Securities Tokens Offerings (STOs): The crypto story in 2019?

Colin Platt, again, and we’re back with our regular blog programming, exploring some of the topics that Zeth, Shaun and I found interesting and worth exploring further.

A lot of people have been talking about securities tokens, in this post we’re going to look at what they are, how they are different, and a bit about why people are excited.

Securities obviously exist today, and usually in a digital form, so what’s the reason for tokenising this?

Efficiency and cost of moving a token versus the perceived cost of doing the same process through traditional means (i.e. with a broker-deal, and at an exchange then through your custodian bank and perhaps central securities depository), is generally cited as the main reason. However there are other potential benefits. Pointing towards the relatively strong buy-in, high trading volume seen in cryptocurrency markets and relatively low cost of issuance,  proponents see the potential to create markets and trading opportunities for assets which currently are illiquid (like real estate) or all-together untradable.

So what brought us to here? We know that initial coin offerings (ICOs) have kind of been a big deal, and the most popular implementation of an ICO token was done via the Ethereum ERC20 token standard.

Broadly speaking, the projects raising funds with ERC20 tokens can be split into two camps.  Firstly, those using the ERC20 token as a stand-in for an allocation of tokens in a future service, which will eventually have a greater range of functionality onchain. And, those using ERC20 tokens to raise funds with no firm intention to develop the smart contract on a blockchain. For the latter, many lawyers, and regulators have suggested that the mechanism (ERC20) and the approach to fundraising (usually light on Know-Your-Customer “KYC” and Anti-Money-Laundering “AML” processes) may not be appropriate.

Enter the STO.

STOs don’t start with the pretense that their token will be used in any way for a function other than representing ownership and rights in a common enterprise, though some may also potentially give legal rights to convert into another form of token (utility token).  Though lots of rules depend on the legal jurisdiction in question, at a minimum it is commonly understood that a security token should allow for tokens to be blacklisted from a party who is not legally allowed to own them. There may also need to be a function that allows for a pre-approval (whitelist) before initiating a transfer.  These rules clearly fall under KYC and AML regulations, as well as other potential rules. As the functionality of ERC20 token are pretty basic, transfer and approve, members of the Ethereum ecosystem saw an opportunity to improve and have made a few competing standards proposals (ERC777, ERC1462, ERC1410, ERC1411 and the Harbor supported R-Token, amongst others). Nothing has yet achieved the adoption that ERC20 current enjoy in the ICO space.

Beyond the technical functionality of the tokens themselves, other activities including the initial sale of securities tokens, the trading of securities tokens, and custody of securities tokens may also incur greater regulatory scrutiny, requiring issuers, investors, brokers, and exchanges to retool and reinvest to support these activities. Some of the interesting companies at the forefront of this include, Harbor, SharesPost, TokenSoft, and tZero.  Despite the apparent bear-market in cryptocurrency-land, many large mainstream financial institutions, like the Swiss Exchange (SIX), or NASDAQ have begun stating their intentions to support these activities in the near future. While many others have said, behind closed doors, that they are closely watching the developments in the space.

Perhaps opportunity abounds?

While, personally, I remain unsure of many of the promises of efficiency and new liquidity which many security token-supporters claim will come as a result of tokenisation, particularly when the cost of regulatory compliance is added on at the service provider level, it would be wrong to entirely discount this phenomenon. Should issuers and investors truly find benefits from tokenisation, service providers who have started to make inroads could benefit in scales which dwarf the 2017 ICO phase by an order of magnitude. Whether this has a positive (or negative) impact on cryptocurrency prices, however, is currently unclear (I’m certainly not giving trading advice). It is probably good for people who understand these new markets, and/or the markets that they are attempting to disrupt.

As always we hope that you enjoy this series of fortnightly posts, and welcome your feedback.

Note: Nothing in this post should be construed as investment advice, legal advice, or a recommendation of any particular project or crypto-asset.