Out of you experience, what is the biggest misconception people have about Security Tokens?

That depends on whether we are talking to someone with a background in finance versus someone with experience in blockchain and cryptocurrencies.

For those in finance the most common misconception we see is that security tokens are still 5–10 years away from truly impacting their business. As someone who started his career in finance, I have the most fun giving these guys live demos because we get to see the look on their faces when they realize the technology is capable of handling the robust compliance, risk, and intelligence requirements of institutional finance. In the words of the head of legal for a global tier one bank:

“We have never seen something this sophisticated, we didn’t realize the future was already here”.

The future is now, when combining a decentralized identity such as iComplyKYC with blockchain enabled “smart securities”, licensed broker dealers, asset management firms, and development banks can dramatically reduce human error and lower their costs of compliance by 98%.

For those in crypto, it is quite different. The most common misconception in the blockchain community is that security tokens will trade on the same exchanges as cryptocurrencies. This simply is not true — as the issuer of a security you are responsible for the maintaining the compliance, record keeping, and reporting for the lifetime of the asset according to the unique standards and legislative restrictions for both the buy and sell side of each and every transaction. Many issuers and STO platforms think this will be managed by the liquidity providers in the future but that is simply not an efficient market structure nor does it meet currently regulatory standards.

In my experience, many players who end up on podiums discussing security tokens simply do not understand the difference between a simple smart contract to manage a whitelist and even the most simple of securities restrictions such as the US Reg D 506(c) or 12(g).

In short, it’s not about how many accounts (a.k.a. wallets) but about how many ultimate beneficial owners. This is incredibly important for the STO issuers looking to accept any funds from a corporate or VC investor. For example, there could be 20 shareholders in one corporation using a single wallet or two investors could own an account jointly. Similarly, without liveness detection and fraud monitoring at the token level it is too easy to defraud the KYC systems. These seemingly small details could impact the issuing company forever, not to mention every one of its directors, officers, and major shareholders.

Where do you see the biggest pros and cons doing an STO as a means to raise funds?

The pros are almost harder to list because there are so many advantages to tokenizing financial instruments. I think the primary benefits are due to the fact that, if the token is configured properly on day one, it can automatically screen, record keep, and report all of the required tax, compliance and securities requirements for the entire lifetime of the asset. For broker dealers, asset management firms, and investment or development banks, these “smart securities” are a far cry for the security tokens that most refer to — which still require massive manual work and are restricted to only accredited investors.

The number one con of any tokenized financial instrument today is the lack of institutional adoption. While this is a primary focus for our team at iComply, it will take some time before individual retail investors are spinning up self custodial wallets and investing in regulated blockchain securities at a Tier 1 financial institution. That being said, this technology is also expected to give the early adopter firms a compounding ROI on their technology investment and gain a massive competitive edge over the laggards who are left behind to struggle with their existing infrastructure and no capacity to innovate.

What would you recommend to projects considering doing an STO?

Watch out for the experts, and their ‘compliant’ platforms. It was only two years ago when every coach, advisor, and consultant become an expert in initial coin offerings, blockchain, and AI. Now, they are all security token experts and many have the technical resources to build STO platforms that, if you use them, could put your entire project at risk once your token is out in the world and you realize that you spent the entire time planning for a wedding day crowdsale, not a lifetime of marriage to your new investors. In short, if they can not tell you what they will charge you to create, issue, and maintain compliance on your token throughout the entire lifecycle — and how they will do it — keep looking. Or, come talk to us ;)

There are five things I tell every issuer to look for when talking to any potential advisor, STO platform, or KYC provider:

BSA/AML and KYC compliance rules change country by country. Your obligations and screening procedures must be performed and documented to the standards of where the investor is, not the jurisdiction you issue from. How do they manage the variations in legal and business requirements during a token offering? Sanctioned blockchain addresses. As of December 2018 this became a massive liability for not only the issuer but also their investors, shareholders, and management team. You need to make sure the first and foremost you do not accept funds from a Bitcoin or Ethereum address that has been sanctioned — or from a new wallet they are simply trying to wash funds through, often on an entirely separate blockchain. Doing so could put your investors, shareholders, and management team at risk of being sanctioned themselves. Source of funds reporting. If you raise more than $10,000 in your offering you can expect this to be a major hurdle for your business. If the potential advisor you are talking to has never had to deal with the pain of a source of funds report for an ICO/STO, it is likely that they have not worked closely with a successful project. Consolidated Audit Trail. Without a comprehensive audit trail of where every penny in your offering came from and went to (in accordance with current accounting standards) your company can become nearly unbankable on a global scale. If the STO platform or KYC provider can’t screen for on chain money laundering, terrorist financing, and source of funds according to the current AML directives…keep looking. You don’t want to pull a Telegram and have the FBI make you repay the funds you worked so hard to raise. This not only makes your offering more successful, it saves you a huge amount of painful weeks or months in excel when — not if — you are audited by a regulator. Plan your post raise relationships. For issuers using iComply this is a big value add on. To start, we support issuers with token creation and deployment, compliance and token distribution during the crowdsale, and ongoing compliance for secondary trade management. That is critical to your success because you need to think about whether your token will trade on exchanges (centralized or decentralized), peer to peer, or only within your permissioned environment.

