Security tokens hold the potential to unlock trillions of dollars in illiquid assets. How? By bringing liquidity to private assets that have historically been illiquid or had 5–10 year lock-up periods. Unfortunately, this potential of liquidity remains to be primarily a promise until mechanisms are developed that allow for compliant trading of security tokens. From token issuance to secondary market trading — we need scalable solutions that ensure wallets adhere to regulations such as KYC (Know Your Customer) and AML (Anti Money Laundering).

This article will serve as a guide to what needs to happen to enable compliant trading of security tokens. It will highlight the regulation that needs to be followed and showcase the growing list of exchanges and protocols building out a compliant security token trading infrastructure.

Background on security tokens:

What is a security token?

A security token is a digital asset that is subject to securities regulations. A security token is issued digitally on the blockchain, or ‘tokenized’ but represents a financial security. Security tokens are backed by something tangible such as: real estate, shares in a company, fine art etc.

Why have security tokens?

By tokenizing private securities — assets can be more easily traded on secondary markets without the administrative burdens of traditional private securities. The current private securities market is massive (in the trillions) and it is predicted that the current illiquidity discount can be as high as 20–30%. On top of creating private security liquidity — security tokens also promise to bring a wealth of additional benefits such as: eliminating middlemen, increasing inclusivity and faster deal execution.

Anthony Pompliano, Partner at Morgan Creek Blockchain Capital and frequent commentator on security tokens states:

“Security tokens bring a number of improvements to traditional financial products by removing the middleman from investment transactions (usually some form of a banker). The removal of middlemen leads to lower fees, faster deal execution, free market exposure, larger potential investor base, automated service functions, and lack of financial institution manipulation.” — Anthony Pompliano

How do you issue a security token?

Issuing a security token is the process of “tokenizing” or converting rights to an asset into a digital token on a blockchain. As security tokens are also securities — all security tokens needs to be compliant from day 1. If you want to tokenize an asset — prepare for a multi month process of advisors, lawyers and learning how to engage with the existing platforms in the security token space. There are currently a few platforms you can work with to help with token issuance such as: Polymath, Harbor and Securitize to name a few. (More on this later)

What regulations are associated to trading security tokens?

As mentioned above, tokens need to remain compliant from the initial offering to all secondary trades. From issuance to delivery, security tokens must follow regulations such as KYC/AML accreditation and other legal requirements. Despite security tokens being relatively new, the laws that govern them are decades in the making (ie The Securities Act of 1933). To further complicate compliance, regulations can differ based on jurisdictions.

A note on global trading 🌎

For tokens to remain compliant and fulfil their potential for opening up a network of investors across the globe — they need to remain compliant both in the issuer’s as well as the investor’s jurisdiction (e.g. a Chinese seller and American buyer). This is thanks to the global-by-default nature of blockchains and can create further complications (and problems) for those involved with tokenization or with operating the market places where tokens are traded.

For US based security tokens, tokens must adhere to regulations such as Regulation D, Regulation S and Regulation A+. *Not legal advice.

What solutions are currently in place for regulated trading?

1 day in the life of security token trading…

As highlighted above — the legal requirements around security tokens are complex. Fortunately, there are already a variety of startups(and major players) working to address these legal challenges. Crypto leader, Coinbase announced in June intent on listing SEC-regulated crypto securities. Nasdaq is also a frequent commentator and increasingly a supporter of the security token space:

“Security tokens digitally represent ownership in any asset, such as a piece of a tech startup or a venture capital fund and can provide investors with various rights to that company or fund. Furthermore, Security tokens provide liquidity to investors, access to compliance features to issuers, and a framework for oversight to regulators.” - Nasdaq, Security Tokens Set To Take Center Stage in 2019

Today there are two major solutions proposed to enable regulated trading of security tokens.

Solution #1: The Walled Garden Approach: Centralized Exchanges.

The Walled Garden Approach refers to tokens being issued and traded within one exchange. By centralizing where the tokens can be traded, that exchange is responsible for ensuring each trade made on its exchange is compliant. This solution for compliant trading is already in the works. On May 22nd the Boston Stock Exchange announced they would be working with tZero to launch the world’s first regulated security token exchange. Sam Noursalehi, CEO of tZero stated:

“Together, we will continue to work with the SEC as we develop a first-of-its-kind platform that will integrate blockchain capital markets into the current U.S. National Market System.”

While the centralized ‘walled garden’ approach is one of the closest to delivering compliant trading of security tokens — it still has limitations. For one, only allowing trading within one centralized platforms does not deliver on the full promise of global liquidity as a decentralized solution could. Furthermore — if a token were to leave an exchange, the issuer may be unable to enforce the core securities regulations.

