This blog summarises the potential benefits and pitfalls of security tokens and is part of our wider blog on crypto assets. For an audio introduction to this topic, please listen to episode 1 of our Tech in Two Minutes podcast.

What are security tokens?

Security tokens are a digital representation of ownership rights in real world assets (such as property or shares) and have captured the curiosity of entrepreneurs, startups and investors.

Key concepts of security tokens

The creation and exchange of security tokens is underpinned by blockchain technology and smart contracts i.e. software algorithms which programme a token’s functionality and features. The creation of security tokens takes place by a process known as “tokenisation” whereby an asset is fractionalised into digital units that are issued onto a blockchain, such as Ethereum. The data of each online transaction is tracked and stored in blocks linked to each other chronologically on a chain verified by autonomous third parties called ‘miners’. This string of independently verified transactions forms the blockchain. The phrase ‘STO’ or ‘Security Token Offering’ is used to describe the issue of security tokens to individuals, which is recorded on the blockchain.

Potential benefits of security tokens

OPENING INVESTMENT OPPORTUNITIES TO THE WIDER PUBLIC

The emergence of security tokens could significantly increase the successful use of online crowdfunding to raise capital. Issuers of tokens can potentially reach a global audience of interested retail (consumer) investors, rather than being restricted to the more traditional offline sources of funding from sophisticated investors, such as angels and venture capitalists, as well as debt financing from banks. In addition, buying a security token gives the investor a share in the ownership of an asset which in many cases would be too expensive to buy entirely, for example property.

UNLOCKING LIQUIDITY

Tokenising typically illiquid assets unlocks liquidity in them, given the ability to easily buy and sell tokens at any time via the use of blockchain technology. In the real estate sector, an initial investor in a property development project would typically have his funds locked-up until the construction is completed and the properties sold to willing buyers, thereby generating a return on investment. Tokenisation of a development project allows interests in the project to be easily bought and sold at any time, thereby giving investors liquidity they previously wouldn’t have enjoyed.

COST, SPEED AND TRANSPARENCY

Payments such as rental income from a property are distributed to token holders using blockchain. This means there are no banking intermediaries to charge processing fees and the visibility inherent in the peer-to-peer system of verification means that the history of all past transactions can be seen by investors. Certain aspects of the exchange process are automated by smart contract technology which means payments can be made more quickly.

Pitfalls of security tokens

REGULATORY COMPLIANCE

According to recent guidance from the Financial Conduct Authority (the “FCA”), in the UK tokenised shares and debt instruments are treated as a form of ‘specified investment’ (given the specific investment rights granted to holders) and are therefore potentially regulated in accordance with the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001. Businesses proposing to issue tokenised shares and debt instruments need to ascertain whether they fall within the FCA perimeter and, if so, ensure that they comply with all relevant rules and requirements. By way of example, offering tokenised shares to the general public is likely to result in the need for the issuer to produce an FCA-approved prospectus setting out important details relating to the issuer and the tokens so that potential investors can understand the risk profile of the investment. Many startups will, of course, struggle to meet the time and cost demands which are necessary to overcome regulatory hurdles of this nature.

ADMINISTRATIVE COMPLEXITIES

Assets which are tokenised may be subject to administrative obligations which do not fall away as a result of tokenisation. By way of example, tokenising shares will still require issuers to draft bespoke articles of association governing the rights and obligations to which shareholders are subject, as well as the tokenisation process and those articles will still need to be filed at Companies House. In addition, despite the record on the blockchain, the issuer will still need to regularly file its yearly confirmation statement at Companies House setting out the register of shareholders at that point in time.

DILUTED RESPONSIBILITIES

If tokenisation is successful, an asset will have multiple owners and a healthy secondary market will mean the identity of such owners will be changing on a regular basis. This, of course, creates the risk that responsibility for any necessary governance of the asset could be overlooked by the crowd. This is particularly important for tangible assets, such as real estate, given that important matters such as maintenance and rent collection need to be managed, irrespective of the tokens consistently changing hands. As a result, certain tokenised assets are likely to be owned by companies incorporated solely for the purpose of holding them (‘SPVs’) so that their boards are responsible for management of the asset. Shares in the SPV could then be tokenised or tokens could be issued by the SPV which provide recipients with rights to income or capital arising from exploitation of the asset. However, each of these structures could result in the need for the issuer to comply with regulatory requirements such as those referred to above.

The culmination of emergent technology, a reputation for volatility and a lack of confidence in crypto assets mean that security tokens are not a typical part of the business model in most UK companies. That said, interest from entrepreneurs and investors keen to explore unprecedented opportunities to unlock value in otherwise illiquid assets presently remains intact. Momentum is also likely to gather as more startups tokenise their assets to raise capital.