Part 1 Audio: The Definitive Intro To Tokenized Securities



Part 2 Audio: How Security Token Platforms Actually Work



Part 3 Audio: 7 Predictions About Our (Wild) Tokenized Future



Case Study Addendum: Tokenizing a Fund w/ Rob Nance (Part 1 of 2)

Case Study Addendum: Tokenizing a Fund w/ Rob Nance (Part 2 of 2)

The State of Asset Tokenization in 2020 w/ Hart Lambur & Michael Oved

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Table of Contents

Introduction to This Documentary

I decided to create this documentary about security tokenization after learning that many of my preconceived notions about security tokens were just flat wrong. During my journey, I also discovered that several individuals I respected (and who were otherwise well versed on cryptoassets) also had misconceptions about security tokenization, how and where security tokens attempted to add value, why they might be needed, and the mechanisms of how they worked.

As my friend, Taylor Pearson pointed out in a really long Tweet storm: understanding how cryptocurrencies work means understanding cryptography, distributed systems, economics, and politics.

Security tokens add to this list . . .

SEC regulations & securities laws

Equity mechanics

Private and public issuance of stock

Secondary trading

Guidelines from over 100+ legal jurisdictions

My purpose here is not to convince you that security tokens and asset back tokens are valuable or needed, but instead to simply the complex and tell the story of projects makers, issuers, investors, and influencers driving adoption of security tokens.

To create this content, I had conversations with leading thinkers and creators in the field. What I found is that, at every step of the way, the tokenization of securities, real estate, art, and other real-world assets is forcing us to reexamine old habits and ways of operating.

This documentary started off as a passion project, quickly turned into a huge, time-consuming pain, and is now back to being a passion project as we hit publish.

I hope you enjoy our tokenized security documentary, “Tokenize The World.”



Thanks To Our Sponsors

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Tokenize The World, Part 1: The Definitive Intro To Tokenized Securities

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Thanks To Our Sponsor:

This documentary is brought to you by Nomics’ Cryptocurrency & Bitcoin API. The Nomics Market Data API offers squeaky clean and normalized primary source trade data offered through fast and modern endpoints. Instead of having to integrate with a bunch of exchange APIs of varying quality, you can get everything through one screaming fast firehose. If you found that you or your developer have to spend too much time cleaning up and maintaining datasets, instead of identifying opportunities, or if you’re tired of interpolated data and want raw primary source trades delivered simply and consistently with top-notch support in SLAs, then check us out the Nomics Market Data API.

Welcome to Part 1 of “Tokenize The World: A Security Token Audio Documentary”

In this first installment, we discuss:

The origins of securities and how we determine what qualifies as a security.

Why Beanie Babies, art, and other collectibles are not securities.

The purpose behind securities laws.

The benefits of tokenizing a security and fractionalizing property ownership.

Why private securities often trade at a huge discount.

How blockchain technology has changed trade execution.

How tokenization unlocks liquidity.

How security tokenization provides different kinds of value to public vs. private companies.

Why cap table management largely not an electronic process right now.

Ideal vs. non-ideal security token use cases.

Why centralization within security token platforms is unavoidable and doesn’t erode the value proposition of these systems.

The kinds of problems are being solved through security tokens.

Which average American businesses could benefit the most from tokenization.

How blockchain technology has changed trade execution.

How tokenization unlocks liquidity.

How security tokenization provides different kinds of value to public vs. private companies.

Ideal vs. non-ideal security token use cases.

Which average American businesses could benefit the most from tokenization.

We also discuss three misconceptions about security tokens:

The first misconception is that security tokens are not valuable, because they are centralized around the issuer and in many cases are not censorship resistant. The second misconception is that securities should not be represented with a blockchain because securities are not, at their core, digital assets. And the third is that security tokens are overkill and that all that is needed is a highly efficient database, rather than a blockchain, to address the needs of issuers and traders.

Special thanks to all of our guests including Professor Stephen McKeon, securities attorney Zach Robins, Harbor CEO Joshua Stein, and Bruce Fenton (CEO Chainstone Labs/Atlantic Financial and Board Member at Medici Ventures, tZero & the Bitcoin Foundation). Thanks also to Polymath’s CEO Trevor Koverko & COO Chris Housser, who appear prominently in part 2 of this audio documentary.

For Reference:

Links Relevant To This Episode:

Terms Mentioned in the Episode:

Part 1 Transcript:

Clay Collins: 00:00:03 Welcome to Flippening, the first and original podcast for full-time, professional and institutional crypto investors. I’m your host, Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the front lines of financial disruption. Go to Flippening.com to join our newsletter for cryptocurrency investors and find out just why this podcast is called Flippening.

Announcer: 00:00:25 Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion and do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.

Clay Collins: 00:00:40 Welcome to part one of Tokenize the World, a security token documentary. If you don’t know what a security is, let alone what a security token is, we’ve got you covered because right after this intro, we’re starting from the top.

Clay Collins: 00:00:51 I decided to create this series after learning that many of my preconceived notions about security tokens were just flat wrong and that several individuals I respected and who, otherwise, were well versed on crypto assets had misconceptions about security tokens, how and where they attempted to add value, why they might be needed, and the mechanisms of how they worked, and who could blame them really?

Clay Collins: 00:01:11 As my friend, Taylor [Pearson 00:01:12], pointed out in a really long Tweet storm, just understanding how cryptocurrencies work means understanding cryptography, distributed systems, economics, and politics. Security tokens add to this list, SEC regulations, securities laws, equity mechanics, private and public issuance of stock, and guidelines from over 100 legal jurisdictions. With this in mind, my purpose here is not to convince you that security tokens and asset back tokens are valuable or needed, but instead to simply the complex and tell the story of projects makers, issuers, investors, and influencers driving adoption of security tokens.

Clay Collins: 00:01:45 To create this content, I had conversations with leading thinkers and creators in the field. What I found is that, at every step of the way, the tokenization of securities, real estate, art, and other real-world assets is forcing us to reexamine old habits and ways of operating. This documentary started off as a passion project, quickly turned into a huge, time-consuming pain in the [beep 00:02:06], and is now back to being a passion project just as it’s about to be released.

Clay Collins: 00:02:10 I should mention two things before we end this intro. The first is that I am not an attorney or financial advisor and absolutely none of this should be taken as legal or investment advice. The second thing worth mentioning is that this documentary is brought to you by the Nomics API. Nomics employs me and is making this content possible, so here’s a bit about the API. The Nomics API offers squeaky clean and normalized primary source trade data offered through fast and modern endpoints. Instead of having to integrate with a bunch of exchange APIs of varying quality, you can get everything through one screaming fast fire hose. If you found that you or your developer have to spend too much time cleaning up and maintaining datasets, instead of identifying opportunities, or if you’re tired of interpolated data and want raw primary source trades delivered simply and consistently with top-notch support in SLAs, then check us out at Nomics.com.

Clay Collins: 00:02:58 Let’s get back to the documentary, which starts out by addressing two questions. The first is how we traditionally interact with securities in the past, and what needs improvement? The second is, what’s a security in the first place? Here to address that topic is securities attorney, Zach Robins.

Clay Collins: 00:03:19 At it’s most basic level, what is a security?

Zach Robins: 00:03:27 The Securities Act of 1933 and then the Securities and Exchange Act of 1934 are the bedrock laws that oversee securities laws and were both responses to the Great Depression. Today, we judge a security by something known as the Howey Test. The Howey Test is a four-part test, which basically says, “Is an investor contributing capital? Is the capital being contributed to a common enterprise that relies upon the work of others,” and the fourth part, most important part, “is there an expectation of profits?” That Howey Test came from case law, and that, today, is still how we judge a security.

Zach Robins: 00:04:16 The vast majority of securities out there are privately held. Those are shares in private companies, those are interests in real estate, in many other assets out there.

Zach Robins: 00:04:28 When I’m trying to explain a security to someone, and it’s obviously helpful to describe it in as layman’s terms as possible, I love to use the example of Kickstarter because, in 2018, everyone knows what Kickstarter is, and Kickstarter is where you back a campaign, you give money to that campaign, and you never have an expectation though of making money off that campaign. Your expectation is that you’re going to receive access to a service or perhaps a physical good will be coming back to you, and so that is not a security, whereas if I were to invest in an investment crowd funding campaign, there is a clear expectation of profits.

Clay Collins: 00:05:17 There’s some interesting nuance in Zach’s comments, but the most essential part of what Zach said is the Howey Test as a set of conditions used by the FCC to determine what is and is not a security. I think it’s important that we restate this four-part test. Something qualifies as a security if it involves:

Clay Collins: 00:05:33 1. An investment of money.

Clay Collins: 00:05:35 2. A common enterprise.

Clay Collins: 00:05:36 3. With the expectation of profits.

Clay Collins: 00:05:39 4. Predominantly from the efforts of others.

Clay Collins: 00:05:42 This last part is arguably the most important component. It is key that profits are derived from the efforts of others. That’s why a direct fractional ownership stake in real estate generally doesn’t constitute a security, and that’s why Beanie Babies, lottery tickets, pieces of art, and collectibles are not securities.

Clay Collins: 00:05:59 For more on this, here’s a piece of my conversation with Bruce Fenton. Bruce is the owner of Chainstone Labs, hosted the Satoshi Roundtable, and one of the leaders of the Ravencoin Project.

Clay Collins: 00:06:10 You mentioned that you could have a token that represents a Beanie Baby, and that wouldn’t necessarily be a security. The somewhat absurd example of a Beanie Baby might help us get to the core of this discussion about securities. If you had a token that represented a Beanie Baby, that would not be a security, but if you could have fractional ownership in a Beanie Baby that you believed would appreciate in value and these tokens that represented fractional ownership or being traded, would that be a security?

