What is a Security Token?

Our world is full of assets: stocks, real estate, debt, gold, oil, etc. Many of these assets are difficult to physically transfer or subdivide, so buyers and sellers instead trade paper that represents some or all of the asset. But paper and complex legal agreements are cumbersome, difficult to transfer and can be hard to track.

One solution would be to tokenize these assets by converting rights and ownerships of an asset into a security token on a blockchain.

If cryptocurrencies like Bitcoin are considered “programmable money” then you can consider Security Tokens a version of “programmable ownership.” Security Token behaves like a security and is backed by something tangible, such as an asset, equity, or revenue of a company. Security Tokens are also subject to federal security regulations, therefore they are compliant.

Why tokenize asset/ security?

The main driver of asset tokenization is to solve the liquidity issue.

An example: I wanted to sell my Pokemon cards which were valued at $100. I went to the only card shop in town and told the owner that I requested $100 for my Pokemon cards. But the owner only offered me $50. I wasn't willing to sell at $50 but unfortunately, that was the only card shop in town. I had to accept the $50 (bid price). The shop owner then puts my cards on the shelf with a $100 price tag (ask price). This is an example of a very large bid-ask spread. Therefore, my Pokemon cards are considered a relatively illiquid asset as I wasn't able to sell at the price I wanted.

Sites like eBay made life a lot easier for Pokemon cards traders because it opened up competitive markets with more participants and volume, and assets could be bought and sold with smaller spreads, additional liquidity also increases the expected value from the trade.

Now let's apply this framework to other assets like equity in private companies. A share of stock that’s traded on an exchange is of higher value than the private company (Startups, SMEs etc). This is because publicly traded stocks have more market participants, more volume, smaller spreads, and less price impact.

Hence, tokenizing relatively illiquid assets and creating a market in which to trade these tokens can solve the illiquidity issue.

Applications

Example 1: Jane is a diamond wholesaler who owns $15 million of diamonds. Diamonds are difficult to transfer to buyers because they require security and careful inspection to ensure that a fake isn't introduced somewhere in the supply chain. Alex would like to invest a few thousand dollars in diamonds but doesn't want to deal with the hassle of physically receiving them. Alex also would like to own a small piece of many diamonds to diversify his diamond position and hence, diversify the risks. However, it's not worth Jane's time to find Alex just to sell him a couple diamonds; she just wants an easy way to subdivide her diamond stock and sell fractional pieces of it to a variety of people. On the other hand, Alex wants to be able to easily trade his fractional ownership to other people (i.e he is able to sell his ownership of the diamonds to anyone who is willing to buy, rather than just with Jane). By tokenizing the diamonds, Jane can sell the tokens backed by diamonds to anyone in the world. Alex can enjoy the benefits of owning different types of diamonds and he is able to sell his tokens to anyone, anytime.

Example 2: Typically, investors in venture capital (VC) funds are locked up for years because VC funds invest in illiquid securities and cannot fulfill redemption requests in the interim. By issuing a token backed by the assets invested by the VC, the fund receives the capital they need to invest in illiquid securities, yet investors can exit by selling the token to another investor. Furthermore, since tokens are highly divisible, it eliminates the need for minimum investments. Blockchain facilitates trade in the secondary market.

Example 3: Consider commercial real estate. Publicly listed Real Estate Investment Trusts (REITs) provide some liquidity, but they are expensive to set up and typically hold a basket of properties rather than a single building. Some REITs and real estate development projects require a minimum investment amounts ($25k even higher). By tokenizing the real estate, everyone might be able to buy $10 of a single commercial real estate asset or invest $100 in the development of a housing project. Real estate focused token exchanges will increase liquidity for asset owners.

Advantages of Security Tokens

Increased Liquidity and Market Depth — Most private assets are relatively illiquid, which means the ownership interests are costly to trade. For private assets like an LP interest in a venture capital or private equity fund, exiting the position before fund liquidation frequently involves deep discounts.

Harbor CEO, Josh Stein, stated the benefit of tokenization succinctly: “lock in the capital without locking in the investors.” Tokenized funds allow the fund managers to invest in illiquid assets without fear of redemptions, while fund investors can access liquidity in the secondary market. A deeper market for the ownership interests and the increase in investor liquidity is expected to be accompanied by an increase in value. Beyond VC, private securities of all types are often highly illiquid. Security tokens promise similar gains in liquidity for asset classes like real estate and early-stage equity.