How far are we when it comes to trading of Security Tokens (especially across citizens of different legal jurisdictions)? What are the biggest problems and how/when will they be solved?

In 2016, I completed a PoC where the problem was the time and cost of trading interest rate swaps (IRSs) over LIBOR. Due to changes in Basel II legislation the costs to trade exceeded $12,000 USD per trade — thanks to Ethereum smart contracts we were able to bring that cost down to under $1 of computation!

This technology is now patented and trademarked as “Prefacto” and is a core functionality of our platform. While the an IRS transaction is significantly more complex than that of a security, the fundamentals and application of the technology are quite similar. Where we ran into complications for tokenized securities is over DEX frameworks and account holdings statements for “street name”. I’m happy to say that we successfully executed the first multi-jurisdictional transaction of a security token over a DEX in November 2018.

In short, the technology is here and it is ready for the institutional and enterprise financial markets. Unfortunately, too many issuers are focused on only one exchange in the US market and are missing out on the bigger shift in the institutional markets all over the world.

Currently, we are serving and working with liquidity providers in nine jurisdictions. This means issuers on our platform can easily list and cross list across multiple exchanges in multiple jurisdictions. These range from existing stock exchanges capable of serving retail investors, to accredited only OTC, ATS or MTF licensed firms planning to launch security token trading platforms. Some of these projects are planning to use our Ethereum instance, others are testing Hyperledger or Hedera Hashgraph, but overall each of these projects should be live within the next eighteen months.

Can you explain to us how the transfer of Security Tokens works, both technically and legally? Is my ownership of an asset “just” stored on the blockchain or is there an “offline copy” keeping track on my transactions (change of ownership)?

This depends on which platform and token standard you are using. On iComply a transfer function works in nearly the identical fashion you see in the world’s top clearinghouses and transfer agencies today — the main, and incredibly powerful, difference is that the blockchain handles all custody, transfer, and settlement.

Many of the biggest platforms today suggest that the “token is the security” when legally this is troublesome at best — especially for European and North American regulators and tax agencies. The token is merely a “smart security” that can represent debt, equity, royalty, title, or utility. The power of this is that these smart securities are self aware and able to screen for compliance, risk and governance in real time and once the trade occurs they can automatically report the required tax, securities, and compliance filings that will be unique to each issuer.

Whether your certificate is stored on blockchain (self custody) or offline in street name or a custodial wallet is up to the individual investor to decide what is best for them. While it is clear that the institutional market will lead this next wave, I believe this is just a migratory phase towards increasing decentralization and democratization of finance.

One of the best articles I have seen on this subject is Tokenizing Corporate Equity by Gabriel Shapiro. It’s a deep dive but critical for anyone considering a tokenizing shares

What will happen if I lose the private key to my Security Token? Will I lose my ownership right?

Not if the platform you are using has set up proper remediation procedures. Using iComply, investors can flag any of their wallets as lost or stolen and this will immediately begin a remediation process — starting with initiating a “no trade” alert to every exchange, wallet, and participant in our network. While you may never recover those specific tokens the issuer can update the cap table and distribute a new smart share certificate (a.k.a token) in much the same manner as it is done in today’s financial markets. This type of remediation process ensures accountability and fraud prevention procedures are executed and documented correctly.

Where the investor is holding a utility or non-equity token this may not be the case. While the functionality exists, the availability of remediation or recovery will depend on the rights given to the investor in their legal agreements and the applicable laws governing both the offering as well the investor’s property rights. Here in Canada, we already have a 2018 BC Supreme Court precedent on this due to a case involving an Ethereum based offering. It’s a good read if that’s your thing.

Many people see a big advantage of tokenizing Venture Capital — thereby bringing more liquidity into the market. Can you explain to us how Security Tokens are enabling this?

This question is a bit of a Pandora’s box. The promise of tokenization is that you will have more access to capital, more liquidity, less human error, and less compliance to manage.

The reality of the market today is that funds are spitting out their tokens with little regard for ensuring they are filing the appropriate reports of exempt distributions with the regulators of the jurisdiction where each investor is. It is the responsibility of the fund manager to ensure compliance, not doing so could destroy returns for the investors, lock up funds in endless regulatory sanctions and cease trade orders, or — in jurisdictions such as Singapore — mean a criminal record and jail time.