Bruce Fenton: 00:06:44 No. That’s a great question. I’m glad you asked that because that’s a common misconception. A lot of people are really misunderstanding what tokens are and how they work and what securities are and how they work. The fact that something is a token doesn’t change it at all, whether it’s a security or not. That’s completely based on just the Howey Test.

Bruce Fenton: 00:07:02 A Beanie Baby, nobody argues that a Beanie Baby is a security. If you tokenize it, basically, something being a security doesn’t change its properties. What really matters is what the agreement is, going back to when we talked about what a stock is. What is the agreement between people? What is the agreement between human beings? In the example with a Beanie Baby, if you have a fractional Beanie Baby and you believe it goes up, that alone doesn’t make it a security, and that would not be subject to the Howey Test. That wouldn’t be considered a security under the Howey Test. Collectibles are allowed. They are not considered securities. You can trade them freely. You could certainly tokenize them and trade them. There’s no reason you couldn’t. Just because something’s anticipated to go up in value doesn’t make it a security.

Bruce Fenton: 00:07:49 That’s one part of the Howey Test, whether somebody anticipates that it’s going to go up, but that alone doesn’t make it … People think that things are going to go up all the time. People were buying ringtones for a while. People buy magic cards. They buy comic books. They buy art. They buy rare cars. None of those things are securities, and the tokenization of something and splitting it into fractions doesn’t make it a security. What makes it a security is the agreement between people. If you’re raising money from people where they think that the person’s work … That was a key component of the Howey Test, a person’s work, as in CEOs and CFOs and COOs, are going to do something that will make someone else the shareholder or the instrument holder money. That’s a very different thing.

Bruce Fenton: 00:08:36 If you invested in a company that sells Beanie Babies or comic books and says, “We’re giving you a token and we’re gonna buy X number of Beanie Babies and you’re gonna get a percentage of what we sell,” or something, those are the kind of things when you’re getting into being a security.

Clay Collins: 00:08:52 What if we take the example beyond Beanie Babies and we say, “Fractional ownership in a piece of Vincent Van Gogh artwork or fractional ownership in a piece of property that isn’t being put to productive use.” Is it the same thing apply or not?

Bruce Fenton: 00:09:08 It depends. The law is complex. In the example of a Van Gogh painting, sure, I don’t believe that would be a security, also. Real estate, it depends how it’s sold. If it’s just real estate in itself, that wouldn’t be a security. Real estate is not a security. However, real estate investments can be securitized depending how they’re sold. If I go out and say I want to be a developer and I’m going to raise 100,000 each from 20 people or something, those are the areas where you’re likely getting into something that’s going to be a security. It depends exactly how it’s done. There are ways to structure real estate transactions, which is not a security. We have joint owners and they all own part of the real estate, but Howey and the FCC and the law is mainly concerned about is when someone is asking someone else for money for something that they are claiming or presenting or the people believe will yield them an investment return based on the efforts of another person. That’s where it really comes down to it.

Bruce Fenton: 00:10:06 You could buy a Van Gogh, and that’s just going to do what it … It’s going to go up or down in value based on supply and demand. Same with Beanie Babies, comic books, Van Goghs, ’67 Mustangs. All of those things will be based on supply and demand, whereas if you have interest in Bob’s Car Repair or Jane’s Art Stor or something like that and you own a 1/1,000th of the company, then that is a security because your efforts don’t depend on supply and demand. They depend on Jane’s efforts as a art dealer or Bob’s efforts as a car dealer or whatever. That’s one way that it becomes a security.

Bruce Fenton: 00:10:44 There’s other ways, too. You could have something where you don’t depend on anybody’s effort, but because of what the instrument is invested in, then that becomes a security. For example, if you buy other securities, you’re automatically a security. That’s one thing that we ran into with my company. I want to issue an asset management product that would invest in securities, and I spent probably a year looking at the law, and I’m very clever and creative with these things. I love to think outside the box. It’s probably my biggest strength, and I have a decent understanding of both the securities industry and blockchain, and I looked and looked and looked and tried to figure out a way around it. They’re just isn’t any way around it, at least for my particular product. If you have an investment that buys securities or if you are having something that is basically shares of your business or something like that, it’s definitely a security, so for, at least in my case, there was no way to try and claim it was a utility token or something like that. That’s important to know exactly how the Howey Test decision works and what they’re most likely to look at when they’re looking at these things.

Clay Collins: 00:11:48 What I noticed during my discussion of securities is that there seems to be a definitional tautology. Something is a security because it’s regulated by the FCC, and it’s regulated by the FCC because it’s a security.

Clay Collins: 00:11:59 Here to help us gain clarity on this is Joshua Stein. Joshua is an attorney and the CEO of Harbor, one of the leading platforms for issuing blockchain-based security tokens.

Joshua Stein: 00:12:09 There’s the tautology of a security is that which is defined as a security under the law. That’s the legal answer of, when do the security rules apply, but underneath that, there’s a underlying public policy concern. Why do we define certain things as a security? What is it that drives the categorization? The answer is it’s a classic principal agent problem. When you have fractional ownership and you give over your money to someone else to then invest and manage that, there is a principal agent problem where the interests aren’t aligned exactly. That’s where the regulation springs up so that investors can be protected and that the capital can be formed, and the securities laws are designed to do that. They’re designed to protect investors, facilitate capital formation, ensure orderly secondary markets, and it drives out of this principal agent issue where you have to have some level of disclosure and trust of the third party that you’re entrusting your money to.

Clay Collins: 00:13:06 Securities laws were created to prevent fraud and to prevent bad actors from making decisions that negatively affect others. I think Josh’s answer gets at the root of this issue, which is that they were created to solve the principal agent problem. The principal agent problem in political science and economics occurs when one person or entity, i.e., the agent, is able to make decisions or take actions on behalf of another person or entity.

Clay Collins: 00:13:27 Professor Stephen McKeon from the University of Oregon has some further insight into the purpose behind these laws.

Stephen McKeon: 00:13:34 One thing that’s not talked about often enough is that there’s a difference between a scam and a bad idea. Regulations should attempt to curb the first, but not the latter. It’s hard to tell [inaudible 00:13:47] what are the bad ideas and what are the things that are going to be world-changing. Sometimes, it’s actually not obvious right away. What regulations should do is try to curb market manipulation, try to curb outright scams, but not actually try and protect the investor from taking a chance on a particular idea. The government authorizes many ways for the general public to lose money. They sell lottery tickets. They regulate casinos and so on.

Stephen McKeon: 00:14:18 I think it’s up to the investor to decide whether the investment is good or not or whether it’s something they want to put their money behind, but what regulations should do is try to prevent the purely bad actors.

Clay Collins: 00:14:31 There we have it. The spirit of this regulation is to prevent fraud and principal actor situations, and the letter of the law is the Howey Test.

Clay Collins: 00:14:38 It’s probably obvious to everyone listening, but still worth noting that stocks, bonds, ownership interest in mutual funds, hedge funds, etc., these things are all securities. With this established, let’s move to security tokens.

Clay Collins: 00:14:49 To kick of this exploration, we’ll feature a little audio from my conversation with Josh Stein from Harbor.

Clay Collins: 00:14:56 I think what’s interesting about this space or perhaps what people find confusing is you’re taking something that’s already complex and not well understood, which is tokens and blockchain technology, and then you’re adding to that something else that’s pretty complex and not well understood, which is securities laws and then everything else that goes around that, including trading and settlement and all of those things. When you explain, I guess, at dinner parties what security tokens are at their core, how do you explain it?

Joshua Stein: 00:15:31 They’re the same security interests you have today, only with electronic wrapper. I think a great analogy is email to snail mail and what happened with written communications. I can type out the same exact written communication, and 25 years ago, I would click Print, put it in an envelope, put a stamp on it, wait two to three days and have it delivered. Now, I click Send on an email. It happens instantaneously at almost no cost. The content of the written communication is exactly the same, whether it’s in electronic medium or paper medium, but the difference is once something’s electronic and digital, I can send it faster, cheaper, and easier by orders of magnitude.

Joshua Stein: 00:16:10 Similarly, with photography, whether I use film or whether I use digital sensor, the photo of the object looks the same. What’s different is, again, digital photography is orders of magnitude, faster, cheaper, and easier to develop or use the images, and once in this electronic format, you can do a lot of transformative things.

Joshua Stein: 00:16:31 Similarly, when we tokenize or digitize securities, we can issue, but especially trade them, orders of magnitude, faster, cheaper, and easier, and that leads to transformative uses that we didn’t do before.

Clay Collins: 00:16:44 There’s definitely a group of people who I think misunderstand fundamentally what’s going on, and they say things like, “It’s not centralized. The issuer has a lot of control if theft happened or if shares need to be reissued.” That could absolutely happen. I don’t think anyone is trying to necessarily decentralize company ownership. Though, with that said, what do you see as the primary benefits of tokenizing a security versus what is arguably an electronic process already?

Joshua Stein: 00:17:21 It’s not an electronic process today. In the public markets, it is, and the public markets function very well. In fact, tokenization does not offer huge benefits to the public markets. There are some administrative efficiencies using blockchain technology. Settlement becomes faster and easier, and cap table management is more accurate, but for public securities today, shares in a public company, tokenization doesn’t offer transformative value. Where it does is the tokenization of private security interests, which, today, exists only on paper and have zero liquidity. The purpose of Harbor and the purpose of security tokens is to take some of that liquidity from the public markets, bring it to private securities through the technology, and then you unlock tremendous value.