Divisibility of high unit costs places these assets within reach of a much broader market, but market depth will also be increased through a few other channels: (1) The rise of cryptoasset prices have created billions in crypto wealth, some of which would love to diversify into more stable assets without returning to fiat. (2) Algorithmic market makers such as Bancor show some promise of increasing market depth. (3) Security tokens could mitigate market segmentation, making it easier for buyers in one country to access assets in another country.

24/7 Market — The major U.S. stock market exchanges open at 9:30 a.m. and close at 4:00 p.m. Eastern Time each weekday, with the exception of holidays. After the closing bell on Friday, you can’t trade your stock again on major exchanges anymore. Tokenized assets will accelerate the integration of global markets. Around-the-clock trading hours will accommodate all time zones. Do we need a blockchain for 24/7 trading? Of course not, but it’s part of the package. The blockchain ecosystem is a technology stack where “always open” is the de facto standard for exchanges.

Fractional Ownership — Fractional ownership is not unique to blockchain, however, some assets classes such as commercial real estate and fine art continue to be characterized by high unit costs.

A typical retail investor cannot harness the resources required to buy a Manhattan high rise. The investor is left with two options: (1) Forego exposure to Manhattan commercial real estate in their investment portfolio, or (2) gain exposure through an intermediary, for example a publicly traded Real Estate Investment Trust (REIT), where it is often bundled with a portfolio of other buildings of varying quality and characteristics. Security tokens offer an efficient path to fractionalize a single high value asset. As more assets are fractionalized, we can achieve more optimal asset allocation at the retail level. It moves us closer to being able to construct a true “market portfolio”

At scale, this also opens up new investment strategies. Long-short strategies have been used in stock markets for years and these will expand to any asset class with fractionalized ownership. Imagine being able to go long Brooklyn and short Manhattan, thereby creating an “NYC market neutral” real asset portfolio. With increased trading activity of fractional ownership, price discovery will be enhanced and markets will become more efficient for assets that have historically traded infrequently due to high unit costs.

Asset Interoperability — Interoperability is one of the most important concepts in technology. The Internet itself is essentially a stack of protocols that enable many different types of software to exchange and make use of information (i.e. TCP/IP, SMTP, FTP, SSH, HTTP). It’s the reason I can use Outlook to compose an email, send it from my .edu address to a friend with a .com address, who then reads the email through Google Chrome.

Let’s take a moment to address the question every blockchain skeptic loves to ask: “Do we need a blockchain for this? Couldn’t this be done with a database?” The answer is yes, some of it could be done with a centralized database, but it begs the question “why hasn’t it already been done?” The answer is that the current centralized solutions for electronic value transfer lack compatibility — they don’t talk to each other. I can’t send value from PayPal to Venmo, or from E*Trade to RealtyShares. These layers aren’t interoperable.

Interoperability within the Ethereum protocol is facilitated by the ERC-20 token standard, which allows a wallet to hold any token that adheres to the standard. It makes distributions easy. For example, let’s say I own some ERC-20 tokens that represent ownership in an apartment building. Each month the lease payments from the tenants are converted to a ERC-20 stablecoin by the building manager and pushed to all the owners’ wallets in the corresponding proportions. Regardless of which ERC-20 wallet the owner uses, it can hold both the ownership and distribution tokens. The innovation is that ERC-20 is an example of a standard that allows me to hold security tokens that represent many different types of assets in the same wallet.

Some ownership claims, like the deed to my house, are literally on paper, but the point is bigger than digital versus paper. Most asset ownership is already represented digitally. I don’t have any paper certificates for the public equities I own, and frankly neither does my broker, although they could produce them if requested. I don’t have any paper for many of the LLCs and Limited Partnerships of which I am a member. These ownership claims were documented on PDFs and signed electronically. The issue is that even though all these claims are represented digitally, the digital systems don’t all play with each other, which inhibits compliant trade.

The thesis underpinning the idea that everything will be tokenized is grounded in the aspiration that everything will be interoperable. If the ecosystem for global assets becomes interoperable, it means we can hold ownership claims to a commercial building, early stage equity, corporate bonds, a T-bill, my house, and a decentralized network on the same platform. It means these assets to be able to reference each other contractually and interact in an automated way. It could mean global pooled liquidity for all asset classes through a single interface. Perhaps, it even means that we’ll hold less cash as working capital.

Transparency — All ownership rights would be inscribed on a permanent, tamper-proof ledger

Lower Fees — Many fees associated with financial transactions are derived from payments owed to middlemen (bankers, etc). Security Tokens remove the need for most bankers which reduces fees, and smart contracts may one day decrease the reliance on lawyers as well. These smart contracts will reduce the complexity, costs and paperwork with managing securities (collecting signatures, wiring of funds, etc).

