The meteoric rise of ICOs throughout 2017 and early 2018 was unprecedented and spawned a whole new method of raising huge sums of funds in just minutes. However, the sheer volume of ICOs that turned out to be scams, failed to deliver on their promises, or ran out of funds before launching a product led to the precipitous decline of ICOs in the second half of 2018.
However, the power of blockchain-based tokens to create more flexible financial assets and instruments has not dissipated. Decentralized finance (DeFi) is on the rise, with financial instruments of secured debt platforms for decentralized prediction markets materializing left and right.
One of the main focuses of a DeFi landscape is the transition from conventional financial securities to digital tokens on a blockchain.
Commonly referred to as “security tokens,” these assets are securities that represent equity or debt with a digital wrapper around them, designed to provide a set of advantages and flexibility to the assets.
Following in the footsteps of the ICO, the ‘Security Token Offering’ (STO) has garnered widespread attention as an ecosystem of investors, service providers, exchanges and more vying for position in a burgeoning market. Security tokens have some intriguing prospects, and the STO presents a valuable tool for companies to issue digital assets on the blockchain.
What is a security?
A traditional financial security is a fungible instrument that has value and can represent debt or equity.
Securities such as shares can represent ownership of a company (shares), where the owners can benefit from the asset’s capital gains or even receive dividend payments in specific cases. Equity security holders may be owned by public or private companies, and the owners are generally entitled to some form of ownership in the company.
Securities representing debt are a representation of borrowed money, which must be repaid and is subject to various loan conditions. There are numerous types of debt securities, including:
- government bonds
- Collateralized debt obligations (CDOs)
- Collateralized Mortgage Obligations (CMOs)
- corporate bonds
- Certificate of Deposits
Holders of debt securities are generally entitled to receive interest payments on the principal amount of the loan, and may be backed by various means, including collateralized and uncollateralized.
Securities play an important role in finance and are most relevant to STOs in their ability to leverage to raise funds. Companies can raise huge sums through Initial Public Offerings (IPOs) of shares when they go public, and governments can even issue municipal bonds to raise funds.
Government securities are traded on major stock exchanges and can be transferred between investors in secondary markets as assets.
Security Tokens and Security Token Offerings (STOs)
Common misperceptions about security tokens are that they are different from securities. Although they exist on a blockchain, they are ostensibly securities, subject to the same rules and jurisprudence as traditional securities.
However, security tokens offer some unique advantages — particularly in improving secondary market liquidity, reducing compliance costs, automating trading restrictions, providing fractional ownership, and enabling asset interoperability.
STOs have opened up an opportunity for companies to raise funds by issuing digital security tokens to investors in a compliant manner. The advantages exist for both the investor and the issuer, while also providing much better guarantees against fraud compared to an ICO. Issuers can come from a variety of backgrounds, including commercial real estate, venture capital firms, and small and medium-sized enterprises (SMEs).
There is discussion around the semantics of what constitutes a ‘security token’ or a ‘tokenized security’, but for all intents and purposes STOs in this context are focused on launching new security tokens and not tokenizing existing ones. existing financial assets.
One of the easiest and most beneficial applications of an STO is with an SME looking to raise funds when they are unable to access commercial banking services. In parallel with the rise of other DeFi services, SMEs can access open financial services, issuing security tokens for investors to earn on the blockchain. This has important implications for lowering barriers to entry for retail investors while providing powerful financial services to SMEs in local and regional areas where they have historically been limited in their financial capabilities.
Additionally, SMEs issuing security tokens provide a great example to highlight the multiple players needed in the security token ecosystem.
Read: Tokenization of Financial Assets
Participants in the security token ecosystem
If an SME (i.e. Company A) wants to issue security tokens representing shares in their company, they can do so with the help of multiple market participants, including:
- Issuance platforms
- legal accomplice
Company A can formally issue its security token to investors through an issuance platform. Popular streaming platforms include Scholar Y Portthat are integrated with service providers such as custodians, broker-dealers, and legal/compliance entities to facilitate a secure and compliant process.
Issuance platform developers are also working on standardized token interfaces (ie ST-20 for Polymath and R-Token for Harbor) that encode regulatory parameters into token contracts, such as explicit trading restrictions. Standardized token interfaces for security tokens also enable asset interoperability, which has positive downstream effects on secondary market liquidity and reduces friction in token trading.
Read: Our guide to Polymath
Custodians are popular for storing digital tokens in secure cold storage, particularly with institutions. BitGo is one of the most established custodians of digital assets, and custodians are often associated with exchanges or issuance platforms.
Exchanges exist for investors to trade security tokens, allowing for better access to capital, increased secondary liquidity, and democratized investor access to securities. tZero is a high-profile exchange that went live recently, backed by Overstock. Company A’s security tokens can be traded on exchanges like tZero, where investors undergo KYC/AML verification. Some exchanges can also operate as issuance platforms.
As an SME, Company A’s security tokens may be offered to retail investors who are largely excluded from SME investment opportunities due to various barriers to entry. However, democratizing such access to security tokens can help SMEs raise funds from local communities, providing a boon to small businesses and helping local businesses grow.
Open financial frameworks such as Mount Pelerin even looking to provide SME marketplaces for entities like Company A to take advantage of broad and open financial services on the blockchain.
Other applications of security tokens, already underway, include commercial real estate investment funds (i.e., REITs) that reduce high investment minimums and even allow concepts such as fractional ownership to emerge. port has already hosted an STO for a South Carolina residential building with a significantly reduced minimum investment compared to typical rates.
STO vs. ICO
Overall, STOs eliminate ICO fraud and offer legitimate securities to a broader range of investors with better efficiency, interoperability, and liquidity than conventional securities. STOs are backed by real assets, while ICOs are primarily based on “utility tokens”, with no underlying collateral and are not protected by securities law.
STOs also offer advantages over IPOs. They are cheaper and can cover a much wider range of assets, such as fractional ownership in high-value works of art or investment funds. Banking and brokerage fees are also drastically reduced through automation with the launch of an STO compared to an IPO.
It is important to note that while STOs are governed by US securities laws, there are legal nuances to launching security tokens as they are based on newer technology. Several countries outside of the US have also banned STOs, including China and South Korea.
In the US, investors are pumping huge sums of money into the security token landscape as the role of young ecosystem participants continues to be fulfilled. Assessing which markets are emerging as the most popular in early-stage security tokens should reveal which sectors offer STOs the best advantages. Both SMEs and REITs are clear applications of STOs, but there are many other opportunities available for security token issuance that are practical, cheaper, and compliant.
ICOs were a novel concept that fueled crazy altcoin speculation during their prominence in late 2017, but the industry has gotten more choosy ever since. As ICOs have failed, security tokens have emerged as a prudent use case for blockchain technology at the convergence of conventional financial instruments and digital assets.
DeFi is on the rise and security tokens are poised to play an integral role in the broader transition to an open financial system.