOs (still not a lot), it is very much a reality. Compliance in the code in its simplest form deals with two key areas: (1) the qualifications and identity of the investor, and (2) the transferability of the security interest on the secondary market.

With respect to the qualifications and identity of the investor, current technology platforms aiding STO issuance are already building controls into their technology offerings for accredited investors (see Rules 501 & 506 of SEC Regulation D).

Similarly, STO issuance platforms are already solving the problem of transfer restrictions using whitelisted addresses/wallets, as well as smart contracts that define trading lockup periods. On this second point, there is a transformational efficiency to be gained.

Take the case of a Regulation D offering in a mortgage-backed securities pool, where the issuer remains responsible under U.S. law for the issuance and secondary market sale of the securities. Rule 144 categorizes an investor’s sale of a security interest they own on the secondary market as an offering governed by SEC rules, so investors must work with issuers to sell securities to another qualified investor.

A tokenized security can have a code-level restriction or control built in to limit transfer of a security only to wallets and investors that are both properly accredited and have passed anti-money laundering and know-your-customer (KYC) review. So the burden on the issuer or fund manager to manually vet the accreditation and identity of the new investor is reduced.

Smiley icon 5. Give control back to security owners

Cash Icon 6. Increase the number of liquidity options for security owners

Bitcoin icon 7. Remove rent-seeking intermediaries

Those who believe strongly in the decentralization and democratization of our current financial system will tell you that ownership and control of one’s own private cryptographic keys is a fundamental principle, allowing the individual to be a self-sovereign who controls their financial freedom.

Others would argue that more centralized solutions for the custody of digital assets allow users the same end results, but with more security. (And if you put these two at a bar together, they would go around and around on this very topic...)

What is undisputable is that the current way many leading security token platforms are aiding in the issuance of security tokens is increasing the security owner’s control over the digital assets, because the owners will hold the private keys.

As mentioned earlier, tokenization of security interests hasn’t been accomplished at high volume or scale yet, and much of the infrastructure to support STOs is still being built. If it all shakes out as designed, however, investors could reduce the number of intermediaries needed to buy, trade or encumber their own digital assets.

Specifically, tokens can be bought and transferred to a new owner’s whitelisted wallet address in a matter of minutes, without the need for expensive legal drafting, escrow, etc. Furthermore, secondary trades can also take place without the traditional encumbrances that make trading private paper so costly today.

Fingerprint icon 8. Maintain the cap table for private companies
Table icon 9. Reduce cost of tax compliance and cap table reporting
People search icon 10. Provide cap table analytics to public companies

Blockchains present “state.” This could be the state of transactions in a shared ledger, or the state or number of a given token in circulation. Cap table management deals with the “state” of ownership at a point in time. Simply put, this may be one of the best uses for a public blockchain network (second to monetary transfers, of course) because it is analogous to simple money transfer.

While we believe the administrative efficiency of cap table management in the early days of STOs will still require a deep expertise, the future is almost certain to hold a number of programmatic options that will reduce the cost of cap table management significantly.

Similarly, future software solutions offer the promise of cap table analytics that will empower issuers with insights into the identity of security owners, secondary trade pricing, trade volumes and more.

Building icon 11. Allow for fractional ownership of property like paintings and fee interest in real estate.

Stopwatch icon 12. Reduce settlement times from days to minutes

Dollar icon 13. Make it cheaper to go public

Handshake icon 14. Increase opportunities and reduce cost of capital formation

Finally, tokenization of private securities offers the potential for issuers to cast a wider net and draw capital from currently untapped sources. While doing so, issuers can also lower costs by leveraging an issuance platform and the marketplace these tech providers are building.

If issuers can cast a wider net, there is also hope that tokenization can do some good and democratize access to investment opportunities that have for so long been out of reach for the average person.



1 An important distinction here is that a tokenized asset is not necessarily a security. See SEC v. Howey Co., 328 U.S. 293 (1946). Some examples might include tokenized fractional ownership of a rare collectible, artwork, collection of classic cars or the like. If the token is simply used to represent ownership of the asset, and not an investment contract where money is invested in a common enterprise with the expectation of profits from the efforts of others, then the token is not a security.
2 SIFMA Statistics. Archived copy from the original on 2016-11-21. Retrieved 2013-07-10.
3 For a good listen, please check out his Flippening podcast.

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