Clay Collins: 00:18:07 Hey, it’s me cutting in here. This is absolutely key distinction that Josh just made. Security tokens provide enormous incremental value for publicly traded companies, but the real transformative value here is for private companies, which is what most of the world securities are. For private companies, security tokens are a huge lever. Let’s go back to my conversation with Josh.

Clay Collins: 00:18:29 Let’s then take an example, maybe a local coffee shop. Let’s say my neighborhood here doesn’t want Starbucks to move in, but the local beloved coffee shop is having problems, so the neighborhood decides that they’re going to chip in and help the coffee shop do a fundraise. The coffee shop is going to issue security tokens with Harbor. As an example, is that a use case for what you’re doing?

Joshua Stein: 00:18:57 Yes. It is a use case. You can tokenize stock holdings in a private company. When you tokenize ownership of a private company, you get the administrative advantages you talked about, better cap table management, and you don’t have those double-counting shares and other issues that often happens in private companies. The real transformative use is unlocking liquidity, which investors value.

Joshua Stein: 00:19:20 I actually think private companies are a mixed use case. For some private companies, tokenization of shares makes sense. For others, they don’t, and I want to explain why.

Joshua Stein: 00:19:31 What tokenization does is it brings liquidity, so where you want to lock up the capital, but not the investor, it’s a great solution.

Clay Collins: 00:19:41 Hey, it’s me, again, cutting here from the editor’s booth to emphasize what Josh said. Most private companies lock up both capital and investors. That is they make it impossible for investors to resell their interest in a business. Tokenized securities allow businesses to retain invested capital while making it easier for investors to enter and exit their positions and companies by selling their shares to others. Back to Josh.

Joshua Stein: 00:20:03 Where you’re sensitive to the cost of capital, where you want to gather in or you have the ability to gather in investors, a broader investor base, particularly globally, tokenization is a great solution. Where you really care about the identity of the ownership, where you are not interested in a lot of liquidity in the security, tokenization provides some of the incremental administrative advantages we discussed, but it doesn’t bring transformative value because the transformative value comes from liquidity.

Joshua Stein: 00:20:33 I think a great example of where this locking up the capital, but not the investor becomes really transformative is think about investments that are long-term, plays that are very capital-intensive, and where they’re very sensitive to the cost of capital. Real estate is a great example. If you think about a private REIT today, REIT is a real estate investment trust, it’s simply a C corporation that has special tax treatment, depending on how it pays out dividends and it limits its investments to real estate, a REIT is a common investing vehicle in real-

Joshua Stein: 00:21:00 It’s its investments to real estate. A REIT is a common investing vehicle in real estate. Real estate is very capital intensive. It’s very sensitive to the cost of capital. There’s real desire for investors to get into U.S. real estate worldwide. Today they could get into public REITS, but those own huge baskets of property. There’s a lot of opportunities on the private side, but it’s difficult to get into. Private REITS, like private securities today, there is no liquidity. The reason there’s no liquidity is because buyer and seller can’t find each other, you have to repaper every transaction, and most importantly, there’s fundamental transfer restrictions on those shares or interests. You can’t just go sell them, even if you do find a buyer. You have to go to the fund manager to get their say-so. The reason is because there are very complex requirements, both regulatory and contractual. That the issuer has to manage.

Joshua Stein: 00:21:57 The example of a private REIT is they have to have a minimum of 100 investors for tax purposes, not more than 2,000 or they have to go public. They have to have non-U.S. persons own less than 50% and the top 5 shareholders have to own less than 50%. What happens when you tokenize and what happens when you can apply those restrictions at the token level is that now buyer/seller can find each other and they can transact directly without having to go through the fund manager for prior approval.

Clay Collins: 00:22:24 This is a really interesting aspect of security tokens. I’d love to dig into what the law says here a little bit. As a founder, I’m familiar RAG-A, RAG-D, RAG-CF. I’m familiar with the obligations that I have when selling private company stock. I am not as familiar with what the law says about what a purchaser of that stock can do with regards to selling it to other people. Under the laws the issuer held responsible for what a stock purchaser does in terms of buying and selling stock once it’s been purchased.

Joshua Stein: 00:23:08 There’s certain aspects of it that rebound onto the issuer. For instance, if you don’t have these type transfer restrictions on the private shares in a company and you end up with more than 2,000 shareholders that company must go public.

Clay Collins: 00:23:22 Wow. So the SEC holds the issuer responsible for the action taken, or for at least regulating what happens with its own stock.

Joshua Stein: 00:23:33 In some aspects, yes. If you’re a REIT and you end up with less than 100 investors you blow your favorable tax treatment. If you’re an investment fund those generally have a limit of 99 investors, if you have more than that you have to go public. There are sometimes liquidity restrictions, there’s things call publicly traded partnership rules where if you’re LP interests in a fund are too liquid in certain ways you can blow the payroll tax treatment for that investment fund.

Clay Collins: 00:24:02 Me again, so what Josh just said is a big deal. If you’re a REIT or a company, having too many or too few investors can be a big problem. Going over or under the required number of investors can result in you being forced to go public or having to pay millions of dollars in additional taxes. That is, if you have too many investors you might be forced to go public. If you have too few investors you might lose your tax status.

Joshua Stein: 00:24:25 Also, there are special restrictions on affiliates of the issuer, so think not just subsidiaries, but think about persons who have a controlling interest or controlling influence in the issuer. It rebounds on the issuer, on actions that they take, so there’s a whole host of issues that the issuer has to control for. The way they do that today with private securities, which exist in paper, is they put these tight transfer restrictions and you have to go to the issuer and manually get a waiver. Then they have to go try and find the counterpart usually. They may have 50 or 100 investors, they fax, they phone, they email, they expend a lot of elbow grease to fid somebody. As a result, when you have a private investment if you need liquidity it takes weeks or months. It takes a lot of elbow grease, it costs you $10,000 to repaper the transaction and then you get what’s called the illiquidity discount, you get a hit on the valuation. The academic literature says that’s 20-30%. In actuality, if you’re in a hurry it can be a lot deeper than that.

Clay Collins: 00:25:25 I can certainly see that coming into play with artwork. There might be a painting that’s worth $20 million, but if you want to sell that now there’s like 4 people in the world who might want it and you probably won’t be able to make that happen without taking a huge hit.

Clay Collins: 00:25:40 Hey, so this is a key point. Private securities often trade at a huge discount by virtue of there not being real secondary markets for them. This is known as the illiquidity discount. For more on this we’ll turn to my conversation with Professor Steven McIan.

Clay Collins: 00:25:56 In a lot of these valuation models they let all the money that you would spend on attorney’s fees and all these expensive bespoke activities, or I guess maybe ad hoc activities that require human time. They move those to the balance sheet of these networks and let the money you would spend on fees accrue to the network value.

Clay Collins: 00:26:25 I think another interesting idea is around liquidity and how something being more liquid actually increases its value. I’ve heard economists talk about one of the reasons why token are so expensive or why we’ve seen sharp rises in the prices of Ethereum, and Siacoin, and other cryto assets, or crypto commodities is because there is liquidity. That, in and of itself, adds to the value of the asset. Do you think as an economist putting your economist hat on, do you think tokenized properties or do you hypothesize that tokenized properties will be worth more because there is that the liquidity that comes with tokenization.

Stephen McKeon: 00:27:14 It’s definitely part of a thesis. It’s a central part of the thesis is this idea of a liquidity premium, or I should say mitigating the liquidity discount. You touched on two things there in that question. There’s a couple baskets of shifts in value. One is just becoming more efficient, taking some of these costs that are involved in transaction and automating them to some extent, which just makes it easier to transfer these things, and reduces the direct transactional costs relative to moving value.

Stephen McKeon: 00:27:49 Then another idea is this idea of liquidity premium. So if you just break it down and you think about why does this thing exist, when we think about measuring liquidity, we often look at … What economists do, financial economists, will look at price impact. If I need to sell this thing, say I own an asset and I need to sell it right now, how much would I have to discount the price or how much would the price move because I’m executing this trade? So you can measure these things with a bid-ask spread or you can look at how much did the price move in response to a particular trade. If I’m an investor and I know that once I buy this thing there’s going to be price impact when I want to go sell it at some point in the future, what that means is I’m not going to pay as much for it today because I’m anticipating that cost in the future. You can just follow that all the way through the chain and understand why the illiquidity discount exists.

Clay Collins: 00:28:48 That makes complete sense. I can see the liquidity premium applying to things other than maybe traditional securities into things like artwork. There might be a very rare piece of artwork and maybe it’s valued at $100 million or $150 million but there’s like 10 people in the world that would be willing to pay that much for that piece of art. Once you have a scenario where there’s fractional ownership and there’s liquid markets around it now we might get more accurate pricing in those instances. Is that something that people are contemplating around this space?

Stephen McKeon: 00:29:30 Absolutely. The idea that you’re touching on there is something called market depth. Market depth is an integral piece of this liquidity premium idea because as I’ve said before, just because you tokenize an asset that doesn’t automatically make it more liquid. It only becomes more liquid if it also increases market depth for the reasons that you touched on. If you have a high unit value asset and there’s very few people in the world that can wrangle the resources to purchase that asset, but if you were to fractionize ownership you now get a much larger pool of buyers. Then you’ve increased market depth, then you’ve potentially increased liquidity, like transferring that value would be less impacted by the trade because there’s more buyers out there that are interested in owning it. So yes, that’s a really important piece.

Clay Collins: 00:30:24 In addition to discussing the impact of security tokens on private companies we would also discuss the impact on public ones as well. Here to discuss this with me is Bruce Fenton, a Wall Street vet who’s been an asset manager and stock broker for over 20 years.

