How Security Tokens Will Democratize Private Markets

As discussed in our previous post, security tokens bring a number of advancements to the securities space that solve age old problems and remove the inefficiencies that have plagued the issuance and trade of securities. In this post, we will expand upon some of the advantages that tokenization brings to the capital markets and focus on the capacity of security tokens to bring about the democratization of the private markets.

Automated compliance

Security tokens are programmable and, therefore, able to self-govern. Programmability facilitates the automation of processes that are laborious, time consuming and expensive for humans to perform.

Checking for full compliance manually (i.e. without an automatic tool) requires a huge amount of time and effort. This in turn incurs significant costs both for the private individual (the investor) and the public servant (the SEC). Smart contracts can be encoded with programmable logic around investor validation (KYC/AML), regulatory norms (Reg D, Reg A, Reg CF or Reg S) and trading protocol (P2P or decentralized exchanges). So long as the writing of these contracts is articulated and clear, the code can automatically enforce any predetermined rules programmed [A number of STO platforms have emerged that offer professional coding services to ensure that the programming of compliance is watertight. Please see this post for a deep dive into STO platforms.].

The programmability of regulation in blockchain technology is extremely valuable because the open source infrastructure is already built. This enables the provision of information in a transparent and immutable way in a common standard platform, providing access to everyone. This technology circumvents unnecessary steps and intermediaries while meeting regulatory requirements, thereby reducing risk, with approvals being made by software rather than humans, and costs where intermediaries are eliminated and paperwork is transformed into code.

To illustrate this point, let’s take an example of a real estate investment trust (REIT). In terms of regulation, a private REIT must:

  • Have no fewer than 100 shareholders. Any less and the REIT loses its favorable tax treatment.
  • No more than 2,000 shareholders. Any more and the REIT cannot stay private.
  • Be less than 50% owned by non-US shareholders.
  • Be less than 50% owned by the top five shareholders.

As a result, any investor who owns a share in a REIT and wants to sell it must obtain the REIT manager’s permission. This is a lengthy process involving significant work to ensure that the transfer of the share complies with the above rules. Investors cannot instantaneously sell these securities. They are, then, illiquid assets. By enforcing compliance at the token level, the manager can lift the prohibition on the transfer and enable the security to trade at the limits of regulation under the rules. Tokenization, if well implemented, increases liquidity, through automation, by enabling the asset to trade without friction.

Ownership reconciliation

Ownership reconciliation is a major problem in today’s public markets as it is an expensive process, particularly for growing companies. The lack of automation and transparency in the public market has led to debacles like that of DoleFoods, where the company issued 12 million more shares than were on its books. This was due largely to the complex and outdated stockholding infrastructure used by the company. This incident is an example of the issues associated with the costly process of ownership reconciliation as it stands today. Blockchain technology holds the potential to do away with such issues.

By issuing security tokens as representations of ownership, companies can avoid these types of situations. Not only does the reduction of friction improve the trading experience, but the ability to build rules into contracts and the ease of auditability created mean that problems can be averted altogether rather than fixed after the fact as current regulatory systems operate.

Liquidity

Public securities tend to be highly liquid because they trade on a secondary market with a large pool of investors. The settlement (transfer of ownership) process takes roughly two business days and is done through broker-dealers that are linked to the common infrastructure of the public markets. Hence, public markets have an infrastructure that automates compliance and is interoperable enough to facilitate the transaction of different assets.

In contrast, with a smaller pool of investors and lack of interoperability, the settlement of private securities can take several weeks, making the transfer of ownership more time consuming and expensive. The process that a private investor must undertake to sell an equity stake to another private investor is highly inefficient. Worse still, only a small percentage of investors have the financial capacity to deal with this process. Tokenization offers a solution.

The programmability of security tokens ensures that the numerous third party agents required to conduct the regulatory steps necessary to invest are not an impediment for investors nor for companies raising capital. Security tokens also massively reduce the cost of conducting a transfer of ownership and tracking of the asset. This ensures that costs do not affect the price of the asset. Tokenization opens the market for assets, facilitating the transfer of ownership.

Interoperability (infrastructure with no silos)

Interoperability is “The ability of two or more computer systems or pieces of software to exchange and subsequently make use of data.” “Exchange” and “make use of” are the key functions that provide a significant advantage to STO platforms that are built on the Ethereum blockchain.

While fractional ownership without a blockchain is possible in closed protocols (See: Reality Shares or Crowd Street) and automation of contracts can be conducted inside each exchange, these types of tokenized markets are siloed because their business model is based on capturing investors while assets stay at the protocol level. The transfer of assets from Realty Share to Crowd Street is, therefore, impossible as they are not interoperable by design. Each platform must develop the whole infrastructure, an issuance platform, a compliance system, a custodian solution and a secondary trading exchange which, when added together, requires a huge amount of capital and risk. Hence, assets in a closed system where exchanges cannot to tap into the protocol and provide liquidity from outside investors are relatively illiquid.

A number of prominent companies in the security token space are building out the infrastructure to facilitate integration in the financial markets. Take Securitize, a platform that focuses on the entire life cycle of security tokens. Securitize has created an adaptation layer that allows any ERC20 token to trade on other platforms (e.g. AirSwap, Open Finance Network). The platform is currently integrated with eight live exchanges, providing deep markets for security tokens. Building all of these tools on a common standard allows assets to move without restrictions from one service provider to another, e.g. from a custodian to a centralized exchange to a hard wallet. As the technology grows, so should the investor’s ability to capture that growth through high-level tools that provide synergies and new opportunities in the financial markets.

Going back to the artwork example from our post “How Security Tokens Provide Greater Market Depth and Create New Forms of Value”, assuming that the fractional sale of ownership is performed on Ethereum, investors can create long or short positions on any ERC20 token through dYdX, a protocol for the trading of derivatives. An investor might want to buy 0.5% of a Van Gogh and short a post-impressionism ETF, made up of several ERC20 tokens that represent different artworks of that era. In this way, an investor can hedge the investment made on the artwork or on any other investment that is backed by an ERC20 token. As a result, the opportunity to freely transfer securities enables higher levels of liquidity through deeper markets, as long as the same standard is common across the ecosystem.

As of now, the next big challenge with security token interoperability is finding a way to reconcile the different standards being offered to the marketplace, each of them having unique proposals for implementation in the issuance and trading structure. The ERC1400 standard developed by Polymath, for instance, gives issuers the option to turn off forced transfers permanently and trusts third parties to conduct their own KYC checks on investors wanting to acquire security tokens issued on the platform.

Securitize’s DS token standard on the other hand requires that all KYC checks are integrated into the platform’s whitelist, which centralizes the process. While Polymath is building a more decentralized platform, Securitize is working to ensure regulatory compliance is always met. Eventually, the industry will likely move to a single standard. Once the adoption of a common standard takes place, building on it will lead to connected markets that make for deeper integrations and relationships when compared to segmented markets.

Conclusion

Tokenization provides far greater dexterity in the markets than has previously been possible. It unlocks liquidity by providing greater market exposure to traditionally illiquid assets and greatly simplifies issuance, trading and general life cycle management through the automation of various complex processes that would otherwise engender the use of rent-seeking intermediaries and specialist third parties. In doing so, it eliminates the expense these layers incur. Finally, it facilitates the integration of the market, thereby allowing assets to move freely and investors to trade across protocols. As a consequence of the democratization of private assets, value that was restricted to the few will become available to the masses.