Companies in this space:

tZero, a subsidiarity of Overstock.com focused on a variety of blockchain supported solutions for the capital markets. Recently the company announced that it plans on scaling its operations by creating a token trading system for crypto securities. tZERO states they are using a plethora of proprietary technology to support the eventual trading of security tokens. Their goal is to build a system that is designed to trade security tokens in an easy, compliant, and user-friendly manner. tZero is certainly one to watch as at the end of June they received a letter of intent from GSR Capital (GSR) to purchase $160M in tZero security tokens

OpenFinance is designed for traditional alternative assets and token-based securities. They have developed a compliant standard for tokenized securities to be exchanged and eventually listed on the blockchain. They promise to create a streamlined compliant process from issuance to secondary market trading. OpenFinance was the first US based regulated security token trading platform to go live in June 2018. They have announced token listings for: SPiCE, Blockchain Capital, Science Blockchain and Protos Asset Management. They are also accepting applications for additional security token listings.

Solution #2: Embedded compliance during token issuance.

This solution occurs on the issuance level of tokens. Through using an accredited issuance platform, regulatory requirements are embedded onto the tokens themselves. Through applying regulation at the token level, this type of solution hopes to enable regulated trading of their tokens across both centralized and decentralized exchanges. There are currently three major players in the space: Harbor, Securitize and Polymath.

David Sachs, ex Pay-Pal executive and founding chairman of Harbor says:

“[Anonymity] is a feature of digital cash, but it’s a bug when it comes to security tokens,” he said, explaining that “Harbor’s permission and attribution system will ensure companies that create tokens won’t fall afoul of the law.”

This solutions sees a lot of improvements from the walled garden approach. However, this solution still remains theoretical as we still have not seen the first compliant trade made utilizing this solution. Furthermore, while this solution does open up trading beyond one central exchange — the issuance of compliant tokens is still centralized.

Companies in this space:

Harbor centralizes compliance on the token issuance level to allow tokens to be traded across any platform. Through Harbor’s R-Token Standard, compliance is enforced across any trading platform that supports ERC-20 tokens. Harbor believes they can serve as a gate-keeper by adding code to tokens to ensure they can only be traded by parties who are compliant with know-your-customer rules and other regulations. Harbor serves as a compliance protocol that standardizes the way securities are issued and traded on blockchains. They describe themselves as a means to centralize the compliance and decentralize everything else.

Securitize offers an end to end platform for issuers that are seeking to tokenize assets. They are able to tokenize securities issued by funds, companies and other entities. They offer a variety of services including: establishing legal and regulatory readiness of the token issuer, streamlining investor regulation with KYC/AML accreditation and customizing smart contracts to match issuers legal requirements.

Polymath is a blockchain protocol to facilitate the issuance of legally compliant security tokens. The protocol will embed financial securities requirements into the design of new security tokens. This is powered through Poly — an ERC20 token that powers the system and acts as the underlying economic unit facilitating compliance.

Security token offerings to watch:

Leaseum Partners: Leaseum Partners is a blockchain based Real Estate investment manager.

SPiCE VC: SPiCE VC is a tokenized venture capital fund. To further support the tokenization infrastructure — SPiCE VC’s investment thesis is focused around investments to build out the tokenization ecosystem. They will invest both in projects building out the tokenization infrastructure as well as tokenization projects.

* Feel free to comment with additional STO’s to evaluate and add to this list.

Hypothesis for the future:

While 2017 was famously the year of ICOs, 2018 could be viewed as the year of STO (Security Token Offering). That being said, security token infrastructure is in its infancy. Of the companies listed in this article, few are more than 6 months old and many have yet to launch or are still in early trials. Currently, many exchanges are not able to support compliant security tokens. As the SEC has already announced that blockchain tokens (not just security tokens) will be considered as securities — ignoring regulation is not an option. Expect to see more solutions come into play and the market adapting to ensure it can meet compliance.

This is a living document (last updated July 2018). The goal to provide readers with an understanding of the current security token ecosystem in regards to secondary trading and regulation. Feedback on the ecosystem is welcome!

This article is not investment or regulation advice. It is meant to help people understand the market landscape and secondary trading regulations of security tokens. You should consult a lawyer or licensed financial professionals for any legal or investment advice you may have.

Recommended Further Reading:

Liquidity is Coming for Security Tokens: Carlos Domingo

The Official Guide to Tokenized Securities: Anthony Pompliano

Your Official Guide to the Security Token Ecosystem: Tatiana Koffman

The Security Token Thesis: Stephen McKeon