2019 Crypto Security Token Wave: Are Tokenized Securities the Way of Finance’s Future?

Everything You Need To Know About Tokenized Securities: Are They The Way Of The Future?

Today, securities are not typically tokenized. You can’t buy a share of AAPL, for example, like you would buy a token. However, that could change in the future. Analysts expect Security Token Offerings, or STOs, to change the world of finance within the next few years.

Are tokenized securities really coming? What kind of changes can we expect when tokenized securities arrive? Anthony Pompliano, founder and partner of Morgan Creek Digital Assets, recently tried to answer these questions in a blog post. Today, we’re explaining everything you need to know about tokenized securities.

Tokens Can Have Three Functions

A couple years ago, it was unclear what the term “token” really meant. Today, however, regulatory organizations are starting to develop a definition for tokens. Switzerland’s financial regulatory organization FINMA, for example, has explained that tokens can have three functions:

  • Payment Tokens (like bitcoin)
  • Utility Tokens (like Filecoin)
  • Asset Tokens / Security Tokens (like tokens that represent a share in a company)

Payment tokens are designed to be a medium of payment. Bitcoin, for example, is a payment token because it can easily be transferred from one person to another and that is the primary purpose of bitcoin. Utility tokens, meanwhile, allow you to “utilize” a product or service. Filecoin’s token, for example, can be spent for storage space on the Filecoin network.

Asset tokens, meanwhile, are a whole new type of entity. They’re like a traditional share combined with a digital token.

How Do Security Tokens Work?

Most countries in the world today have strict laws governing securities. These laws are designed to protect investors. Because of these laws, investors are not constantly bombarded by scammy insurance offers or pyramid schemes: someone needs to pass certain regulatory hurdles before selling securities to investors.

Security tokens, like securities, are subject to federal security regulations. They’re not designed as a way to circumvent existing regulations. Trying to circumvent regulations using security tokens is illegal, and many companies have already faced severe penalties for conducting ICOs that resemble security sales. This is considered an unregistered, unlicensed security sale, which is illegal in most countries.

Pompliano, in his Medium blog post, had a nifty way to think of security tokens in comparison to other digital assets:

“If cryptocurrencies like Bitcoin are considered “programmable money” then you can consider Security Tokens a version of “programmable ownership.” This means that any asset with ownership can and will be tokenized (public & private equities, debt, real estate, etc).”

Benefits Of A Security Token

We already have well-established systems for trading securities. You can trade stocks on stock markets, right? So what’s the benefit of a security token? Why do we need to put securities on the blockchain?

Pompliano identifies a number of advantages of security tokens, including all of the following:

No Middleman: One of the main benefits of a security token is that you remove the middleman from investment transactions. Typically, to buy a security, you need to work through a middleman – like a broker, a bank, or some type of financial institution. With a security token, however, a business could sell, say, a share of itself without the need for a middleman.

Lower Fees: Because of the lack of middleman, a security token-based system would be associated with lower fees. The modern financial system is based on fees, and banks take a cut of virtually every financial transaction. Security tokens remove the need for most bankers. Meanwhile, smart contracts could also reduce the need for lawyers.

Faster Trades: Middlemen not only add costs to the deal, but they also increase friction. A security token sale would have no middleman, which means faster deal execution. When fewer people are involved with a deal, it means faster speeds.

Free, International Market Exposure: Today, our economy is more globalized than ever before. Traditional financial systems, however, have not caught up. It’s difficult for investors in the United States to invest in a Taiwanese company or real estate product, for example. Security tokens could introduce a truly global, international securities market where businesses can market their assets to anyone with an internet connection (assuming they abide by regulatory requirements).

Automated Functions: Security token marketplaces could have significant automated functions built into the system. Smart contracts could automate various functions, reducing the need for lawyers and reducing friction.

Less Manipulation from Big Finance: Big financial institutions have enormous sway over the market. Power corrupts, and financial institutions are often caught manipulating markets for their own gain. A security token marketplace will lead to less manipulation from financial institutions.

How To Make Security Tokens Legally Compliant

Security token laws vary widely worldwide. Some countries have started enforcing traditional laws on today’s digital assets. Other countries have let major tokens like ETH and XRP continue to occupy a “grey area” of the law.

When done correctly, however, security tokens don’t have to break the law: they can easily be legally compliant. Here are some of the regulations that security token sellers need to be aware of, moving forward:

Regulation D

Some security tokens are eligible for Form D. You can electronically file Form D with the SEC to avoid being registered. The form can be filed after the securities have been sold. In order for your security token sale to qualify for a Form D submission, your sale needs to meet the requirements of Section 506c. A 506c-compliant token sale is one where investors are accredited and where the information provided to investors is “free from false or misleading statements”. Many investors are also prohibited from selling their ownership stake for at least 12 months after their initial purchase.

Regulation A+

This regulation is another exemption available to certain security token sellers. Under Regulation A+, companies can offer a security qualified with the SEC to non-accredited investors through general solicitation for up to $50,000,000 in investment. Regulation A+ requires users to register their token as a security, and security registration also requires an audit, which is why this regulation takes longer than other offerings.

Regulation S

Certain security token sales will qualify for Regulation S, which is when an offering of securities is executed in a country outside of the United States and is therefore exempt from the registration requirement. However, the company running the security token sale must still abide by appropriate securities laws in the country in which they are offering the security.

Disadvantages of Security Tokens

Security tokens aren’t perfect. They might represent the future. Or, they could never take off due to certain disadvantages. Those disadvantages include:

Middleman Responsibilities Need to Be Shifted to the Buyer or Seller: Removing the middleman from the transaction might seem like a good thing – and it is associated with powerful advantages. However, removing the middleman means that middleman responsibilities need to be absorbed by the buyer or seller. Investors might be responsible for doing their own due diligence, for example. Financial institutions that underwrite a deal may be replaced. Other duties of a middleman include preparing marketing materials, gathering investor interest, and reducing risk by verifying security and regulatory compliance. All of these things contribute to a successful security offering.

Independent Firms Need to Step Forward: In the future, security token offerings may be required to underwrite their own offering. Of course, they can’t technically perform their own underwriting, which is why they may need to pay independent firms to complete the process. This could be an effective system if the independent underwriters are genuinely neutral third parties, but it can also lead to conflicts of interest.

Independent Investors Can Be Taken Advantage Of: Independent investors may need to perform their own risk analysis. Instead of trusting a middleman financial institution, you might be responsible for doing your own due diligence. You already have to do this today, but a more open market of security token offerings would require greater due diligence. A large percentage of investors don’t have the skills, experience, or background to adequately investigate an investment, which is why we rely on financial institutions to do it for us. Future security token marketplaces might depend on investors to do their own hard work. Or, it could create a system where investors are constantly falling for scams.

You can read Pompliano’s full discussion of security tokens and regulations here.

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