In our last article, we discussed what security tokens are and some of the unique benefits tokenized assets offer. For those who missed it, security tokens primarily represent fractional ownership of an underlying financial asset. Unlike utility tokens, the tokenization of securities places significant emphasis on regulatory compliance which was more or less non-existent for most crypto assets to date.

Security tokens unlock a multitude of benefits which are either costly or difficult to execute in legacy systems including but not limited to: global accessibility, accelerated liquidity, and real-time cash flows. By utilizing blockchain technology, compliance can be programmed directly into smart contracts, thus making the use of middlemen a feature rather than a necessity.

While this sounds very exciting and innovative from a high level, it’s only logical to ask:

What assets should be tokenized?

Generally speaking, just because any asset *could* be tokenized (and likely will be in the future) doesn’t mean it should be just yet. As such, we chose to focus on the tokenization of three viable assets which have captured hundreds of trillions in market value.

Equity

Tokenizing equity, whether private or public, has quickly become the leading use-case for security tokens. While legacy equity markets continue to function quite well, it’s important to highlight why this use-case has become so desirable in the larger crypto asset ecosystem.

The emergence of retail-driven demand for uncapped primary markets was a large reason why Initial Coin Offerings (ICOs) gained so much traction. Unlike Reg CF or Reg A+ offerings, there was no legal limit to the amount of capital an ICO could raise from a retail audience, and better yet, liquidity was often present within a month of the initial offering ending.

Unfortunately, these tokens were not backed by any underlying warrants. As a result, the issuing entity had no legal binding to act in the tokenholder’s best interest. Despite the large amount of capital raised from ICOs, early-stage startups often carelessly burned their funding as there were no repercussions (yet) for doing so. This recurring cycle caused much cynicism about blockchain-based fundraising, thus leading to a drastic decrease in ICO appetite.

Introducing a New Standard

Thankfully, the emergence of tokenized equity presents an entirely new paradigm for investor confidence. While there still remains a high level of risk (as with investing in any early-stage company), the sale of tokenized shares or stocks present a much more connected interest between the issuer and the fundraising vehicle.

Theoretically speaking, tokenized equity will be treated almost identical to traditional shares. Companies will need to focus on building sustainable revenue streams rather than marketing schemes to allow for dividends and buy-backs as the company matures. While this may seem comical to many of our readers, the large majority of blockchain-based projects have yet to find a tangible way to profit off of their business outside of the issuance and sale of their own currency.

Thanks to the advent of blockchain technology, early-stage companies can utilize the benefits described above to access an entirely new audience in a disruptive fashion. There is no longer a need for companies to go “public” in order to entertain a retail-oriented audience, and the cost of doing so becomes drastically cheaper.

With this being said, the appropriate time to launch an equity-based security token offering (STO) is largely dependent on the state of the company. The biggest question(s) your company should consider are: What is the current stage of the company? Is the company a pre-seed start-up, raising a Series A, B, C or looking to go public? Generally speaking, the more investors involved in the deal, the more attractive it becomes to launch security tokens.

While there are other important details that need to be ironed out before raising capital through an STO, we personally believe that companies looking to raise anywhere from $5–50M in a series A, B, or C will largely benefit from a security token offering. Similarly, we personally believe that companies in the pre-seed or low valuation Series A (<$3M) are most attractive to prospective investors.

It is important to note that raising $50M via a security token offering does not resemble raising capital via a utility token ICO. Valuation models should be justified through real revenues and a scalable business.

Debt

The debt market is enormous. In 2019, Bloomberg estimated that the global outstanding debt exceeded $244 trillion.

With security tokens enabling the potential for real-time automated cash flows, enhanced security and significant cost reductions, tokenizing debt issuance is a very attractive opportunity for any entity. As such, we’ve recently began to see some government agencies exploring the tokenization of bonds.

Back in September 2018, one of Austria’s biggest banks announced the issuance and tracking of $1.3b in government bonds on the Ethereum public network. More specifically, the Austrian government plans to leverage blockchain hashes to represent notarized data from Austria’s established system.

Companies like Cadence have introduced a new paradigm for fixed rate interest. Nelson Chu, CEO of the company was quoted saying that, “(Cadence) is structuring private, bespoke debt opportunities supported by diverse cash flows from alternative assets. Digitization of debt is optimal because we can easily standardize and reuse the smart contract templates for each structured debt offering we tokenize. This cuts down on back office costs and lets us pass on these savings in the form of higher yields for our investors.”

To summarize, tokenized debt allows for access to investment opportunities that were once reserved for large financial institutions. The access to these opportunities can be communicated across a much broader audience, allowing for debt to issued faster, and by a large amount of entities. Furthermore, debt issuers benefit from upstream demand to purchase their bonds while investors benefit from automated systems to ensure that legal compliance and coupons are paid in seamless and trustless manner.

Real Estate

As far as physical assets are concerned, real-estate is quickly emerging as the fastest growing tokenized asset class. The slow, costly and inefficient incumbent system for real estate is primed to be disrupted by blockchain technology and asset tokenization. As of now, real estate investments can be fairly illiquid as it’s time consuming and costly to sell a property. In the instance where multiple investors have ownership of the property, the situation becomes increasingly more complex.

With real estate based security tokens, property investments become much more manageable through fractional ownership. An investment property *could* have an unlimited amount of investors for close to zero marginal cost. More importantly, investors have liquidity on the property as transfer of ownership can be easily facilitated in a trustless and compliant manner.

In a proliferated blockchain ecosystem, real estate investors could increase or decrease their holdings on an investment property as easily as buying or selling a stock through a brokerage account.

As we noted in our previous article, security tokens provide the potential for real-time cash flows. With this in mind, monthly rent payments from an apartment building with hundreds of tenants can now be automatically distributed to tens, hundreds or even thousands of the investors who participated in funding the building.

In practice, the St. Regis Aspen Resort launched a security token offering for an asset-backed token representing fragmented equity ownership in the Aspen hotel. The security token, launched by Securitize, is expected to offer an annual dividend of 4.7% to its investors. While this isn’t necessarily “real-time”, the notion of being able to compliantly distribute dividends to investors across the globe through blockchain technology is a step in the right direction.

Conclusion

In order to properly aggregate the value of deeply rooted financial instruments into a new blockchain ecosystem, this asset class requires a concrete foundation of infrastructure, regulatory clarity and interoperability.

Ultimately, tokenizing real assets into a frictionless global financial system will likely take decades. Fortunately, we’re at the forefront of this financial revolution. The security token market is still in its infancy as innovative new tokenization models are restricted due to regulatory uncertainty. While we are still a long way away from a global and frictionless financial system, we at Fitzner Blockchain firmly believe in the future value of tokenized securities and are working to make this a reality one day at a time.

If you’re interested in launching an STO or require general guidance on security tokens, please schedule a free consultation with us through our website: fitznerblockchain.consulting

Writers: Cooper Turley — https://twitter.com/Cooopahtroopa

Lucas Campbell — https://twitter.com/0x_Lucas