I believe there is something much more powerful on the horizon than simply making it easier for accredited, qualified, and professional investors to transact. We are already seeing rumblings from both the US SEC and Congress regarding their own rules and requirements for accredited investors.

As digital finance continues to disrupt the status quo we will see new fiduciary models emerge and, quite likely, new applications of currently ignored structures such as investment cooperatives and community owned public-private-partnerships.

When I can invest in a toll bridge in my home town and collect a revenue share every time a non-token-holder drives across we will only be beginning to see how powerfully this technology will transform the very fabric of today’s market structure.

One often mentioned advantage of Security Tokens is that of fractional ownership? Can you explain to us, why this was not possible before Blockchain technology came along?

Fractional ownership has been possible without blockchain for over 400 years. What has changed is the threshold of economic viability. Take my interest rate swap example from earlier. The firms engaged in these transactions require a minimum asset size of $25M USD in order to recoup over $12,000 of legal fees and weeks of processing time. Now, this can be done in under a minute for less than a dollar — if all other factors were equally weighted, (which they are not but for illustration purposes) we should see anyone with a loan balance of over $2084 dollars to be economically viable for an interest rate swap.

While fractional ownership has been available for hundreds of years, it was simply not economically viable beyond a historically high threshold. Security tokens, if done correctly, can shatter the floor on the floor on costs of compliance. Unfortunately, most of the issuers I see in the market believe so strongly that their Reg D/Reg S is in compliance they simply refuse to look beyond what they have already assumed, or been told, to be true.

Can you describe a benefit Security Tokens are generating by walking us through a process before and after Tokenization/Blockchain came along? Help us to understand the increase of efficiency and cost-saving opportunities Security Tokens can provide?

Sure! For institutional finance I believe this will be the breaking point that forces rapid blockchain adoption. In our institutional clients — mostly broker dealers, asset management firms, investment banks, or exchanges — we are seeing cost and friction reductions as high as 95% as they begin to take advantage of this exciting technology. For the fintech platforms and security token issuers, the benefit of this technology goes well beyond cost — it is about competitive advantage, scalability, and streamlining lean operations.

As an example, one of our clients, a real estate security tokenization platform. Essentially they use our technology to create unique investment vehicles per property and manage the compliance and fraud risk of their users across their platform. By using a vertically integrated identity stack and smart asset management platform they are able to beat their competitors by listing more projects, onboarding users faster and with better documentation, and keeping pace with regulatory reporting.

Perhaps one of our favourite examples of how this technology is transforming the securities market is a client in Europe, who hold the coveted title of consistently being rated one of the world’s Top 10 whiskey manufacturers. Rather than continuing to sell to the monolithic global alcohol distributors they used a security token to sell this luxury good directly to their retail market. This not only funds their operating costs to produce and distribute, it allows them to build a stronger direct relationship with their clients while capturing a much larger chunk of value from the supply chain. No VC would have funded an age old multi-generational business like this but their customers loved the idea to own part of product they were consuming.

What was the best learning you made during the last year?

For me, the biggest learnings were quite personal. We launched iComply in fall 2017 but only started serving the first clients in March 2018. Now, we have clients in 15 countries, exchanges going live in 9, and platforms that we saw as competitors previously — most notably security token platforms — are turning into great partners and clients to help build this industry globally.

My three primary learnings from 2018 were:

First, making a transition from being a startup — with a grand vision, story, and plan — to a business with a product, strategy, and customers. This seems natural but it took us as a team several months to make these changes, introducing new KPIs around sales, customer success and responsiveness over product features, fundraising, and financial projections.

Second, as we move from ideas to execution so do our competitors. In many cases, such as Templum, Harbor, or Securitize, we realized we had focused on entirely different areas of execution. We built our entire global identity stack and open compliance protocol in house where each of these other platforms buy these services from vendors or outsource their development overseas. From a market engagement perspective, these other platforms focused on creating the tokens, promoting the offering to their list of subscribers, and taking a slice of the raise. Our approach was very different, we simply charge a SaaS fee per company and bill for things like KYC/AML, Accredited Investor, or Corporate UBO screening — everything else is value added for our clients, no setup fees and no success fees. However, because no money flows through our platform and we do not promote the offerings to the public, we started getting white label enquiries from these previously perceived competitors. What we realized is that these two approaches were not exclusive but rather that we could work together with other STO platforms to help the market as a whole gain more traction and user adoption.

Finally, work-life-balance. I feel like in the rush to raise capital, push product, gain traction, and so on we can quickly lose site of the “why” behind it all. For me, this has meant taking moments to breath, go for a hike, sail, run — do something I enjoy. Being an entrepreneur is not a destination but a journey, it is important to savour the moments because — if you are successful — it is only going to get busier with bigger opportunities and risks to balance. Take a breath, look at the incredibly exciting world of decentralized finance unfolding in front of us, and hold on for the ride!

Thank you for the Interview!

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