Clay Collins: 00:30:39 During this period that you’ve been involved in this highly regulated industry, how has trade execution changed?

Bruce Fenton: 00:30:49 A lot of people don’t really understand how things work. Some of the big changes, when I started they had what’s called T+5 settlement, so it was 5 business days. If you had a weekend, well you always had a weekend basically because it’s five business days. Then sometimes you’d have a holiday or something like that. You could end up taking a good part of a week to get your trade settled. Then that moved to T+3 and now T+2. With block chain technology you can get that down to basically minutes. That’s why the t0 chose the name t0, 0 day settlement.

Bruce Fenton: 00:31:24 The industry has moved along, but not very fast going from probably I don’t know how long T+5 was there before I came in, but I think it was decades probably. So going from 5 days when I started 25 years ago to 2 days isn’t a really big change when you can have the technology that a block chain has, which can enable that to be done in 10 minutes.

Clay Collins: 00:31:47 What intelligence or analytics have issues historically had about their shares, the liquidity of those shares, holders of those shares, whales, et cetera, what has been known by companies about what is being done with their stock.

Bruce Fenton: 00:32:05 They don’t know anything. For public companies they don’t know anything and that’s a really important thing to note because a lot of people in the block chain, bitcoin space are from startup environment. They assume that everything works like startups. They assume that oh you’re company you do a round, you do another round, you have a database, you have your cap table and you know who owns what. That is not the case for publicly traded companies. When we talk about taking on Wall Street, when we talk about truly disrupting the global financial system we’re not talking about a startup raising $30 million. We’re talking about a completely different type of scenario. Up until recently there’s been a very, very big difference between private companies and public companies. That’s why it’s been so hard and expensive to become public. That’s why you need so many professionals and other people involved, and there’s so much intermediary, some of which add value, some of which don’t. There’s tons of lawyers, and exchanges, and regulators, and brokers, and transfer agents, and all kinds of things like that that you need in that system. It’s important to note that it’s two different things basically.

Clay Collins: 00:33:09 I guess within that system, and you might not know the answer to this, but within that system how do they do basic accounting around outstanding shares? They can certainly know what they’ve issued, but if they do want to find out what’s in circulation … You mentioned something that happened in 1996 with the DTCC, could you speak a little bit to that?

Bruce Fenton: 00:33:31 Yeah that’s an important point. What happened is if you’re thinking of it from a startup angle, as a lot of people do, they say, “Okay, you have a company. The company tracks who owns what and people have their shares.” They can change it if somebody changes it, the company can change that out. People who think of it that way don’t see the advantage of a block chain and there’s a lot of critics who will say … and I’ve spent a lot of effort trying to explain why this is incorrect, because these are typically very smart people who know a lot about block chain, some of them are bitcoin Maximalists. On this particular subject they’re wrong because they’re misunderstanding that is being solved for. They’re assuming that a block chain is going to solve for making it so that the company doesn’t have to keep the database, but that’s not correct. The company never kept the database.

Bruce Fenton: 00:34:17 To answer your question, the way that public companies do it now is a real mess. What happens is Apple doesn’t know who their shareholders are. They have no way of really getting that. The reason they can’t know that is there’s millions and millions of transactions a day. You’d need a department of 100 people at Apple just to figure out who owns what and it would never work because they would have to interact with a whole bunch of other people. A lot of people who think that a block chain is the solution they say things like, “Oh you just have GPG keys,” or all these other centralized solutions, but those won’t work, because again, it’s not the issuer that actually keeps the database because there’s so many trades.

Bruce Fenton: 00:34:56 You have all of these brokers involved, so who keeps the database, who keeps the list of who owns Apple? Well nobody really. It’s a distributed database, which kind of sounds good at first until you look into how it actually works. It’s distributed but also centralized. It’s distributed in the sense that Merrill Lynch knows how many shareholders own Apple at Merrill and Morgan Stanley how many at Morgan, and Goldman knows how many they own, but they don’t tell each other. They don’t communicate with each other.

Bruce Fenton: 00:35:22 What happened is this got so untenable and they couldn’t even keep track of who owned what. So throughout the 60s, 70s, and 80s, 90s, they would drive around in bicycles and deliver certificates between offices and then they’d have interoffice curriers and messengers. So Goldman would net it out at the end of the day and Merrill would net out this, and people would transfer physical shares between offices. They did that all the way up until the 80s and 90s basically. Then they tried to create a system that would be more electronic and more modern. The thing is, Wall Street doesn’t sleep, it’s constantly going. You can’t just shut it down for a year and build a better system. You have to just constantly build on, build, and build. The system that’s built now has been built layers and layers on it going back 100 years. A lot of the things that we have are legacy systems that are going back from the 50s, 60s, 70s.

Bruce Fenton: 00:36:09 In 1996 this capacity issue, you could call it the capacity debate on Wall Street, there wasn’t much of a debate about it though because they don’t think about things like decentralization. They said, “All right, this isn’t working. It’s a big mess. We can’t figure out who owns what. There’s fake shares being issued. There’s all of this stuff. Merrill Lynch and Morgan Stanley won’t communicate with each other. Nobody knows who owns what.

Bruce Fenton: 00:36:31 Companies, in order to send out a proxy statement or a voting statement, have to hire a consultant company who can come in and figure out who the shareholders are so they can send it, which they’re legally required to do. So they trust a third party to do that. In 1996 what they did is they said, “Well let’s just put everybody’s money in one name. Forget about trying to pretend that his is Bob’s stock, and Susan’s stock, and ABC company’s stock, and Bruce’s stock. We’ll just put it in one name. We’ll put it in one big company name. We’ll call that company CD & Co and we’ll make sure that it’s protected by having a whole bunch of complex legal trusts, and documents, and stuff to make sure CD doesn’t steal the stock, which they haven’t. CD will have all the money. Then the DTCC, the Depository Trust Company will work with them in a complex system to figure out and net out at the end of the day or the end of the week who actually owns what and when those brokers want to contact us and figure out who actually owns what, and we settle up.

Bruce Fenton: 00:37:27 They can do that through centralized parties like DTCC. That’s the system that exists right now. It’s a distributed, but centralized ledger. It’s distributed because there’s a whole bunch of parties, there’s brokers, transfer agents, issues, a whole bunch of other people and organizations involved, exchanges, everything else, but they haven’t had any way that they could solve the byzantine general’s problem and trust other people, so they just put it in one organization and they all agreed that they would trust that organization.

Bruce Fenton: 00:37:57 Some aspects of it have worked better than the old way, certainty, but it has a lot of drawbacks. For example, right now to go from broker to broker it takes between two and three weeks or more to transfer your shares. Even if you’re going from one department of company to another, you could go from within Merrill Lynch to another part of Merrill Lynch, it could take 10 days to move your money. If you’re Amish or you don’t have a driver’s license, or you changed your address, or you’re part of a trust, or an estate, or you had a divorce, or you had a death, or any number of 100 other things your “I” isn’t properly doted. That three week period could stretch to four, five, six, seven weeks. It’s very common. Pretty much any broker will have some horror story, it’s called the A-CAT process, is the internal system.

Bruce Fenton: 00:38:42 By the way, when I talk about DTCC and A-CAT, sometimes I’ve mentioned that and people say, “Oh you’re trying to just replace one company.” This isn’t just one company. It is the entire industry. It is all brokers. It is all publicly traded companies in the Unites States, it isn’t some. This isn’t some little billion dollar company out there that somebody’s trying to displace, this is trillions, and trillions, and trillions of dollars, it’s all the money in all the system pretty much. There are a couple very, very rare examples where certain founders will have special 144 stock that’s not listed and they control it themselves. Maybe Elon may have his own shares or something. Generally, even those examples are rare. So pretty much all the stock in the world … Certainly, if you’re a stock holder any of your listeners, people who own stock in their 401k, even multi-millionaires, even deca-millionaires, even billionaires, I’ve served billionaire clients for years, all of them same way, it’s in the same system.

Bruce Fenton: 00:39:38 You could talk to brokers about the A-CAT process and say, “What’s the worst A-CAT you ever had?” Everybody has a horror story, sometimes it takes 11-12 weeks. I had a client where they had a death in the family and death certificates and stuff like that could take weeks, and weeks, and weeks. Whereas, with a block chain type asset it would be instant.

Clay Collins: 00:39:54 That’s super interesting. I think most people, because the infrastructure around it appears to be very efficient they don’t see what happens on the back end of those trades. Maybe Scottrade said something, but you don’t have it yet.

Bruce Fenton: 00:40:10 You don’t actually own your stock. When you open a brokerage account at Charles Schwab or Scottrade you have 12 pages of documents. When I started in the business, this is funny, this shows how the industry has changed, when I became a broker in ’92 you could open an account over the phone with no ID and you didn’t even need any money.

Clay Collins: 00:40:30 Wow.

Bruce Fenton: 00:40:30 They had the same five business day settlement, the had five days to get the money in. You could literally have somebody call in and say, “Hey, I want to open an account. I want to buy IBM.” They could buy it. You just took down their name and address and then hopefully they paid you. It’s funny, as crazy as that is there was very cases of fraud. What you could do obviously with that front run, you could call five brokers and short sell IBM at five of them and buy at long at IBM at five of them. Surprisingly, those things didn’t happen. It’s the kind of thing that happens once every couple years. You’re going to have fraud in any business. It wasn’t as common as you think.

