At Consensus this year, security tokenisation was a theme that kept cropping up. I met up with some leading projects in the area, including the Polymath team; Joshua Stein of Harbor; Philipp Pieper from Swarm; and also saw a great talk on tokenised securities at Token Summit lead by William Mougayar. Last week, securities and Exchange Commission declared that Bitcoin and Ethereum are not securities. Many tokens sold in initial coin offerings, on the other hand, will likely be considered securities at least until the network is launched, and because most aren’t decentralised. Coinbase acquired a FINRA-registered broker-dealer for its licences. If approved, Coinbase will be capable of offering blockchain-based securities, under the oversight of the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Goldman Sachs backed Circle is following a similar path and seeks registration as a brokerage and trading venue.
All this chatter has led me to think about the concept of a security more broadly. Some questions that have been turning over in my head:
- What are securities?
- How are they regulated?
- Why are they regulated?
- Would it be possible to make a token that bakes in the necessary jurisdictional compliance for the legal sale of a security?
- What projects are trying to create protocols for compliant security tokens?
- What issues are there with the whole concept of security tokenisation?
The intention is for this piece to cobble together these conversations, as well as give some context to securitisation. I hope this proves to be a sober and balanced investigation into the possible opportunities and threats of tokenised security offerings.
What is a Security? Why are they regulated?
The Oxford English Dictionary defines a security as “A certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.” Securities thus encompass a significant proportion today’s financial ecosystem; they are a broad category that can be divided into three principle areas:
- Equity securities (e.g., common stocks) i.e. an ownership interest in an entity that entitle the holder to some control of the company on a pro rata basis, via voting rights, and often a companies earnings.
- Debt securities (e.g., banknotes, bonds and debentures) i.e. money that is borrowed and must be repaid, with terms that stipulate the size of the loan, interest rate and maturity or renewal date. They generally entitle their holder to the payment of interest and the repayment of the principal, and are typically issued for a fixed term.
- Derivatives (e.g., forwards, futures, options, and swaps) i.e. a security where the value is reliant (derived) from an underlying asset or group of assets and where its price will fluctuate in accordance with the fluctuations of price of the underlying asset.
What is the common thread that tie these three security types together? How do you determine whether a financial offering should be considered a security? An instructive and often used test derives from from the US Case, Securities and Exchange Commission v. W.J. Howey Co. (1946). The “Howey test,” put simply, asks:
- Is there an investment of money?
- Is there an expectation of profits?
- Is the investment of money in a common enterprise?
- Do profits come from the efforts of a promoter or third party?
If the answer is affirmative to these questions, the investment product must comply with a bundle of regulations that are aimed to promote market confidence, financial stability, consumer protection, and reduce financial crime. To understand why these regulations came about, we need to cast our minds back to 1920s America.
The ‘Roaring 20s’ preceded the enactment of US federal securities regulation that are still relevant today. Much like how internet and ‘dot-com’ stocks rallied markets in the 1990s, the new technologies of electricity, automobiles, radio, and penicillin, helped fuel massive speculation in 1920s America. It was a period was marked by strong economic growth, technological change, and speculative investment. The Radio Corporation of America (RCA) is the classic example of this speculation. Despite warnings of then Secretary of Commerce Herbert Hoover who described “the growing tide of speculation” in 1925, the market remained manic. In the five years prior to the Great Crash of 1929, RCA stock soared from about $11 to a September 1929 high of $114 before crashing to a nadir of less than $3 per share in 1932. The dramatic correction of October 1929 began a a prolonged period of economic depression that lasted for about a decade, and during which almost a quarter of the American workforce was unemployed. The following regulations were enacted in order to restore confidence in the securities markets in light of the excesses of the 1920s. They remain the cornerstone of public trust in the US securities markets, domestically and internationally, and exist in order to avoid the mania of markets from affecting the broader economy.
The regulations are:
• Securities Act of 1933 – that regulates the distribution of new securities
• Securities Exchange Act of 1934 – that regulates the trading of securities, brokers, and exchanges
• Trust Indenture Act of 1939 – that regulates debt securities
• Investment Company Act of 1940 – that regulates mutual funds
• Investment Advisers Act of 1940 – that regulates investment advisers
Circling Crypto-Assets In
Most regulators have not expressed interest in creating new regulation to fit the industry, but will regulate in accordance to the above. Industry, on the other hand, have put forward legitimate arguments that ask for regulators to adapt to crypto assets, not the other way around. Some tokens don’t clearly fit into the exisiting definition of a security or currency, it is argued, but function as something different. For example, a token may be bought at a seed round, before the product is built. Here there is an investment of money, an expectation that the token will rise in value, and it is issued from a common enterprise. Later, however, when the product is live, when the network is sufficiently large, the very same token may be used to pay for products, to fuel the network, and be used as a high velocity utility token. But regulators have been clear here as well, arguing that definitions can morph over time, from security to utility token. Jay Clayon, the current SEC Chairman, has been even clearer and said “we [the SEC] have been doing this a long time, there's no need to change the definition.”
