In a recent press release on March 14th, Nasdaq-powered DX Exchange launched its platform for Security Token Offerings (STO) and security token trading. The platform originally went live back in January offering a handful of digital asset and fiat trading pairs along with a select few tokenized stocks and ETFs — namely the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). To our knowledge, DX Exchange is currently the first exchange with live security token capabilities with many others coming online over the next few years.

Back in July 2018, the Swiss national stock exchange, SIX, announced intentions to launch a full end-to-end integrated digital asset trading, settlement, and custody services. In recent developments, SIX announced their intentions to use R3 Corda to power its digital securities exchange. This is just the beginning as dozens of new exchanges, protocols and issuance platforms are launching throughout 2019. Progress is happening. The infrastructure for the digital securities market is coming, and it’s coming soon. At Fitzner Blockchain, we are closely monitoring the developing market and the opportunity it holds.

What is a security token?

Before discussing what security tokens are it’s good to understand what a “token” really is. Many assume that each new token is competing to become the next Bitcoin or Ethereum. In reality, tokens represent some functionality, ownership, or rights beyond a transfer of wealth. Not so long ago, the most common function was the creation of unique utility tokens that drove Initial Coin Offerings or “ICOs”, a new form of crowdfunding for blockchain-based projects.

Today, these tokens are beginning to embrace a more traditional landscape with the tokenization of real world assets. In theory these tokenized assets will improve existing systems by removing unnecessary intermediaries and processing costs associated with asset tracking, transfer and execution of associated rights.

In essence, security tokens represent fractional ownership of underlying financial assets that are not only compliant with federal security regulations, but operate on a distributed ledger. Generally speaking, these financial assets break down into two major classifications: equity and debt. In addition, there are also other real assets such as real estate and commodities which hold the same potential to be tokenized. With this logic, hundreds of trillions of dollars in public and private equities, bonds, commodities and real estate can now be optimized through the removal of friction and costly middlemen thanks to the advent of blockchain technology.

B E N E F I T S

Increased Accessibility

For the most part, investment opportunities today are generally siloed within a respective region. For example, it is extremely difficult for Asian investors to participate in US private equity deals or Dubai-based real estate offerings. Given the borderless nature of blockchain technology, security tokens allow these offerings to be exposed to anyone with an internet connection. As a result, security tokens dramatically increase the accessibility of any investment opportunity to a global network of investors (assuming it’s legally compliant with securities regulations within the respective country).

Accelerated Liquidity

Not only can the investment opportunity be exposed to a larger audience, but liquidity on the underlying investment is accelerated significantly. Today, primary market participants are often forced to wait years for the parent company to successfully exit before they can liquidate their holdings and see a return on their investment.

Once a security token offering is completed, it is entirely possible for investors to trade their asset(s) between other whitelisted accredited investors following a 90 day vesting period. After the one-year vesting period, the trading can be opened to other non-accredited investors. Ultimately with security tokens, liquidity on any private or public deal can occur seamlessly within months rather than years, or even decades.

Compliance

Initial Coin Offerings (ICO) have recently come under heavy legal scrutiny due to their questionable justification of what a “utility token” really is, along with the ambiguous jurisdiction of where these ICOs were conducted in. The SEC has already prosecuted numerous utility token-based startups which conducted crowdsales in the past year, and this is likely only the beginning.

Unlike the regulatory uncertainty surrounding utility tokens and Initial Coin Offerings (ICOs), security tokens and STOs make a conscious effort to adhere to Security Exchange Committee (SEC) regulatory standards via their respective filing(s) (more on this later). With security tokens, lawyers become required service providers as compliance is vetted and programmed into smart contracts.

Real-Time Profit Sharing

Security tokens can streamline profit-sharing by providing real-time, autonomous weighted dividends. The amount of security tokens an individual holds relative to the total supply directly correlates to the percentage of profit-sharing dividends they are entitled to. Smart contract functionality allows dividend payments to be automated with significantly lower transaction costs while token owners receive their profits within minutes or even seconds after a quarterly earnings report is published. It’s important to note that in order to enable fully automated real-time dividends, company’s revenue, operating expenses and dividend parameters would have to be hardcoded into smart contracts.

Efficient Investor Management

Security tokens leverage blockchain technology to allow for highly efficient investor management relative to traditional methodology. Usually the more people involved in a deal, the more complicated the procedure becomes and ultimately, the more time it takes. With distributed ledger technology, middlemen can be removed from managing the investment transaction and enable a more streamlined procedure for issuers to execute the deal.

