*This article discusses legal concepts on a high-level. I am not a lawyer, and I am certainly not your lawyer. This is not legal advice.*
Security Tokens burst onto the scene towards the second half of 2018. Suddenly, it seemed that every blockchain project raised funding through a Security Token Offering (STO). The popularity of STOs grew after regulatory pressure forced token issuers to use compliant instruments. Security Tokens have the potential to be so much more than just a fundraising tool for entrepreneurs and startups, but only after the outstanding legal questions are answered.
In 2018, the SEC made a number of negative statements regarding the compliance of utility tokens, and in the process created regulatory uncertainty. So in order to become compliant, projects began using STOs which granted investors more protection and certainty with the hope of increasing both liquidity and willing buyers.
These Security Tokens, also known as Digital Securities, are at present simply ‘tokenized’ standard financial instruments (equity, debt, derivatives etc.), that are subjected to the same regulations. Tokenization makes verifying and transferring ownership technically simpler and faster. In theory, easy transferability, plus the regulatory certainty associated with a known asset, should increase market liquidity. However practically, the current financial regulations also restrict liquidity. For example, KYC / AML rules in almost all countries prevent transferring stock to unknown parties. According to a report published late last year, in the USA accredited investor laws prevent startups from offering unlisted assets to ±92% of the population. Additionally, disclosure requirements (which prevent insider trading) are onerous for any compliant asset on a secondary market.
So, although Digital Securities introduce a major improvement in the infrastructure of financial management; in my view, current regulations still limit their actual liquidity. However, because of regulatory arbitrage, I believe these rules will change rapidly.
Placing current iterations of financial products in a blockchain wrapper is a quick win, and is what I believe we’ll see more of in the near-term. However, programmability is arguably the most compelling promise of Security Tokens. Simply combining debt and equity instruments into one tradeable product (with linked cash flow streams) opens up entirely new design spaces.
Soon, tokenization will enable other exotic features, such as tokenizing assets that were previously not subdivisible. But, in order to achieve the true potential of tokenization, ownership rights must first be altered. Let’s visualize tokenizing the Mona Lisa, or any other piece of rare art, into 10,000 ‘shares’. What rights would a share give you? Intuitively, it should give you economic rights i.e. you profit if it is sold (this is currently offered to investors in a non-blockchain format by Masterworks).
But, should a share also give you decision-making rights? Decisions like where the painting is stored, who it can be sold to and for what price, all impact every shareholder. So how should these decisions be made? Should the decisions be decided by a simple majority or a super majority? Which legal jurisdiction should apply these rules? The answers to these questions are less clear than the intuitive economic rights. For example, could 5,001 shares vote to destroy the art piece? To me, that seems wrong. But what about 9,999 shares? There must be clarity around these legal (and philosophical) questions prior to investors fully utilizing exotic instruments. If clarity is not achieved, these assets could suffer from the “tragedy of the anticommons” where the misalignment of rights prevents them from being effectively utilized.
One other exciting application is funding a decentralized network through an STO (typically a convertible equity offering) that converts into equity and utility tokens in the future. This lets founders raise capital and investors claim utility tokens and equity at the point of network launch. Rational investors would aim to maximize the value of their purchased assets (in this case, equity and tokens). A convertible instrument of this nature also presents interesting philosophical questions. What happens if the founders want to transition from a centralized corporation to a decentralized autonomous organization (DAO). What is the obligation to their shareholders (assuming investors want value captured by their equity holding)? The responsibility of traditional company management is to maximize shareholder return. So, could equity holders prevent converting to a DAO if they felt company management was reneging on this responsibility? These are all philosophical questions as well as legal ones, that need to be answered.
To me, the most interesting part of current Digital Security use is examining which legal jurisdictions are open to dealing with these tough questions and regulating this brave new world. We conducted in-depth research for our Primer on Security Tokens that showed that Malta, Gibraltar and Bermuda are the friendliest countries in terms of STO regulation and all have Digital Securities regulatory frameworks. But, I believe other countries will soon follow their lead, or risk inhibiting innovation.
The global nature of the blockchain industry means that companies can easily perform regulatory arbitrage to find the friendliest legal jurisdictions, Binance is an early example of this. This arbitrage will cause investment in highly regulated countries (such as the USA) to lag as startups leave for friendly jurisdictions. The jurisdiction which balances livability for talent, crypto-friendly regulations and enforceability would foster the world’s largest and most innovative blockchain community.
Digital Securities require two aspects before they truly revolutionize finance. The first aspect is the technical infrastructure, which as our Primer shows is rapidly being built out. The second aspect is the legal clarity for the more revolutionary products. This clarity will take time, but some jurisdictions are making early progress.
I believe that regulatory frameworks that adequately answer the questions posed in this article will be the catalyst to exponentially increase liquidity in the Digital Securities market. This is the single most important segment of regulation development that investors must follow.