Security Tokens

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A lot of financial innovation involve novel ways of securitizing real world assets such as a business or piece of real estate. To securitize something is to create a relationship between a contract, that is legally enforceable by the law/state, and an underlying real world asset. The contract and the underlying are separate but related. The “security” derives its value from the underlying real world asset but can be bought and sold separately. The security by force of law has a life of its own although it is forever dependent on the underlying entity as well as the law itself. Security tokens give securitization a new form and could enable new capabilities not possible under the status quo.

When we hear the word “securities” we often visualize public stock markets like those in New York, Toronto, and London but those are just a fraction of the securities universe and only one type of security. There are securities based on government and corporate debt, securities based on the equity and debt of non-public companies(private placements), real estate based securities, auto-mobile based securities, and even securitization of credit cards and commodities.

When you hear commentators talking about security tokens you shouldn’t reflexively think of a public company like Apple issuing equity tokens on your favorite blockchain. This is probably the last to happen of all possible applications but not entirely out of the question. And if it does happen many more successful security tokens have probably already been launched and the tokenized securities market has evolved in such a way that a blue chip stock has an obvious reason to raise money in such a novel way. This would take many years of successful infrastructure build out, national and global regulatory clarity, and years of success of other securitizations.

What is more likely and has already happened are smaller, private assets being tokenized. Big, public assets already have ample liquidity and are broadly available in investable form to a large percentage of the investing public. However smaller, private entities are generally much less liquid and are not available to much of the investing public. The regulatory and legal process of buying and selling private securities can cost the parties of the transaction tens of thousands of dollars and can take months to complete. This makes investing in private entities cumbersome, complex, and prohibitively expensive for large swaths of the investing public.

By tokenizing securitizes of smaller, private bundles of assets and enabling transfers of those assets over public blockchains, issuers can split up their securities into extremely small units and those units can be stored and sent cheaply over publicly auditable blockchains. This atomization lowers the barrier to entry significantly for investors which broadens the available pool of investors, increasing liquidity of the securitized assets, and lowers the cost of capital of the issuers.

↓Barrier to Entry→↑ Available Pool of Investors→↑ Liquidity of Assets→↓Cost of Capital

In addition, regulators would benefit from improved audit-ability and enforceability. In all likelihood these securities will be issued on and traded on regulated marketplaces that will automate KYC/AML compliance. Not only will these marketplaces have records of all the participants and happenings on their platform, there will be an immutable digital trail of evidence provided by the always audit-able public blockchain the securities anchor to.

Where’s the Innovation?

Security tokens themselves aren’t a technological innovation but the combination of public blockchains, financial entrepreneurs, and regulators working together will lead to the further democratization of financial markets and monetization of previously illiquid assets. Most of these markets and assets are only accessible to the wealthy. The innovation is more of a social innovation, increased accessibility, as opposed to a paradigm shifting technological advance.

However there could be some real financial innovations that come out of the convergence of technology, entrepreneurs, and regulators. The tokenization of assets leads to the possibility of programmable ownership much like invention of Bitcoin realizes the possibility of programmable money. Programmers and financial engineers would be able to embed logic in their tokenized securities allowing for a preponderance of financial creativity that wasn’t possible before.

There could be a diversity of dividend schemes where issuers could embed logic that allows dividend pay outs every week or every month or every year instead of the standard quarterly dividend. They could even make those payments in a cryptocurrency like Bitcoin. This might make sense for a miner who has issued a security token based on its operations. Yield rebalancing, covenants, and coupon payments for debt tokens could be embedded into the logic of tokenized debt. Corporate governance could take place via shareholder controlled wallets for activities like shareholder voting and direct communication between the corporate entity and the shareholder.

From the look of it security tokens look like an open playground for entrepreneurs, programmers, and financial engineers for years to come.

Outstanding Issues

Presently, there are both technological obstacles or questions and regulatory issues. Security tokens are a convergence of a lot of moving parts coming together. Bitcoin is a self sustaining self contained system that has native rules and only really anchors to the physical world and doesn’t really care about anything outside of that. Security tokens are trying to bridge the gap between public blockchains, capital markets, and government regulation. It is a patchwork job that can be done, but it still has to be done. And it’s not clear exactly how it should be done or how it will play out.

We can think of  the creation of security tokens as a stack of tools working together simultaneously. At the bottom of the stack is the blockchain itself. It’s not clear which chain or platform will be used and there could be multiple that are used simultaneously. Will they be interoperable? Are these chains or platforms ready for it? What kind of token standard will reign supreme? How many different standards could emerge? Only time will tell.

At another layer is the compliance or regulatory layer. Major regulatory bodies in almost every country on earth have been asked about blockchains, ICOs, and securitization and many have issued some guidance and some have made positive moves in the direction of security tokenization. US states like Delaware, Wyoming, and California have even passed laws permitting the maintenance of corporate share registers on public blockchains. Many small and big steps have been made around the world but it is still an open question as to what the regulatory environment will be for security tokens.

STOs also have another potential problem to contend with, which economists and financial engineers know well. A novel way of raising money is going to attract those who couldn’t raise money using the traditional avenues which can imply a lack of quality. It doesn’t prove that the entity raising money in this manner is stupid or illegitimate but the early days of STOs will have to contend with the problem of adverse selection. Although it is tough to navigate the traditional avenues of raising money, these traditional fundraising mechanisms are relatively healthy in developed countries. Since STOs are just a new way of doing an old thing and not much of a technical innovation, STOs will ultimately depend on the quality of securities it produces which depend on the quality of the underlying assets they represent.

If the entity issuing the security is unscrupulous, incompetent, or naive it doesn’t matter that it issued an STO on a public blockchain.

Could Edge raise capital through an STO?

We could be a great candidate for an STO(Security Token Offering) in the not too distant future but we have no plans as of this writing. Although STOs have been issued it is still a very nascent offering. There are still plenty of other pathways and tools available to raise capital without the unknowns that accompany security tokenization. As a company at the edge of financial and technological innovation we are always open to new ways of performing old tasks provided they make sense for us.

Having said that we do believe an STO is far superior to an ICO for our purposes. We are a for profit company that focuses on security and user experience. We are not a protocol and do not intend to be. As a wallet and platform that supports many blockchain based assets we have no need for a utility token. We have always thought it would hinder our user experience trying to cram a useful function into a utility token to justify a substantial raise of capital and keep regulators at bay. We also prefer the straightforwardness of an explicitly regulated financial security as opposed to the ambiguity of the utility token so that there is no misunderstanding with potential investors.

Conclusion

We are in spirit very supportive of security tokenization. We think it is another way in which a greater number of interested people will be able to access financial resources and financial markets that they have historically been unable to access. And this is true for not only investors but issuers and entrepreneurs. Truly global capital markets can develop, people in almost any country will have access to a greater pool of capital to fund their projects and companies. Investors will have much greater ability to invest in projects or companies they think deserve their capital. And lastly regulators will have far richer analytics and audit-ability than the current status quo.

We also believe this could be a future use case of our platform. Tokenized securities are at their core cryptographic key pairs that allow users to interact with blockchain based networks. We are already hyper focused on securing those key pairs and making use of those key pairs on blockchain based networks as easy and intuitive as possible. Security tokens are definitely something we could support and help facilitate even if we never actually use them for capital raises.

It will be fascinating to watch all of this play out over time. Only time will tell.

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