Transparent Ownership

The use of blockchain technology allows for equity ownership to become fully transparent in the eyes of the public. Despite the fact that tokens may not be publicly traded during their early years of operation, public blockchains such as Ethereum create a fully transparent and accurate mechanism for equity ownership. Permissionless blockchains like Ethereum allow anyone to easily see which addresses hold security tokens and therefore, the amount of equity retained by each respective owner.

Furthermore, blockchain systems enhance the ability to actively track and monitor internal cap table management systems. Rather than relying on human-driven systems to monitor the current owners of a security, the use of Ethereum’s permissionless blockchain quickly allows any interested party to track the current owner’s weight of tokens.

R E G U L A T O R Y

For our readers unfamiliar with how private placements begin, we’ve taken some time to outline the most common equity offering filings and some high levels pros and cons of each.

Regulation D

From our experience, this is the de facto offering for STOs which only allows verified accredited investors in the US and Canada to participate in the offering. With a Reg D, investors are subject to a 12 month vesting period before liquidating their stake to unaccredited investors. However, one of the more attractive aspects of a Reg D is that following a 90 day vesting period, investors can trade the equities among other whitelisted accredited investors.

One of the interesting aspects of a Reg D is that it does not require the SEC’s approval before beginning the offering and is generally the quickest avenue for companies to take in capital through a security token offering. With this in mind, it is important to note that without the SEC’s approval, if a company raises capital and made a mistake at any point during the offering, it leaves the door open for the SEC to prosecute the company on any wrongdoings at any point in the future.

Regulation A+

Reg A+ seems to be the holy grail given the decentralized and accessible nature of the crypto industry. This filing allows for equity and debt offerings up to $50 million over a 12-month period from an unlimited number of unaccredited investors in the US and Canada. However, Reg A+ is a bit more costly and subject to SEC review which significantly increases the time to be approved to begin crowdfunding, especially for STOs. The benefit with this becomes once the SEC approves the offering, companies are mostly clear from any possible future litigations from the agency. Tokenized projects who’ve filed their Forms 1-A back in 2017 are unfortunately, still awaiting for approval. In comparison, this process typically takes 2–3 months for traditional companies. With tokenized securities and the notion of a completely new format for public offerings, it seems that the SEC is in no rush to qualify these filings before the agency has a better understanding of the asset class.

Regulation CF

Thanks to the passing of The JOBS Act in 2012, entrepreneurs gained the ability to go to the retail crowd and publicly advertise their capital raises. Four years later, Title III (aka Regulation CF) of the JOBS Act went into effect, allowing private early-stage companies to raise money from any American citizen. Startups can now use Reg CF for equity offerings up to $1.07M. Reg CF allows companies to raise funds online from their early adopters, similar to GoFundMe’s and other public crowdfunding platforms. However, instead of providing investors a reward such as a t-shirt or a card, investors receive securities, typically equity, in the startups they back.

Regulation S

The Reg S allows for the offering of securities to occur outside of the US. Similar to the Reg D, the offering is not subject to be reviewed by the SEC however, must still abide by the security regulations in the respective countries of where the offering is solicited and executed.

C O N C L U S I O N

We’re extremely excited about the proliferation of securities tokens and legally compliant tokenized offerings. Blockchain and DLT based securities have the potential to drastically improve traditional financial products — from accelerated liquidity to improved investor management. So far 2019 is set to be a progressive year towards building a global and frictionless financial system, and we’re thrilled to watch it unfold.

On a more cautious note, our recent experience with securities lawyers have lead us to believe that security tokens will likely remove a lot of the “creative freedom” that came with utility token use-cases. With that being said, we believe that tokenized stock is a huge step forward in garnering adoption from traditional financial institutions.

While no tokenized Reg A offering have been approved by the SEC to date, we’d like to think that a filing from a reputable company proposing a plain vanilla offering will help kick-start a wave of blockchain-based followers once the groundwork has been laid for an acceptable framework (similar to how SAFT was adopted by virtually every ICO in 2017).

In our next article on digital securities, we’ll be covering different assets that we believe should be tokenized, along with the providers, platforms and entities paving the path to do so.

If you have a company or blockchain-based project interested in launching a security token offering, please feel free to reach out to us to see how we can help you prepare for the next wave of innovation.

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

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