Bruce Fenton: 00:41:08 People tend to know … Brokerage was more community based back then. You had a stockbroker and they could spot something that seemed unusual, and we’d have unusual trades, and people would come in, but nobody actually owns the stock that they think they own. If you have accounts at a brokerage firm when you read those 12 pages in the back you’ll see that you don’t actually own it. You have these pledges and hypothecation agreements. Your actual share or legal ownership, if you were to have a certificate, if you were to go to Apple and request a certificate, which I don’t think they’ll do any more, but if you could it wouldn’t have your name on it. It would have DTCC’s name on it.

Clay Collins: 00:41:42 Thinking through what security tokens actually solve for it seems like there’s a number of things that it solves for. One, it solves for analytics on the part of the issuer. Two, it solves for inefficiencies with the current infrastructure. It seems like for issuers it also solves a liquidity problem. For investors as well it solves for

Clay Collins: 00:42:00 … solves a liquidity problem and for investors as well it solves for a liquidity problem. This isn’t about turning shares of your company into bitcoin. All the normal laws still apply, all the normal regulations still apply. In your view, what are the main categories of problems being solved through security tokens?

Bruce Fenton: 00:42:20 That’s a great question. A lot of people misunderstand what the problem is, especially if you go back to that example I mentioned of people looking at the startup environment assuming that you’re solving for a company database, saying well, it’s already centralized anyway, which is true. Companies are centralized so if you have Disney and Disney stock, Disney’s centralized. It’s a place. It has a CEO. It has headquarters. It has offices. It had parks that you can go and visit.

Bruce Fenton: 00:42:47 That’s always going to be centralized, at least in the foreseeable future. Maybe in a couple hundred years, somebody will figure out another way with VR or something, but for now all companies that we know in general corporate law and the general world of the global economy are centralized. So you’re not going to decentralize a company. There’s no way that a blockchain can become aware of Disney or Apple or anything else.

Bruce Fenton: 00:43:09 So that’s not what it’s solving for. What it is solving for is the custody issues of how equities, how stocks are actually held around the world. In the case of larger publicly traded companies, it’s a very complex, messy, consing system that I just mentioned that has lots of layers that don’t make any sense and don’t need to be there. What those layers do is they cause a lot of inefficiency. It takes you a minimum of a week or two to move your money from one broker to another.

Bruce Fenton: 00:43:36 I’m not talking about trading. Another misconception people have is they mistake trading and custody and asset movement. Wall Street is very good at certain tech. They can trade millions of shares in a second. They have huge, robust capabilities to do high frequency trading. Trading is different from settlement. They’re not actually moving the money. It’s kind of like Coin Base when they do off-chain transactions.

Bruce Fenton: 00:43:59 If you’re doing transactions within Coin Base, that doesn’t show up on the blockchain. If you send money from one Coin Base user to another and then they trade it back and forth, that doesn’t show up on the blockchain. That’s an internal Coin Base thing. So the current movement, all this high frequency trading is what we would call, it will become off-chain transactions basically. It will be done by brokers using the existing technology and systems that they have.

Bruce Fenton: 00:44:24 The money won’t be able to be moving. You know, a high frequency trader, somebody who does 80 trades of a stock in a day, they’re not actually sending shares to somebody and back. They’re just making a marker to figure out what settles up at the end of the day. So it will solve for that, which will make it much more efficient to move money around. It’s not going to change the high frequency trading thing, but it will make it easier for money to move around.

Bruce Fenton: 00:44:46 The other thing it will do, it will give people more control of their own money. You asked if I had stock certificates. Almost nobody has them anymore other than for small companies. Publicly traded companies very rarely issue them. They’re really not used, brokers don’t really recognize them. Most of the younger brokers now who came in 10 or 15 years after me have probably barely ever seen these certificates.

Bruce Fenton: 00:45:07 So we’re not solving for the trading aspects and we’re not solving for our company database. We’re solving for this overall complex system of intermediaries which don’t add value, that add a lot of delays, so we’re making that more streamlined, more efficient. That’s what a token can do. And what that does, it enables people to control more of their own money, which is if you believe in bitcoin you should believe that people should control their own wealth. You have a lot more liquidity options and things like that if you control your own money.

Clay Collins: 00:45:40 One of the new liquidity options that comes with security tokenization is the option for public and private security token holders to sell their tokens in a peer-to-peer fashion. A lot of early adopters report buying their first bitcoins at a coffee shop or over eBay from another person. Unfortunately, these types of transactions aren’t possible with securities right now, but not because peer- to-peer transactions are prohibited by the law. Back to Bruce Fenton to explain more.

Bruce Fenton: 00:46:05 You have the right to sell your property. If you own Apple shares, you can sell those to me legally. People don’t understand that. They’ve been so beaten down by this system of compliance and laws and you know, nonsensical rent-seeking intermediaries that they’ve forgotten something as basic as the fact that yeah, if you own your own property you don’t need a broker to sell it. You could sell it to somebody.

Bruce Fenton: 00:46:29 It’s going to be very, very interesting to see the rise of decentralized exchanges and if you look at the wording and the way that a lot of the laws are written, as soon as the SSC really figures this out, and some people there are quite smart and so they probably already figured it out, it’s a big deal for the way the things will work because you’re not going to need exchange as much. The biggest control point that they have is issuers and exchanges.

Bruce Fenton: 00:46:51 Issuers is pretty easy. Just comply with the law and either be exempt or register or make it not a security or you get in trouble. Those are your four options. But the secondary market is going to be a very interesting thing and that’s where I’ve been focusing most of my efforts for the last three years because I saw this secondary market as being the key. I think a lot of these ICOs are missing the boat. They’re focusing on the primary market, which is a big pain in the neck, and a lot of them are going to get in trouble.

Bruce Fenton: 00:47:16 But once you get the shares out there, if they’re legally issued the first time people can do whatever they want with them. I can buy a share of Bayer stock, if it exists anymore, I can buy that from somebody and I can make a deal with somebody at a coffee house to buy their Apple stock. Now the problem is that the systems, not the law, law doesn’t have a problem with me buying Apple stock from somebody. It’s the systems that have a problem.

Clay Collins: 00:47:41 As long as it’s public. If it’s private placement or like reg D or something like that.

Bruce Fenton: 00:47:46 Yeah. Well, if it’s Apple, I mean if it’s Apple it’s already public. The trick with Apple is that you need to have a registrar and everything say that you actually own that or you’d have to have it in some kind of vehicle or something like that. There isn’t really a way to have somebody else on it, but with a blockchain token, then ownership would be determined by whoever controls the private keys.

Clay Collins: 00:48:05 So we’ve spoken about the benefits of security tokenization for public and private companies, but it’s important to note that tokenization isn’t a great fit for everyone. For example, venture-backed companies are just one kind of company where tokenization might not make sense. Here’s more from Harbor CEO Josh Stein. When you think about maybe venture-backed companies or you know, startups in general, what do you see as the pros and cons of going this route and what might a startup founder think about when they’re going to do a raise? At what point should they start considering using a security token? How would they go about doing it?

Joshua Stein: 00:48:41 So I think security tokens actually do not offer transformative value for what we think of as a classic high tech startup. That’s because those startups are not capital-constrained. They’ve got far more people wanting to invest and far more potential capital than they can take on. They’re being choosey about their investors and they certainly don’t want their investors to freely trade. So you can tokenize for some better cap table management, but you would not as a company lift the transfer restrictions on those investors.

Joshua Stein: 00:49:10 You wouldn’t want to. But I think what we often forget is that the high tech startup that’s got more capital than it knows what to do with is a tiny fraction of a percent of all the companies out there in America and around the world. So your typical company is the neighborhood coffee shop, it’s the franchise of autobody shops that needs capital to expand, it’s real estate investments that are capital intensive and sensitive to the cost of capital.

Joshua Stein: 00:49:35 Anywhere where you are relatively indifferent to the identity of the investor but you’re sensitive to the ability to raise capital and the cost of that capital, that is where the transformative use of tokenization comes in. Eventually every private security will tokenize because there is inefficiencies to ring out. You do need liquidity sometimes and tokenization enables that, but if there’s going to be very little trading, then tokenization doesn’t offer anything particularly transformative.

Joshua Stein: 00:50:03 On the other hand, if let’s say you’re trying to gather investment in real estate, let’s say to use the good example, you’ve got a beautiful class A office building, it’s worth maybe 50 million dollars in a major metropolitan area, it’s on the National Historic Register. There are tons of people around the world who would love to get into US real estate, who’d love to be able to invest at the asset level in a single asset, something they can touch and feel and understand.

Joshua Stein: 00:50:28 So today in paper they would never hear about it. They’d have no practical way to get into it and they would have no liquidity, which is really daunting, but if you tokenize, if you now make this digital and it’s faster, cheaper and easier to gather in a larger worldwide base of investors, and if it’s faster, cheaper, easier by orders of magnitude to trade that later to get the liquidity people want, suddenly you can raise far more capital from far more people at a lower cost of capital, and that is really transformative to that industry.

Clay Collins: 00:50:58 So we’re about to get into the nitty gritty details around use cases and how security tokens work, but before we do that it’s worth taking a second to take stock of the benefits of security tokens that we’ve encountered thus far. Security tokens one, increase liquidity and market depth. Two, give control back to security owners. Three, increase the number of liquidity options for security owners such as peer-to-peer exchange and decentralized exchanges.

Clay Collins: 00:51:23 Four, remove rent-seeking intermediaries. Five, maintain the cap table for private companies. Six, provide cap table analytics to public companies. Seven, allow for fractional ownership of property like paintings. Eight, reduce settlement times from two days to minutes, and nine, make it cheaper to go public.