When all the ownership claims are tokenized, cap tables will be reconciled in real time by code. All the contractual features such as liquidation preferences, ratchets, and drag-along rights will be baked in to the securities allowing managers to easily run scenario analysis to calculate payoffs under different assumptions.

Faster deal execution — The more people involved in a deal, the longer it usually takes to execute. Security Tokens remove middlemen from investment transactions, hence enabling issuers to offer their security in a shorter time period. Additionally, immediate trade settlement on the secondary market for Security Tokens will become an attractive advantage for issuers & investors too.

Rapid Settlement — The first distinction to understand is the difference between execution and settlement. Trade execution means recording an agreement between a buyer and a seller to exchange a specific quantity of an asset at a specific price. Settlement is when ownership (documentation and payment etc) of the assets actually changes hands.

Trades for bitcoin or ether settle in minutes, not days, but there are a lot more parties involved in securities transactions — more than most investors appreciate. There are complexities such as short selling and margin buying. Blockchain has the potential to increase settlement speed for securities, but it’s more complicated than a comparison to cryptocurrencies. The degree to which these processes can be automated through interoperable smart contracts will determine the gains in settlement speed.

Free market exposure — Most investment transactions today lack exposure to a global investor base. For example, it is hard for investors in Asia to invest in private US companies or real estate. With Security Tokens, asset owners will be able to market their deals to anyone in the world. This free market exposure should lead to a significant change in asset valuations since any asset that is not exposed to a free market is mispriced.

Larger investor base — When asset owners can present deals to anyone globally, the potential investor base is drastically increased. For example, would you rather show your investment opportunity to only US accredited investors & institutions or every potential investor in the world? Competition is healthy and a long-term net good for financial markets.

Automated service functions — Lawyers are less middlemen and more service providers in most transactions. With Security Tokens, issuers will begin to use smart contracts to automate the service provider function through software. This doesn’t mean that lawyers will disappear, but rather that their role will be more advisory based.

Automated compliance — The case for tokenized securities often revolves around relaxing frictions to trade, and one of the most complex frictions is adhering to regulations. It is complex for at least two reasons:

(1) Regulations can vary along multiple dimensions such as asset type, investor type, buyer jurisdiction, seller jurisdiction, and issuer jurisdiction. Each of these dimensions has numerous regulatory permutations and multiple regulatory agencies that govern trade.

(2) Regulatory compliance is typically documented through a series of separate ledgers, each constructed by entities that facilitate issuance and/or secondary market trade. It is only through reconciliation of these ledgers that ownership and compliance is legally validated. In this environment, maintaining compliance adds latency and cost to trade, segments markets, and reduces liquidity.

A key feature of security tokens is that they are programmable. Many elements of the contracting environment can be hardwired into the architecture of the security. When securities are tokenized, compliance can be automated, which means that security tokens will be able to trade anywhere, including decentralized exchanges.

Lack of financial institution manipulation — The likelihood for corruption and manipulation by financial institutions is decreased if those institutions are removed from the investment transaction process.

Disadvantages of Security Tokens

Incapability of token issuers — Normally financial institutions serve a few functions: underwriting a deal, preparing marketing materials, soliciting investor interest, ensuring high levels of security & regulation compliance, and ultimately driving a successful execution of the transaction. Security Token Offerings (STO) will require the issuer to underwrite their own deal via third party audits, prepare marketing materials, generally solicit investor interest, and have high confidence in their security & regulatory compliance. Many traditional investors believe that a large percentage of potential issuers are incapable of successfully executing these functions without traditional financial institutions.

Challenges to mass adoption — Mass adoption of traditional asset tokenization is going to take years, and possibly decades, to fully develop.

Governance — If one entity owns a building they have the incentive to monitor things like maintenance and timely lease payments. If 10,000 people own the same building then it may be the case that no owner has the incentive to monitor, because the cost of monitoring exceeds the value of their investment.

Platforms and Protocols

Platforms: Securitize, Templum, Coinlist, Open Finance, tZero, TrustToken

Protocols: Harbor, Polymath

Sources

Please note that I DO NOT write this article. I only summarized all the main points of articles I find useful.

Sources:

• https://hackernoon.com/the-security-token-thesis-4c5904761063?gi=7699cd8d72b1
• https://hackernoon.com/traditional-asset-tokenization-b8a59585a7e0
• https://www.nasdaq.com/article/how-tokenization-is-putting-real-world-assets-on-blockchains-cm767952
• https://medium.com/@apompliano/the-official-guide-to-tokenized-securities-44e8342bb24f