When Security Tokens are done correctly, they don’t skirt law and regulations, they remove financial institutions and middlemen.”
Anthony Pompilano, The Official Guide to Tokenized Securities
Security tokens, regulated tokens, tokenized securities – they go by a few names, but they all attempt to solve the same problem: bringing together securities regulation and blockchain token offerings. They are also the latest blockchain innovation to promise all kinds of intriguing and potentially lucrative investment opportunities to you and me.
But what is a security token? Why do we need them and how are they different from the other tokens out there?
Security tokens are securities
First thing, security tokens are designed to be securities. No debating the Howey or Pacific Coast Coin tests. These tokens unabashedly declare themselves as securities with all of the accompanying rights and regulations. A big part of that regulation is the control of trading. Not just anyone is allowed to buy just any security whenever they want. Newly issued securities have lock-up periods during which no trading can occur. And if a security is sold using an exemption to the prospectus requirements, there are then restrictions on how it can be resold.
This is a problem for regular cryptocurrency tokens since easy transferability is built into their design. The ERC-20 token protocol standard, which is used for most Initial Coin Offerings (ICOs) and Token Generating Events (TGEs), is made to be traded (an explanation of the ERC-20 token protocol standard is here, and a list of the functions that make it up can be found here). Once an ERC-20 token is transferred to your wallet, you can send it to any address on the blockchain at any time. Without some of the innovations discussed later, there is no way for a token issuer to enforce a lock-up period or to restrict token sales to only accredited investors (i.e. people with money to lose).
If a token is to behave like a security, then it must have a way to control the secondary trading. Security tokens are designed with functionality to solve this problem. There are a few ways this can be done, but the most straightforward is by embedding a vetting function right into the token protocol. Instead of just the standard set of functions present in the ERC-20 protocol, a security token has extra functions that can be used to check the address of the receiver and the sender of the token, as well as the token contract address and the amount of the transfer. For example, let’s say that a particular security token can only be sold to accredited investors. These investors are people that have a net worth of at least 1 million (the 1 million does not include our house – bummer for Vancouver homeowners). For each transaction of this security token, the token protocol would export the information from the transaction and wait for a confirmation before executing. People with over one million in net worth could have the address of their Ethereum wallet verified and whitelisted with an investor vetting service. The service would feed the whitelisted wallet information to the blockchain via an oracle. If the recipient address for the transaction with our security token is one that is on the whitelist, then a confirmation is received, and the transaction is executed. If the address is not on the whitelist, then the transaction fails.
Why is controlling the secondary trading of securities so important to regulators?
There are a few reasons, but the big one is to control exempt market trading. The exempt market, also referred to as the private market, offers a way for companies to access capital without the onerous requirements of writing a prospectus and making regular disclosure that comes when a company goes public. The company gets an exemption from the disclosure requirements, but they are restricted to selling their securities only to certain types of investors.
Most of the exemptions are outlined in a regulation called National Instrument 45-106 that you can find here. The Ontario Securities Commission provides a good explanation of the exemptions here. The more common ones are for close friends and family, accredited investors, crowdfunding and offering memorandums, but other interesting ones are available in different situations.
The catch with issuing shares under an exemption
If a company issues shares under an exemption, those securities must continue to trade under an exemption. It does not have to be the same one, but any secondary trading has to also comply with an exemption. The fact that exempt market securities cannot be traded on the open market means they are not as liquid as regular securities. It may be difficult to establish a price and the transaction costs are often high – as any potential buyer must be vetted to ensure they comply with an exemption.
Security tokens hold the promise of more liquidity and lower transaction costs for exempt market securities. If investors can be vetted a single time and that information is made available for multiple security token transactions, then transaction costs can be reduced. As long as the vetting process is not too difficult and can be done across multiple countries, the pool of potential investors could be huge – supplying more liquidity to the exempt market.
Currently there are a number of companies offering solutions in this space. iComply and Polymath both provide a means of controlling secondary trading for ERC-20 tokens. Harbor has produced a public protocol for security tokens dubbed the R-token standard. Finhaven has developed a security token standard called ERC-902. I have not seen any comments from regulators about these or other security tokens yet, but here remains an outstanding issue – where can tokens that are securities be traded?
Trading Security Tokens
When something is a security, then the exchanges where it is traded must be recognized by a securities regulator. Currently, in Canada, none of the cryptocurrency exchanges are recognized as places where securities can be traded. Establishing a new kind of securities exchange is a mammoth task that involves breaking new regulatory and technological ground. There are a number of companies racing to do just that. tZero, Templum, Polymath and Finhaven are a few of the companies in this space and they are partnering with established securities trading platforms to do it. In addition to this, the major exchanges are also developing blockchain trading. Significant hurdles remain, such as the processing capacity of a blockchain and the regulatory framework for these new entities. Despite this, regulated crypto-exchanges may not be right around the corner, but they are on the horizon. tZero completed a limited issuance of digital shares of Overstock using a blockchain trading platform. Templum currently operates a platform where blockchain tokens are traded as exempt market securities.
Security tokens are the next chapter in the march of blockchain into capital markets. Expect this chapter to be much friendlier to regulators, to have less hype and to offer more long-term solutions.