Consider this: only one-third of the world’s wealth is held in cash. The rest is held in securities (stocks, COD’s etc.) and real estate. You can’t always simply sell those securities – you may own your house but you can’t simply get $400,000 for it in cash tomorrow. A lot of wealth is locked up. Things could get really, really interesting especially when it comes to ownership of physical assets like art.
Right now there are millions (billions, maybe) of dollars worth of art sitting in museums around the world. The museum owns the art, or some rich benefactor is allowing the museum to exhibit the painting. All that capital is just locked up on their walls.
Here’s an idea: if you’re the museum, you could just keep the right to exhibit the work of art all the time, and sell off the right to the capital appreciation of the piece in the form of User Issued Assets (UIA’s). So, you’re disaggregating the 1) rights to exhibit and 2) the appreciation. The museum could keep the right to exhibit it 90 percent of the time, and then assign exhibition rights for 10 percent of the time to the top two shareholders of the UIA.
A physical asset in the real world gets a token in the digital world. Large buyers would come in and buy these tokens, in hopes that the tokens would appreciate over time. Perhaps these tokens could be listed on an exchange (or maybe only open to private investors), creating liquidity in the market.
Tokenization makes it possible for anyone to own a piece of artwork. Fracturization allows tokens to be divided into even very small units and sold to individual investors. In other words, you could go see the Mona Lisa and own part of it, too.
A new security token on the block
The security token offering (STO) is already turfing the ICO, but this new coin is following the rules. By 2019, ICOs may read like a cautionary tale something like this:
During the early blockchain boom, the majority of ICOs were raising billions of dollars and issuing tokens to investors that could be immediately traded or cashed out after the ICO finished. It was pretty obvious that most of those investors, if not all of them, were buying tokens not just because they thought the project was interesting, but because they expected to profit. According to the Securities and Exchange Commission (SEC), that means the tokens are securities.
The SEC usually uses the “Howey Test” to determine whether an investment is a security or not. Unfortunately, while most of these ICOs met the Howey Test criteria, they did not go through any sort of approval process before their ICOs and were thus technically operating illegally. The SEC cracked the hammer down hard, and rightfully so.
The laws we created for securities have been around for decades, but the problem is that they were created during a time before the internet. Blockchain complicates this, which is perhaps why how the regulations affect issuing tokens is not 100% clear, or can be contradictory. For example, ether is not considered a security, but many projects are ERC tokens, meaning they’re built on top of Ethereum.
Owing to these regulatory compliance conundrums, the tale of the ICO could be a short one, but the story of the blockchain digital ledger is destined to endure like the double entry ledger system of the Medici dynasty. But future blockchain projects will be financed by the regulatory compliant security token offering.
The good news is that generally speaking governments are being cooperative; they understand that blockchain is a new space and don’t want to create complicated rules that could crush innovation, but also want to protect consumers.
The solution? The initial coin offering is transforming into the legally compliant STO. Plenty of players are emerging who are making it easier to issue your token within the current legal framework.
Three Players in the Tokenized Security Space
- Platforms: These help you issue your STO, raise money and issue your money. Examples include Coinlist, Polymath and Trusttoken.
- Protocols: Focus on post-issuance governance. They manage who can hold a token and reject transactions. Examples include Augur and Enigma.
- Advisory services: These companies help founders with the top two. Examples include CrowdfundX.
Evolution or Revolution?
You can argue that tokenized securities are simply an evolution of the current financial system. After all, these are simply digital representations of what we’re already doing physically. At least at the start, most of these assets are going to match up to instruments that we’re familiar with.
For example, we have “debt tokens” that represent a borrowed transaction with another party. Instead of signing a piece of paper with the bank or another individual, this would be recorded on the blockchain; the record is immutable. The risk of default could be calculated. That information and data can then be used to create an accurate profile of your financial history. Once all of my assets are on the blockchain as tokens, it’s easier for me to put up collateral that has actual liquidity. This is basic, but even at its simplest level, it allows for greater efficiency.
Three ways tokenized securities improve the current system:
Liquidity – STOs can help meet the stricter liquidity requirements of mutual funds as their tokenization, fractionalization and multi-jurisdictional traits make these securities more accessible to a larger global investment base.
Programmable equity – Smart contracts can be designed with any function and even to stave off inflation. The PolyMath Token Issuers, for example, can issue different price tranches and set caps and investment limits, including those for non-accredited investors. The ability to tie new equity (i.e., token) issuance to value creation can help avoid the dot-com high flyers.
Innovative investor incentive structures – Beyond price appreciation, investors may share in a percent of the revenue and earn rewards.
So, will the STOs be the new ICO?
Recent financing activity indicates that legally compliant STOs will be the future as more blockchain startups choose to access financing through STOs. There are plenty of early-stage startups popping up in the space and a handful of these will 100x — but which ones?
Real estate is likely to be one of the first big industries that we see unlocked. Harbor – a real estate play focused on investments in South Carolina – is the first company to successfully launch an STO. The largest benefit to investors is access to liquidity for asset classes that have traditionally been very difficult to buy and sell on a secondary market.
As the ICO deal flow slows, 2019 will be the year of the regulated security token offering. Stocks, bonds and other securities may also choose tokenization, or risk being replaced by the more attractive risk-reward proposition of STOs in institutional funds.