Clay Collins: 00:51:42 Almost all of these benefits fall under the category of cheaper compliance. By allowing regulatory compliance to scale without rent-seeking intermediaries and reducing the number of hours required from expensive service providers like accountants and attorneys, security tokens allow smaller companies to afford the kind of regulatory compliance that’s previously only been available to the Fortune 1000. Here’s Professor McKean with more on this.

Stephen McKeon: 00:52:05 In all cases where you see regulation, you know, there’s some effort to sort of keep things on the up and up. Right? But the problem is the regulation can create friction and so I think moving forward the goal, and this would be, you know, what Harbor’s working on as well as many others, is to try and make the regulation not so cumbersome, right? So kind of work within the existing environment, but make it sort of easier to comply with the regulation.

Stephen McKeon: 00:52:33 So Chris [Burnesky 00:52:34] recently wrote about the need for regulation to scale as crypto space scales, and I think that’s right. There are two ways to think about that. One is maybe we need new bespoke regulation around securities. I think this is what he was getting at, but the other idea is that we need systems to scale the regulation we’ve got. So I think that’s where things like Harbor’s R Token Protocol come into place. So in other words, using the existing regulatory environment, but making it less cumbersome to comply.

Clay Collins: 00:53:04 Professor McKean’s thoughts on this are important. One of the main criticisms I’ve heard about security tokens is that they won’t do for securities what bitcoin did for money. These criticisms I believe miss the point. Efforts to tokenize securities aren’t an attempt to turn equity or real world assets into decentralized digital cash and it’s a mistake to consider security tokens through the lens of bitcoin.

Clay Collins: 00:53:24 Instead, one should think of security token infrastructures as providing cheap scalable compliance. At their best security token technology provides open source protocols for frictionalist trading and increased liquidity outside of proprietary walled gardens. Here’s Josh Stein from Harbor with more.

Joshua Stein: 00:53:40 The fundamental value prop of Harbor is compliance as a service. There’s additional layers of value that get built on top of that, but that is the fundamental layer that has to operate or none of it works. If you can’t ensure compliance with the securities laws and contractual restrictions at the token level wherever this trades, then everything else doesn’t work. It’s the foundation to the building of value that we’re building.

Clay Collins: 00:54:03 That’s fascinating. I know of a SASS company that does HIPAA compliance to service and so maybe another way to think about what you guys are doing is it’s a securities loss compliance as a service. It’s very cool.

Joshua Stein: 00:54:13 It is because to get secondary liquidity on tokenized securities you need to be able to ensure that they’re trading compliantly no matter where it is, 24/7, 365 around the globe. The only way to do that is at the token level and those controls have to work reliably. Once you have that, then you can lift the tight transfer restrictions on the tokens and you can allow them to trade as liquidly to the limit of the inherent limitations of the investment. But if you don’t have that compliance as a service, you don’t have that compliance baked in at the token level, that can’t happen.

Clay Collins: 00:54:47 I think a lot of people think about the blockchain is a trustless system and then they go to securities tokens and they’re like, “Well, this isn’t a trustless system,” but I think what they’re missing out on is that the trustlessness doesn’t need to happen necessarily at the protocol level, it needs to happen at the liquidity level in an issue where allowed people to trade amongst themselves in a trustless manner when the stakes or the cost of noncompliance is so incredibly high to a business.

Joshua Stein: 00:55:13 That’s correct. Compliance can’t be trustless. If the compliance is provided, the rest of it can then be trustless. Then you’re in this great decentralized world in which buyer and seller can trade 24/7, 365 around the globe with instantaneous [inaudible 00:55:28] and no counter party risk.

Clay Collins: 00:55:30 Yeah, because the cost of waking up one day and realizing that you have to go public because you have more shareholders than you would like or whatever, that’s just a really bad place to be in.

Joshua Stein: 00:55:40 Yes, or that all your investors are subject to 30% tax withholding.

Clay Collins: 00:55:44 I live in Minneapolis. It’s not a startup hub. What’s an example of maybe a business that would be in a, you know, sort of that average Midwestern city that’s not real estate, that would most benefit from security tokens? You mentioned like an auto dealership. What do you think is like kind of like the prime candidate for this use case?

Joshua Stein: 00:56:03 I think folks who are looking to expand or franchise. So whether it’s restaurants, autobody shops, whatever it is. You’ve got say five, 10 locations, you have a business model that works but now you need a ton of capital to expand. If you go get capital from one, two, five, 10 investors, they’re going to bargain for some really hard control rights. They’re going to take a big chunk of your equity.

Joshua Stein: 00:56:24 You may not be able to get the amount of capital that you want. When you tokenize it’s easier to advertise out through a general solicitation out to a broader base of investors. It’s easier to onboard them. You should get a better cost of capital because liquidity brings value, so if you think that the liquidity discount is 20 to 30%, if you can eliminate half of that, that means your cost of capital should be roughly 10 to 15% lower. Or the price that you get on their shares should be 10 to 15% higher. For all those reasons, those are great examples where tokenization should help.

Clay Collins: 00:56:58 So not only do you give us less control, but you also gain a liquidity premium and potentially a higher valuation. That’s fantastic. What do you think are the downsides for that business that’s looking to franchise? Do they lose anything through going this route?

Joshua Stein: 00:57:16 What you lose is once you pull the transfer restrictions and you allow these shares to be freely traded, you have now lost control over the identity of your investors. You don’t have to do that, but the more tightly you control the investor base, the less liquidity, the less value that tokenization is delivering. Those are two fundamental trade offs.

Joshua Stein: 00:57:37 So to give an example, Harbor can enforce custom white list because we always know the real world identity, so you could say that you know what? I’m going to vet investors coming into the company and then I’m going to let existing investors freely trade amongst themselves, but I’m not going to allow someone new onto the white list unless I’ve approved them ahead of time. So that’s great. That would allow, and if you think of a large startup like an Uber, you could imagine a fair amount of liquidity and trading going on in all those different shares.

Joshua Stein: 00:58:07 But for a much smaller company you don’t have a large number of investors, you’re not going to have much liquidity. I think what becomes really interesting is what happens if say the top 100 VC firms and PE firms all decide that in their investments going forward they want to insist that they can freely trade amongst that group of 100. So now they can get liquidity, there’s a fairly diverse base of people that they can freely trade in and out fairly well, but it’s not wide open to any person around the world who’s unknown, who may be litigious or who you may not want to share financial info with.

Joshua Stein: 00:58:43 So there are varying ways to go about it, but the fundamental trade off is, is the greater the potential pool of investors that you allow and the more freely you allow them to trade, the greater the liquidity, the greater the value that you’re bringing. But the trade off is, is less control over the identity of those investors. So fundamentally we think that the best candidates for tokenization early on are where you want to lock up the capital but not the investor.

Clay Collins: 00:59:10 Security tokens represent ownership claims in all the things you’d normally think of as investment vehicles, stocks, bonds, treasury notes, mutual funds, LP interest in funds, et cetera. And this is important because as Bruce Fenton reminded me during our interview, only one-third of the world’s wealth is in cash. I’ll let Bruce close out part one of this documentary with a reminder of this.

Bruce Fenton: 00:59:31 Only a third of the world’s wealth is in cash, so we’re fighting this great, valuable, noble fight to say let’s make bitcoin or things like bitcoin become the new global reserve currency. Wonderful, I’m all there, but it’s only a third of the world’s money. Even if you win you still haven’t change the whole global economy. You need to give people that kind of same power for their equities.

Clay Collins: 01:00:03 This concludes part one of Tokenize The World. In part two we’ll be digging into the nitty gritty specifics of how security token issuance and exchange works with the founders of Harbor and Polymath, two of the top security token standards. Stay tuned. This podcast was produced by me, Clay Collins. My audio producer and collaborator is the talented Arison Cain. Special thanks to our guests and everyone who helped make this series possible.

Clay Collins: 01:00:28 If you have questions or comments you can contact me @ClayCollins. Thanks for listening. That’s it for this week. To sign up for our free crypto investing newsletter, listen to other episodes or get the show notes from this episode please visit Flippenining.com. I also invite you to check out the startup that funds this podcast, Nomics, spelled N-O-M-I-C-S, at Nomics.com. Finally, if you got value from the show, the biggest thing you can do to help us out is to leave a five star review with some comments and feedback on iTunes, Stitcher or wherever you listen to podcasts. Thanks for listening and see you next week.

Tokenize The World, Part 2: How Security Token Platforms Actually Work

Listen At: iTunes | Stitcher | Google Play

Thanks To Our Sponsor: BlockTrade.com

Blocktrade will be the first fully licensed security token exchange in Europe, focused on listing crypto assets, security tokens, and other tokenized financial instruments. By being fully MiFID II compliant they will enable crypto trading to institutional traders while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few things to announce in the next couple of weeks, including their public beta launch. Be sure to go to Blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.

Intro to Part 2 of “Tokenize The World: A Security Token Audio Documentary”

This episode is a deep dive into the mechanics of how security token issuance and secondary trading fundamentally works.

Indeed, for all the talk about the merits and drawbacks of security tokenization, I’ve found that there’s very little discussion of the mechanics of token issuance and trading.

My purpose in this second installment is to enrich the debate so we can move beyond high-level philosophy to a deeper discussion of the technologies, methods, and mechanisms required of competent security token platform.

In this part of our series, you’ll hear the story of two different tokenized security platforms, Harbor and Polymath. We’ll go into detail about how they work, in an effort to provide a better understanding of the constituents, processes, and technical mechanics of the broader security token ecosystem.

