Security tokens: an introduction
This article is the first in a series discussing security tokens and their function…
- Security tokens: an introduction
- How security tokens work: architecture
- Why are security tokens powerful?
- What is Konkrete and how you can participate?
- Why tackle real estate first?
- A global real-estate backed asset currency
Unless you have been sleeping under a rock for the last few years, you will have already heard about Bitcoin and other cryptocurrencies. You’ve probably also heard about the big upswing and subsequent crash that has followed in cryptocurrency markets, and how the next big thing is security tokens, or tokenising real assets.
So what exactly are security tokens, and what does tokenising real assets mean? Is it an innovation that will change the world as we know it?
All sorts of claims are being made about how you can sell a share of your property to someone sitting on the other side of the world, and about how many people can band together to own one share in Berkshire Hathway (given that they are quite expensive and out of reach for small investors).
First the bad, or rather, disappointing news.
Anything that represents a fractionalised claim on ownership in something else is, in effect, a security.
Securities come with rigorous laws around disclosures and how they can be promoted.
So, the premise of being able to suddenly trade shares in owned assets in a peer-to-peer fashion via a global network of Blockchain investors is unrealistic.
Each time you are tokenising or fractionalising, you are creating a securities offering which, depending on how you want to promote it (whether openly or to a close network of friends or high net-worth investors), carries varying degrees of complexity in terms of the documentation required.
If you are doing a fully public offer, it is effectively an IPO. Needless to say that the complexity and costs attached would be fairly prohibitive and put it out of reach of most small timers.
As for the idea of many people coming together to own one share in Apple or Berkshire Hathway…
I hate to break it, but that is effectively an investment fund splitting ownership of a single share, and token holders are effectively shareholders or unit holders in that fund. That fund, in turn, needs to publish its own disclosure document highlighting its own investment mandate of owning a single share in Apple or Berkshire Hathway, and lodge it with the SEC or ASIC.
Security tokens are securities, plain and simple.
One security token = one share. No splitting it down further, unless you want to go down the tedious compliance path.
As required by securities law, anyone who owns security tokens will need to complete their KYC. So, only those whose identities are recorded and verified are eligible to own security tokens.
Security tokens are securities represented on the Blockchain.
So, how are security tokens different to your typical Bitcoin, Ethereum or XYZ utility tokens?
We’ll start with a simple example.
Let’s say you open an arcade, and choose to accept special plastic tokens that gamers can buy from you before they play, in the same way gamblers go to a casino and buy chips.These tokens or chips allow the owner to make use of the system.
In 2017, a radical idea was born: if you had a concept for an online business, you could create tokens that your users could use within your system. Instead of going to banks for funds, or raising equity via VCs, you could simply sell these tokens upfront to a vast global community of online users. These users would buy tokens in advance, due to a level of interest in your product being built, and likely a substantial discount on the value of the tokens, in comparison what they would cost once the system is built — a bit like pre-sales.
The whole thing was turned on its head when people began lapping up these tokens and trading them with others. Investors who were never likely to be users started buying them purely for speculator purposes. Exchanges sprung up, where hoards started piling on the latest token offering in the search of a quick buck by flipping them.
At its height, this bubble was bigger than the Tulip mania of centuries past, and in effect became the biggest bubble the world had ever seen.
Worse, these tokens were not deemed to be a security (by their promoters, not the regulators who were yet to catch on). They were more like commodities or pre-sales, which meant that the checks and balances accompanying a typical financial market did not exist on any of these exchanges.
Insider trading, market manipulation, and scams became rife. Eventually, the bubble popped and security regulators started actively ensuring investor protection. So much so, that now implementing a utility token to raise funds is sure to attract regulatory attention.
The idea of having your own token for your own ecosystem is sound. It breeds loyalty among its holders, and you can do free-token giveaways to attract users — customers. Within limits, pre-selling these tokens to potential future users should be acceptable as well.
Where it becomes problematic is when these tokens are lapped up by speculators and traded on unregulated exchanges susceptible to all sorts of shenanigans.
If you want to raise capital for your venture, the appropriate way is to sell shares in your business.
The need for regulation
Before we get into the details of how security tokens leverage the power of Blockchain and make securities smarter and more powerful, let’s take a step back to understand why additional regulation and control in fundraising and financial markets is required.
The simple answer is to look at crypto-coins. Financial markets are particularly susceptible to fraudulent activity.
A share or unit (and most crypto-coins) are virtual assets. They represent a share in something else; you cannot touch or see them as you can a tangible asset, such as a house or a car. Suppose a company was issuing 100 shares representing 100% of its ownership, and everyone paid $1 for each share. That would make the company worth $100. What then prevents the company from simply issuing 900 more shares, and diluting the shareholder ownership down from 100% to 10%?
Imagine that the company is engaged in a gold mining venture, but the directors of the company know that there is no gold to be found and are simply siphoning the money to pay for their own personal expenses. Effectively, using incoming shareholders to pay out previous shareholders — running a ponzi scheme.
All these and many more various scams have occurred repeatedly throughout history. The rise and fall of Bitcoin and other crypto-coins is testament to the fact that, left to their own devices, financial markets end up preying on the less informed.
This is why most security regulation relies on two primary pillars:
a. Disclosure
b. Audits
Disclosure is explaining to your investors what you are planning to use their money for. It also includes providing investors with regular updates on the progress of their investment and how the money is being spent.
Audits are third-party checks to verify what you are saying is true.
These are two simple yet powerful tools that can ensure everyone who wants to invest has the data they need to make an informed decision regarding the prospects of the business.
Trust is the most important ingredient required to maintain healthy financial markets; a well-regulated financial industry is essential to the health of any economy.
The whole premise of Blockchain is to eliminate the need for trusted third parties. But the reality of what is needed and what it can deliver for advanced financial markets is like comparing the first plane flown by the Wright brothers at Kitty Hawk to an advanced jet fighter like the F22.
In due time, we will get there. But it will require appreciation for regulation by entrepreneurs in this space, as well as a better understanding of the technology by regulators in this space.
We are at the early stages of a financial revolution, and a lot more will happen in the coming years. But even now, in version 1.0, we already know that security tokens on the Blockchain can be very powerful.