The 2017 boom in cryptocurrency initial coin offerings (ICOs) due to the success of Ethereum was followed by a sharp decline and extended bear market in 2018, amid increasing regulatory concern over fraudulent incidents.
According to a comprehensive token report by Fabric Ventures, 58 per cent of all ICOs in 2018 failed to raise capital, disappeared, or refunded participants.
However, the decline of ICOs has opened the door to a new type of token offering, the Security Token Offering (STO), which according to Nasdaq, is “set to take centre stage in 2019”.
A Security Token is a cryptographic token that shares the profits, pays dividends or pays interest to the token holder based on an underlying asset, such as shares, bonds, real estate, or art collections.
This is different to a Utility Token, which is used to purchase a good or service offered by the issuer of a particular cryptocurrency.
The notion of security tokens and other tokenised financial assets has gathered significant interest over the course of the last year. The potential market for security tokens is enormous, with estimates for the broader transition of conventional financial assets to the blockchain valued at as much as US$24 trillion.
The future landscape for security tokens will depend heavily on the structure of the regulatory environment, which at this point is unclear in many jurisdictions.
In the US, ICOs are viewed as a regulatory grey area, with the Securities and Exchange Commission (SEC) commenting several times that most are indicative of security offerings.
However, STOs provide a much more practical concept for regulators to approach, as know your client (KYC) and anti-money-laundering (AML) requirements and other compliance measures can be made transparent within security token contracts.
Although the regulatory environment remains opaque, some early signs of what it may look like are emerging.
Countries like Malta have become blockchain safe havens due to their friendly and relatively clear rules on this emerging class of digital assets. In July this year, the Maltese parliament passed three laws establishing a preliminary regulatory framework for blockchain, cryptocurrencies and distributed ledger technology.
In Asia, Singapore and Taiwan have shown promising signs of becoming regulatory incubators for digital assets, and Hong Kong has raised its head above the parapet with the SFC (Securities and Futures Commission) recently releasing a circular stating their stance on digital assets.
One of the most notable inclusions is that platform operators (such as exchanges) can apply to enter the SFC sandbox and potentially gain a licence if they offer one or more security tokens. This stance shows that Hong Kong is taking the security token race seriously.
Security tokens are essentially more flexible versions of regular securities – and blockchains offer a unique and highly-efficient medium for ownership and trading of digital tokens that can represent securities.
For instance, Ethereum is a decentralised distributed computing platform that offers peer-to-peer (P2P) trading of digital assets. Settlement of trades can occur much quicker than legacy systems, and transaction costs can be reduced.
There are many benefits for both the issuance and investment of a security token. It speeds up execution as everything is automated via smart contracts. Fees are also reduced by removing unnecessary middlemen such as lawyers and accountants, whilst simplifying the auditing process.
By creating a security token, you can increase liquidity, as it’s faster to trade, allowing for a 24/7 trading environment in a global market, and providing the option to list on secondary exchanges.
The ability to purchase a fraction of an asset (which is traditionally challenging for large investments such as real estate, expensive stocks and art) also opens up a new pool of investors.
Specific rights can be embedded in the architecture of the token, such as dividends, voting rights, and interest which add a whole new element of flexibility.
Meanwhile, the exposure of the asset to a free and competitive market allows for more accurate and fair valuations and increases transparency by ensuring the auditing process is harder to be manipulated by large corporations.
Compliance costs for financial regulations can be enormous, reaching millions of dollars in many instances. Blockchains offer a viable alternative for determining ownership, compliance, and the status of tokens on their network through efficient mechanisms.
Projecting how the security token market will develop is challenging considering how young the idea is along with the underlying technology.
Institutional investors have shown that they will take a cautious approach to cryptocurrencies, and security tokens will likely follow the same pattern. Although there is not a huge liquidity pool for STOs currently, this could change quickly as real estate developers, art collectors and others catch on to its usefulness.
JP Morgan’s Quorum is an enterprise-focused version of Ethereum. Quorum seeks to tokenize assets with the use of blockchain technology to efficiently digitise them so that they can move on distributed ledgers.
The SPiCE Venture Capital Fund conducted a fundraising with STO and its tokens are now tradeable in the secondary market.
The primary benefits of security tokens in the short-term will probably be reduced transaction costs, smoother issuance, and greater flexibility of securities. ICOs may eventually be substituted with STOs once the advantages of STOs are fully realised, and their standard token interfaces are built out.
And although most security token developments at this stage involve technical implementations of the concept, recent moves by regulators in several countries suggests that security tokens are now being taken much more seriously.
The approach institutional investors take towards security tokens will closely follow regulatory developments, but once the technical infrastructure for tokenized assets is clear, get ready for a new wave of digital assets built on blockchains.