Special thanks to all of our guests including Professor Stephen McKeon, securities attorney Zach Robins, Harbor CEO Joshua Stein, and Bruce Fenton (CEO Chainstone Labs/Atlantic Financial and Board Member at Medici Ventures, tZero & the Bitcoin Foundation). Thanks also to Polymath’s CEO Trevor Koverko & COO Chris Housser.

Part 2 Topics include:

How Bruce Fenton tokenized his company on a live stream in about ten minutes.

How security token platforms and protocols work.

The main players in the security token ecosystem.

The two notable ways in which Polymath and Harbor differ.

The role of whitelisting on Polymath.

The life cycle of token issuance on the Harbor platform.

What the secondary market for security tokens looks like.

Why decentralized exchanges make a lot of sense for security tokens.

What happens when a user wants to withdraw security tokens from a security token exchange.

How trust differs among security tokens, traditional private securities, and cryptocurrencies.

The roles that jurisdictions play when it comes to the initial issuance of security tokens.

The pros and cons of Polymath and Harbor.

A glimpse at the inner workings of both platforms.

For Reference:

Links Relevant To This Episode:

Terms Mentioned in the Episode:

Part 2 Transcript:

Clay Collins: Welcome to Flippening. The first and original podcast for full-time, professional, and institutional crypto investors. I’m your host, Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the front lines of financial disruption. Go to Flippening.com to join our newsletter for cryptocurrency investors, and find out just why this podcast is called Flippening.

Automated: Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion [00:00:30] and do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.

Clay Collins: Welcome to part two of Tokenize the World: A Security Token Documentary. This episode is a deep dive into the mechanics of how security token issuance and secondary trading fundamentally works. My purpose with this series is to tell the stories of the projects, makers, issuers, investors, and influencers driving adoption of security tokens, and this episode picks up [00:01:00] where the last one left off. To the few folks who’ve written in asking why we’re spending three entire episodes of this podcast talking about tokenized securities, I want to remind you that only 30% of the world’s wealth is in cash, and much more than this, it’s held as property and securities.

In the previous installment of this documentary, we discussed three misconceptions about security tokens. The first misconception is that security tokens are not valuable because they are centralized around the issuer, and in many cases, not censorship resistant. The second misconception is that security should not be represented [00:01:30] with a blockchain because securities are not, at their core, digital assets. And the third misconception is that security tokens are overkill, and that all that is needed is a highly efficient database, rather than a blockchain, to address the needs of issuers and traders.

Part one of this documentary addressed the first two misconceptions. The third is addressed in this episode. Part one also discussed one, how blockchain technology has changed trade execution. Two, how tokenization unlocks liquidity. Three, how security tokenization provides different kinds of value [00:02:00] to public versus private companies. Four, ideal versus non-ideal security token use cases, and five, which average businesses could benefit most from tokenization.

If you haven’t listened to part one, I’d encourage you to start there. In this second installation of this series, we’re digging deep into how security token issuance and secondary trading works. Indeed, for all the talk about the merits and drawbacks of security tokenization, I found that there’s very little discussion of the mechanics of token issuance and trading for security [00:02:30] tokens, and it is a downright shame. My purpose here today, in this second installment, is to enrich the debate so that we can move beyond high level philosophy to a deeper discussion of the technologies, methods, and mechanisms required of a competent security token platform.

I am especially happy to tell you that this episode of Tokenize the World is made possible by our sponsor, Blocktrade.com. Blocktrade.com will be the first fully licensed security token exchange in Europe, focused on listing crypto-assets, security tokens, and other [00:03:00] tokenized financial instruments. By being fully method two compliant, they will enable crypto-trading to institutional traders while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few huge announcements coming in the next few weeks, including their public beta launch. Be sure to go to Blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.

And just to go off-script here, I had a chance to speak with their CEO, Luka Gubo, and came away really impressed. That guy has a [00:03:30] deep experience in the space, and they’re building something that I find to be pretty impressive. For example, their backend is set up to process more than one million trades per second, which is going to be pretty important for the institutional investors who they’re targeting. I do think this is a company you should keep your eye on, and I’m proud to have them as a sponsor. So thanks to BlockTrade for stepping in and stepping up and making today’s show possible.

Okay, now let’s kick off part two of Tokenize the World: A Documentary about Tokenized Securities.

[00:04:00] I started getting interested in security tokens after watching a Periscope in April of 2018 by a guy named Bruce Fenton, who created a security token live on the internet for the world to watch, he was doing this in real time. He was actually tokenizing ownership of his company, Atlantic Financial, and he did it in about ten minutes using a [00:04:30] web browser, a piece of paper, and ten dollars. Bruce’s stated purpose in creating this video was to show that a legal, real, compliant security could be tokenized on a blockchain. And in my view, I think Bruce proved his point. Bruce’s video is actually a pretty great place to start things off. Here’s a highly edited version of Bruce’s live Periscope demo. Thanks to Bruce for giving me permission to use this.

Bruce Fenton: I’m going to create a security using what’s called the counterparty protocol, which is a protocol that [00:05:00] runs using the Bitcoin network. The reason I’m using that is because Bitcoin is a very secure chain.

All the purpose of today’s broadcast is to do is to show that yes, it is possible to tokenize a security. All this covers is, can you tokenize a security? And the answer is yes, and I’m going to do it right now and show it beyond any doubt, hopefully.

Securities, and companies, and shares are a creation of humans, they’re a creation of law. They only exist in the real world. [00:05:30] There isn’t any way to digitize them, so people know that, which is this much knowledge, and then they’re learning stops. You’re not putting a security on a blockchain. What you’re doing is changing the way a security is recognized.

So first, the thing to recognize is shares are a thing, okay? They’re a thing, they’re always going to be centralized. I’ve never heard of any way to completely decentralize the existence of corporations itself. If you have Disney, that’s a corporation, it’s going to have an office, it’s going to be centralized. Apple is centralized. Google is centralized. Their shares are centralized. [00:06:00] You’re already trusting that, you’re sure to follow the hundreds of years of law we have governing corporations and how these things work.

So the security we’re going to use for this example is my own company, Atlantic Financial. I own 100% of the stock, it’s an eighteen year old company, it’s incorporated in Delaware, it’s a real company and has real revenue, it owns stuff. That doesn’t really matter. What matters is that it’s a company, and I own all the shares, and I have the authorization to do this. But I’m going to do it in a super, super simple way to show you how it can be done. Just to show you how simple, I wrote it [00:06:30] right here.

Clay Collins: It’s me. So if you were watching this video, you’d see Bruce holding up a piece of yellow lined notebook paper with his handwriting on it. It looks like he hastily scrawled some notes on a piece of notebook paper that he just had lying around his office.

Bruce Fenton: I, Bruce Fenton, designate all shares of Atlantic Financial Inc. to be represented by tokens, trading on the counterparty protocol.

Clay Collins: Me again. It’s important to know that he’s written the name of the counterparty token that represents shares in his company on his hand scratched contract. [00:07:00] Essentially, the contract is saying that if you hold a counterparty token with a name listed on the contract, then you hold a token that represents ownership in Bruce’s company, Atlantic Financial. If you don’t know what counterparty is, it’s a peer to peer opensource protocol that allows you to create your own tokens that run on top of, and are secured by, the Bitcoin protocol. Back to Bruce.

Bruce Fenton: Now, is this silly? Is this not legally binding? You bet it’s legally binding. It’s silly and simple, but if I wrote on here, “I’m selling my tractor to Phil for $ [00:07:30] 500.” And I didn’t give him my tractor, Phil can bring me to court. If I say that I’m selling my car for $100,000, then this is binding.

Once you have shares, this kind of document designating the shares of something is legal. You better believe that if Bill Gates met you and loved your business plan and didn’t happen to have any staff with him or something like that and grabbed a little note, and said, “I, Bill Gates, promise to give you 10,000 shares of Microsoft [00:08:00] if you present X Bitcoin address.” And he wrote it, you better believe that’s legal. That is legally binding.

So as a company, as a stock issuer, securities issuer, you’re centralized anyway. Bitcoin purists might say, “Oh my gosh, he just admitted he’s centralized.” Well yeah, that’s what companies are. Disney is centralized, Apple is centralized. I can issue a million new shares if I want, I can dilute you, I can do every other thing, and that’s not a failure of blockchain and it’s not a failure of this governance or anything else. That’s just the reality of the world. [00:08:30] Issuers are centralized. I’m a securities issuer, I’m centralized.

Clay Collins: So let’s transition now to the part where he created the token with counterparty. It’s really fast and simple. The process could even be said to be unremarkable from an operational perspective.

Bruce Fenton: So basically, you have … this is what counterparty looks like. I’ve put an address in there, you can put an address and you can say, “create a token”, it has the token name, and you can say what you want the description to be, how many you want. I can say I want 1,000, [00:09:00] I want to call it the AF token for Atlantic Financial, and I’m going to say, “create token”, okay?

That’s it. If I go ahead and cut and paste this token number, I’m going to say A151482398425338000.

Clay Collins: So if you were to be watching the video that I’m referring you to, you’d see Bruce [00:09:30] write the name of the Atlantic Financial token on his contract, which essentially says that if you possess an Atlantic Financial token on the counterparty protocol, then you possess a share of Bruce’s company.

Bruce Fenton: So I wrote it on the paper. Again, you would want to do that a little more carefully.

This is a truly legal document, and again, this, believe me, something as simple as this has been held up in court many, many, many times.

