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Rehashed - #22 Sizing up Security Tokens

Security tokens constitute any blockchain-based representation of value that falls under the oversight of security laws. This encompasses two broad categories: the tokenisation of off-chain assets (from equity to commodities to real-estate), and any pre-network launch tokens that are deemed securities under U.S. securities law.

Tokenising Off-Chain Assets

The crypto cauldron first began brewing with the inception of Bitcoin, which was followed by a slew of early digital currencies, many of which no longer exist today. Following Bitcoin, the creation of Ethereum opened new paradigms for capital formation; the ICO model has led to an explosion in utility tokens, with over (USD) $20 billion invested to-date.

As the ecosystem continues to mature, we are beginning to see a foray into security tokens. Security tokens represent off-chain physical assets such as equity, debt, derivatives, gold and real estate. They occupy their own niche beneath the cryptoasset umbrella:

Compared to traditional asset classes, security tokens are an alternative method for recording and trading ownership claims. The nature of the underlying blockchain means that there are several unique and arguably beneficial features to the security token over its traditional counterparts.

Features of Security Tokens

Security tokens can democratise investment in traditional assets. Asset classes such as private equity, real estate and fine art are typically inaccessible as investments for the average joe. Tokenising these assets can enable a much wider majority to participate. Furthermore, the ability to fractionalize such assets is an advantage. The high unit costs of investments in real estate and fine arts markets often box out the typical retail investor who does not have the resources to buy a slice of real estate or participate in the $64 billion global art market. Fractionalisation results in lower costs per investment unit, placing these assets within reach of a much broader market.

Security tokens will benefit from all the features of the underlying blockchain. Instead of waiting days or possibly weeks for transactions to be verified/settled by the bank or clearinghouse, the trading of security tokens will result in rapid settlement of mere minutes. Additionally, there are likely to be significant cost reductions associated with security tokens. There are several market activities that result in costly and time-consuming processes. For example, in the venture capital space, once a start-up is acquired, the capitalisation table must be reconciled to determine payout percentages between stakeholders and other claims. This is often a lengthy process requiring expensive legal oversight. If ownership claims are tokenised, such matters can be recorded and reconciled extremely efficiently.

Natural run-off effects from tokenisation of traditional asset classes will also allow for enhanced liquidity. Private asset classes are typically highly illiquid. For example, private equity funds have a shelf life of at least 10 years, where capital and profits are distributed to investors only once underlying companies are sold or liquidated after going public. Tokenisation will allow investors to access liquidity in the secondary markets. In the utility token market, there is an abundance of infrastructure in place to allow investors to buy and sell tokens. In fact, the average daily volume of top crypto exchange, Binance, at its peak trading volume, eclipsed the average daily volume of U.S. equities by more than 3x ($10B vs. $3B). The proliferation of crypto exchanges is likely to be mimicked in the security token market, where regulated crypto and legacy brokers/exchanges will host robust secondary markets for security tokens.

The Blurred Line Between Utility Tokens and Security Tokens

In addition to obvious security tokens which represent traditional assets, many utility tokens that have already conducted ICOs are considered security tokens. Security tokens are subject to the same scrutinous federal regulation of traditional securities, such as equities, debt and derivatives. The designation of “security” relates to whether an investment is a purely speculative enterprise. Although there has been a lack of official guidance, projects that conduct ICOs pre-network launch, before there is any utility realized through the native token (an overwhelming proportion of ICOs), are considered to have issued securities. Judging by the number of subpoenas that have been issued by U.S. regulators this year, many projects have overlooked their legal responsibilities and have not carried out the proper security registration processes. Additionally, in an effort to recoup losses, many token-holders are suing projects for the unlawful sale of securities. Ripple is engaged in several lawsuits brought about by XRP token-holders who assert that Ripple engaged in unlawful securities transactions through the sale of XRP tokens. Ripple has recently undergone a massive rebranding effort in an attempt to decouple the XRP token from Ripple Labs, the company, and avoid “security” status.

The Current State of Security Tokens

Although security tokens boast many features, the model is yet to be proven. The pioneer of the security token is Blockchain Capital who issued the BCAP token last year. BCAP is the tokenisation of an interest in Blockchain Capital’s venture fund where they invest in a portfolio of both crypto-assets (tokens) and companies (equity). The firm conducted a $10 million compliant offering in 2017, following which, the BCAP token traded on the secondary markets. The venture has been neither a success nor failure thus far. The portfolio gives token-holders exposure to equity investments in companies such as Ripple and Coinbase, which are typically inaccessible to the retail investor. However BCAP is currently illiquid; the token has been delisted from all public exchanges, which means that there is limited liquidity for the foreseeable future.

We are slowly starting to see other players dip their toes in the security token space. Following in Blockchain Capital’s footsteps, CityBlock Capital is a venture capital firm that will tokenise each fund it raises. Real estate is another area of security token innovation. A group in New York is attempting to conduct a (USD) $350 million offering to tokenise an ownership stake in the Plaza Hotel. The “Plaza Token” would give an investor a small portion of equity in a group that is invested in Plaza Hotel.

The arrival of security tokens brings a healthy dose of regulatory oversight that is much needed in the ICO wild west. ICOs may be best placed to take conservative legal measures when conducting a sale, in the case that they are not “sufficiently decentralized,” and indeed fall under securities law. This may help protect the retail investor from severe losses in the crypto markets. Although the tokenisation of traditional asset classes seems to present many advantageous features, the model is still unproven in practice. For now, the number of issued security tokens are few and far between, however, this is certainly an area that will see immense growth over the next couple of years.

 

In the News

Three ETF applications were all denied by the SEC for reasons we’ve heard before: insufficient market size for regulated instruments like futures, lack of regulated underlying markets, and inability to prevent fraud and manipulation. The market was unsurprised, with bitcoin trading higher on the news.

China continues to take a hardened stance on cryptocurrencies: 124 foreign crypto exchanges may be blocked access and all crypto media is banned from WeChat.

The $18B Bitmain IPO continues to be in the spotlight. A few observations that the market has made from their offering documents: 1) They traded out of BTC to BCH at an inopportune time. Since, BCH has fallen dramatically compared to BTC, putting Bitmain’s balance sheet in jeopardy. 2) The crypto bear market has severely affect Bitmain’s holdings and cash flow; in a new report, analysts with research firm Alliance Bernstein said the company's "cash flow appears to be questionable and the company may be gradually losing technological edge."

Research shows that major crypto exchanges lose trading volume to smaller peers with larger alt-coin offerings. Volumes are down 83% YTD at Coinbase, coinciding with the drop in prices this year.

Blockchain.com claims strong, sustained user growth, reporting 50,000 new user wallets per day.

 

Upcoming Dates

Sep 30 - The VanEck SolidX ETF application next deadline for a decision from the SEC

 

As always, thanks for joining - see you next week for Rehashed.

Freddie Archibald

 

View previous issue: Rehashed - #21 A Crypto Guidance Update from the FMA

View next issue: Rehashed #23 ICO “Panic Selling” of Ethereum Debunked


About the author:

Capital markets to crypto convert. From Christchurch →  Boston → New York, Freddie became intrigued by the potential of the digital asset economy after plucking a book on Bitcoin off a New York library bookshelf in 2016. Her parents are thrilled that she is chasing magic money on the internet.

 

Disclaimer:  The above references an opinion and is for informational purposes only. The opinions expressed by the author do not represent the opinion of BitPrime.

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