This is the first of a two-part article series on security token offerings. The first part elaborates the benefits blockchain-based financial securities bring to the table. It also looks at its pitfalls. The second part dives into the impact of these tokenized securities on capital markets and the hurdles blocking its rise.
Initial Coin Offerings (ICOs) were introduced in the market with huge aplomb. The sole purpose of the offering was to issue digital coins that could streamline the stock trading process and reduce operational costs considerably. However, over time, scams and hacks have overshadowed the euphoria and taken away the ‘trust’ factor. Interestingly, the top 10 biggest ICO scams managed a fraud of $ 687.4 million1 which is 50% of the GDP of Seychelles and Gambia. Research from Satis Group claimed that 80% of all ICOs in 2017 were fraudulent scams2 .
With the danger of ICOs going into oblivion, Securities Exchange Commission (SEC) is streamlining the industry and is studying the ICO markets to recommend more regulations.
New securities in the form of Security Token Offerings (STO) were born! STOs are a regulated version of digital tokens. This is a revised version wherein the tokens are backed by physical assets like derivatives, stocks, and bonds. Latest research from South Korea indicates that STOs will dominate 20193.
So are STOs the next big thig? Let’s understand these securities.
Benefits of Security Tokens
US regulatory body SEC identifies STOs as security, therefore STOs come under the strict purview of all security investments. Any issuance of security tokens will be treated as per the IPO norms falling under Reg D, Rule 506 and Reg A, Reg S. Currently, SEC is still weighing options and studying to come up with supplementary guidelines to make the STO market foolproof with no ICO scam /hack repeat. This will ensure that security tokens are issued with the intent of mobilizing funds and protects the investors at large.
Security tokens can be used as a medium to mobilize funds on items requiring huge investments. For instance, art collectibles that cost millions of dollars are limited to affluent investors only. With security tokens, the art collectible value can be broken into fractions, which can then be issued to investors reaching wider base. The appreciation of the value of the art collectibles would in turn accrue the security token investors. Similar concept is now extended to the real estate world where the REITs (Real Estate Investment Trust) could be issued as a security token. In fact, real estate market is already embracing the STO uprising. As per latest reports, the world’s real estate value reached $280.6 trillion dollars, which gives a broad indication of the scope we are dealing with4.
However, there is a need to work on semantics such as breaking the value into fractional ownership. Will the ownership value change based on market value appreciation or depreciation? Will this be based on some weighted average format? This will require more clarity as we move along.
The issuance of security tokens is targeted to remove middlemen and provide simplicity to investors. Chainium, a crowdfund based platform, was developed with the sole purpose of connecting investors to investors and avoid middlemen. This will provide more scope to corporates to seek public investments and thereby increase more accountability and transparency in the long run.
Increase in liquidity
Security tokens offer more liquidity in terms of ease in buying or selling in a market or underlying asset not available or complex to buy or sell.
Liquidity is determined from two perspectives – Market and Fund. Market liquidity is transactional liquidity and fund liquidity is the ease for acquiring credit with less transaction or assessment costs. Security token offerings are a win-win situation from an overall liquidity point of view.
Venture capitalists can now expect huge returns as they mitigate the initial challenge of offering illiquid assets that takes its lifecycle to convert into liquid assets, thereby investing more time and resources.
With the benefits more prominent, how does one deal with the pitfalls.
Pitfalls of Security Tokens
Lack of wider acceptability
ICOs earned a bad reputation as it caused huge disappointment to many investors who banked on Bitcoin and blockchain and then realized that the value was overpriced or the offering was a scam.
Due to ICOs’ bad reputation in the market, the STOs will need time to attain trust. Also, how can one deal with insider trading and market manipulation which remains extended to STOs too?
STOs need major financial institutions to vouch for it: this will increase acceptability amongst its peers and their clients. This may take some time even with the protection of regulatory requirements. The need of the hour is to introduce regulatory requirements which will act as a good first line of defense and protect the investors at large.
Although security token offerings are introduced as a ‘badge of honor’ from regulatory authorities, the investors will need more education to build their trust and start investing in STOs.
Integration of systems
How will the internal systems of banks integrate with smart contracts written in programming code?
This is not a traditional paper based business process. This will require building protocols/interface to pull data, and write and maintain in the existing system architecture. This may require specific skillsets and will duly increase costs, both in terms of human resources and enhancing the systems to interface with STO specific blockchain technologies (e.g. smart contracts).
Finding a right fit to maintain security tokens will not be easy. For instance, getting a blockchain expert based in Silicon Valley to work for banks will be a challenge in itself. This may increase initial acquisition costs but this will spread out in the long run.
In part two, we delve into the future of STOs and its impact on the capital market. Access part two of the series here.