So that’s created. If I write this down and then I sign it right here, ta-da, [00:10:00] this is legal. I can hand this to someone, or make a copy of this, or now put it on the internet. This is legally binding. Again, this is for example purposes. This is not the kind of thing you want to use with your lawyers, it doesn’t have enough detail in it, it hasn’t been properly done, but this, believe me, if you gave me $500,000 and said, “Bruce, I’m taking your word for it. I’m taking this piece of paper.” You gave me $500,000 and I gave you some percentage of the business, I think you’d have a pretty good case. It would be a weird [00:10:30] case because they’d say, “That’s a pretty bizarre document.” Especially with the video as evidence, it’s very clear that I have intended to have this.

Clay Collins: There you go. Just like that, Bruce tokenized his company in a legal binding and enforceable way. And of course, this isn’t the first time that this has been done. Blockchain Capital used a platform called TokenHub to issue its B-Cap token, which represented ownership in one of its venture capital funds. And the public company Overstock issued a tokenized security using a platform called RegionLabs in 2017. [00:11:00] These companies aren’t speculating that all of this is legally enforceable. The SCC has recognized tokenized securities, and the state of Delaware has specifically stated that a distributed ledger can be used to issue and record shares.

Now that we’ve seen perhaps the most basic example of security tokenization possible, let’s transition to a high level overview [00:11:30] of how security token platforms actually work. Are you ready? Here goes.

At a very high level, security token platforms and protocols pretty much work the same way. Essentially, these systems that companies, AKA issuers, issue security tokens that represent ownership claims in companies. These issuers are allowed to create and curate white lists of wallet addresses, usually Ethereum wallet addressed, of investors that are allowed to buy ownership stakes in the company. This is how compliance is enforced because when these wallet address white lists are properly set up, [00:12:00] compliance is enforced because the issuer only admits qualified investors to the white list.

So if someone isn’t permitted to purchase shares in a given company because of compliance issues with applicable laws, they are not allowed to hold a security token for that company. It’s important to point out here that issuers can also outsource curation of one or more white lists to trusted third parties like AMLKYC providers, accredited investor checking services, and exchanges that might only admit accredited investors to the platform.

[00:12:30] These white lists of investors qualified to purchase security tokens from a given company comprise a liquidity pool of sorts. This liquidity pool is essentially a network that can execute secondary trades of that stock with each other. What this really means is that everyone on the white list can trade with each other. And that’s where the real power lies. It’s unlocking liquidity for secondary trading.

If all this were done with just a centralized database, trades would be restricted to [inaudible 00:12:56], and we couldn’t have peer to peer security token trades happening, for [00:13:00] example, at a coffee shop, a decentralized exchange, an OTC desk, or via whatever permission list innovation happens in the future that allows folks to swap these things. But because security tokens are built with and on top of opensource protocols like Ethereum, anyone is allowed to innovate at the exchange layer because token level restrictions are prohibiting non-authorized investors to receive or buy shares of a company.

So the main players in this security token ecosystem are one, security token [00:13:30] issuers, AKA companies issuing stock in their company. Two, folks who are on white lists of crypto wallet addresses that are allowed to receive security tokens, so people who are cleared to buy and trade these tokens. Three, trusted third party white list curation services, so AMLKYC providers, accredited investor checking services, et cetera. Four, security token platforms that power the underlying technology that make issuance of these tokens possible, and five, parties [00:14:00] that facilitate exchanges, like exchanges, OTC desks, decentralized exchanges, or potentially a service akin to local Bitcoins, where people can just arrange to meet up and exchange these things in a peer to peer fashion.

There are of course other players as well. For example, lawyers help issuers decide who can legally purchase the stock, and create disclosure docs, file with the right entities, all that stuff. And software engineers who write and audit smart contracts and play a vital role in everything happening here. So that’s [00:14:30] basically security token technology in a nut shell. Of course, all of this gets infinitely more complicated once you go just one level deeper, and everything I’ve said thus far is an oversimplification.

Security tokens can contain transfer restrictions, loading rights, dividend rights, and can be configured differently for different classes of shares and a whole lot more. It all gets pretty complicated pretty fast, so with this high level introduction to security token mechanics established, we’re going to dive into specific use cases, examples, and scenarios. To help [00:15:00] dive into the nuance, we’re going to consider different scenarios through the lens of two top security token platforms, Polymath and Harbor. I should note that both of these platforms were started because their founders wanted to issue security tokens, found the process unnecessarily cumbersome, and decided to start platforms to help others automate what they found to be so difficult.

Here’s Polymath’s CEO, Trevor Koverko, describing the Polymath origin story.

Trevor Koverko: So my idea was I was going to take my fund that was operational and profitable and tokenize [00:15:30] it, and we were going to become the world’s first dividend paying crypto. And after a few months of getting tons of good feedback and tons of demand, we ran into reality, which was the SCC, and it turns out what we were trying to create was a security. And we didn’t really expect that. Back then, there was no distinction between what a utility coin and a security coin was. We actually coined the term security coin back in those days. And that’s what led us on this journey to say, “Hey, maybe [00:16:00] there’s a better way to do things.” It was very complicated, it was very expensive to do a fully compliant security token, so we said, “At the protocol level, why don’t we build a product and an ecosystem that can help launch the next ten thousand security tokens?”

Clay Collins: Polymath was founded by the guy you just heard from and securities attorney Chris Housser. They raised $59 million in January and February of 2018 through a private SCC compliant token sale. Polymath differs [00:16:30] from the other company we’re about to talk about in at least two notable ways. First, Polymath has issued a token, which Harbor has not. It’s called Poly. Second, the Polymath organization is not required for the underlying protocol to operate. Harbor, on the other hand, is designed to fail closed. So if Harbor ever goes away, the issuer would have to reissue tokens with a new provider, which might take some leg work, but in many cases, wouldn’t be an overly cumbersome thing to do.

Harbor, which we’re going to dive into in a bit, has a similar story to Polymath’s [00:17:00] and was incubated at Craft Ventures. As the story goes, David Sacks was interested in tokenizing Craft Ventures, and realized that there was no compliant way to do this. And that gave him the realization that a business opportunity existed here. It’s worth noting that the guy I just mentioned, David Sacks, is Harbor’s most famous founder. David was a co-founder and COO of PayPal, so one of the members of the PayPal mafia, along with Peter Thiel, Elon Musk, and Reid Hoffman. His other two co-founders are the former VP of Engineering and VP of Product at Zenefits, [00:17:30] where David was once CEO, and which was, at one time, the fastest growing SAS company of all time.

Neither Harbor nor Polymath have handled initial issuance for a company just yet, but both have plans to do so this summer. With both of these platforms, the big concept here is really the white list. Here’s what I mean. There’s just no way that a security token protocol can have the rules of 100 plus jurisdictions baked into it, but the vast majority of regulations can be complied with by restricting who can own a security token, [00:18:00] such as accredited investors, US citizens only, qualified purchasers, et cetera. White list curation also allows you to restrict how many total investors can own a stock. And this is important because some laws and exemptions require a minimum or maximum number of shareholders to qualify for a given status.

So both the number of shareholders and the type of shareholders, such as accredited investors only, can be controlled via the curation, maintenance, and grooming of these white lists of addresses [00:18:30] and wallets that are allowed to receive security tokens. Here’s Chris Housser, COO of Polymath, talking about the role of white lists on their platform.

Chris Housser: The way our platform works is it creates a white list on Ethereum, so the issuer defines a set of criteria that an investor needs to have to be able to hold their particular token. So let’s assume to have a token, someone needs to be an accredited American investor. They would go through the process to demonstrate that [00:19:00] they are American and that they are accredited, and their Ether address would be added to a white list. Now people on that particular white list are able to trade amongst each other, and how they do that? It’s up to them.

If your friend or your neighbor John is also on the white list, he’s gone through the process, you can transfer to his Ether address, and then he can pay you, he can go over with your house with a bag of cash, or he can mow your lawn. Whatever your deal with that particular investor was, you can trade those tokens. [00:19:30] It requires that everyone be on the white list, whereas right now, in most blockchains, any two addresses can transfer between each other, but our standard is really creating restrictions so only a specific set of people is able to hold that token.

Clay Collins: Because of the need for KYC and non-compliance to be either a qualified purchaser or an accredited investor, you couldn’t just sit in a coffee shop with two computers that aren’t connected to the internet [00:20:00] and trade these tokens. There is some dialing of home, or dialing into different systems to verify things. Could you walk us through, just step by step, who is calling who and what connections are being made to execute a trade? And I realize that this is different in different jurisdictions, and that there’s different pools of white lists and stuff like that, but just to make it super specific, let’s say it’s an accredited investor [00:20:30] swapping securities with another accredited investor on tZERO. Let’s say we’re at the part in the flow where I’m a buyer and I’ve put in an order and there’s a seller on the other end who decides they like the price that they’re going to be on the other side of that trade. What happens next?

Chris Housser: The beautiful thing about blockchain platforms and just cryptocurrencies in general is people [00:21:00] are able to be their own bank. You’re able to hold your asset yourself, you’re not reliant on putting it into a bank account where a third party, i.e. the bank, is the one that actually holds your assets. Now the way the majority of these exchanges work, and I imagine this is how tZERO will work, we’re still working on our partnership with them, but my understanding is they will hold custody of those tokens. If you’re [00:21:30] a seller and you want to sell your tokens on tZERO, you’ll actually have to transfer them to a tZERO controlled address and then it will be represented in your account. You log in, it will be on your account, and then you’d create a cell order, and then there could be a buyer who has funded their account. They make a buy order, those two are put together, so now the buyer would transfer his, let’s say Ether, and the seller’s securities would transfer to the buyer. However, that transfer will not be happening [00:22:00] on chin, it won’t be happening on the Ethereum blockchain, it’s

Speaker 1: On chain. It won’t be happening on the ethereum 