A major hurdle to tokenise securities is thus compliance with this inevitable regulation. Know-your-customer (KYC), Anti-Money Laundering (AML), income, the total number of investors, the implementation of vesting or holding periods are just some of the regulatory measures that are specific to jurisdiction. These regulations apply not only to the initial offering, but to all secondary trades, where responsibility is also placed on the seller. To further complicate matters, compliance with both the issuer’s jurisdiction as well as each investor’s jurisdiction is required. On top of these securities regulations, private real estate assets have additional legal requirements that must be enforced under the Internal Revenue Code (IRC) and the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
Security Compliant Tokens
What security tokenisation does is imbed the security with its compliance requirements into smart contracts so that its security tokens can be traded on secondary blockchain-based exchanges anywhere in the world. A security token may thus be less an invention than an innovation - it could improve traditional financial products, removing middle men from transactions, reducing cost, and linking more buyers with sellers.
Rapid and trustless settlement - The NASDAQ and NYSE execute trade very quickly but still settle in a number of days. The SEC recently adopted a settlement cycle of T+2 meaning that ownership doesn’t change hands until the passing of two days after execution. Transfers of LP and LLC positions often take longer than that. Back home, the ASX has announced that by 2020 they will be moving to a T+1 system. Bitcoin has been doing global financial settlement every 10 minutes for almost 10 years. Protocols that bake in security compliance into the token itself will be able to make the settlement of securities as efficient as any ERC-20 token, i.e. in minutes not days. Harbor, for example, is creating a ‘whitelist’ of KYC’d addresses, meaning that your Ethereum address, if compliant, could buy any security on a decentralised exchange should your address meet the regulatory standards stipulated in the smart contract.
Liquidity & increased market depth (24/7 markets, global investor base) - Currently security markets are open from 9am - 4pm every day, and closed on weekends. The crypto markets are always open.
Fractional ownership - Fractional ownership has been around since at least the issuance of shares in the Dutch East India Company in 1607 and is certainly not unique to the blockchain. However, some currently illiquid asset classes, such as art, wine, and real estate, remain off limits to the retail investor given high cost barrier to entry due to a lack of fractional ownership. Fractional ownership could mean owning 0.00001% of the Empire State Building, or building your own diversified REIT with 0.00001% of 10,000 properties around, say, New York. This fractional ownership could dramatically improve the liquidity of securities, and create secondary markets for illiquid assets. It would increase price discovery, expose retail investors to venture capital, private equity and many more assets that were traditionally the exclusive domain of the sophisticated (read very wealthy) investor.
Automated compliance - When securities are tokenised, compliance may be automated, which means that regulated trade will no longer be restricted to walled gardens. Security tokens could trade anywhere, including on decentralised exchanges. This is because security tokens are by definition programmable meaning that many elements of the contracting environment can be hardwired into the architecture of that security.
Be your own banker - There are also really creative use-cases for tokenised securities, like using these securities to collatorise and then draw out a stablecoin such as Dai. While speaking to Josh Stein of Harbor, he mentioned the possibility of collateralising tokenised property in a smart contract and then drawing debt. This aims to be less volatile than the current standard collatoralisation of ether. Because ether is volatile it is recommended that the liquidation price is conservative, but with property this could be closer to the borrowed amount. If the consumer could bypass banking institutions in this way, this could have large consequences of the structure of the current economy. And the consumer pull factor is strong: the current interest rate on MakerDao is only 0.05%.
Projects to watch
Harbor has devised the R-Token standard, which stands for ‘regulated token’. Harbor is attempting to create an open-source standard that defines a mechanism in which crypto-securities can be compliantly transferred on blockchains. The R-Token Standard enables ERC-20 tokens to become compliant crypto-securities that can be traded across any ERC-20 compatible platform because KYC, AML, tax and other regulatory requirements are baked into the token itself. Harbor has a particular interest in private real estate assets (including LP interests in real estate investment funds, fractional ownership in land/buildings, and private REITs) primarily because this asset class could benefit greatly from the improved efficiency, liquidity and fractional ownership possibilities of blockchains as described above.
Swarm is creating a security token standard called the SRC20 standard. I met with Philipp Pieper from Swarm last month and have been in touch since then. Put simply, they are tokenising LP positions in Private Equity funds. This means that the barrier to entry to invest in venture capital, for example, would collapse dramatically, and liquidity for current investors would improve by an order of magnitude.
A Sober Final Word
The main issue I see with tokenised securities is that they often are associated with an underlying physical asset. These assets are regulated by the jurisdiction it happens to be in. This means the security is connected with something in addition to the smart contract created. Because of this, possession in a smart contract doesn’t necessarily mean possession in the real world and because of this the security suffers from the same trust problem as normal contracts. Many tokenised securities that use a smart contract that trusts a third party necessarily removes the killer feature of trustlessness. It’ll be interesting to see whether the world of crypto will be able to connect real world ownership to decentralised and global trading through smart contracts; I’m very uncertain about it, although we hope that further work will go into bolstering security, oracles, and the legal enforceability of smart contracts.
It is also worth mentioning that tokenising traditional securities is not a game changer. It presents an improvement on the current securities infrastructure (faster settlement, higher liquidity, price discovery, lower fees). However, it is simply an incremental innovation that will likely keep current power structure status quo largely intact. The reimagining of societal organisation through decentralised governance is not efficiently achieved via this route, but rather via digitally native, decentralised, censorship resistant, and distributed token powered networks like Bitcoin.
We sometimes think of crypto-assets as a distinct asset class, separate from traditional equity, debt, and derivate markets, but what if blockchain-based tokenisation could be used in traditional markets to improve the way society records ownership and trade assets, and thus re-engineer large swathes of today’s financial plumbing. This is the grand hope of security tokenisation, which hopes to increase the settlement speed, liquidity, and increase fractional ownership. Tempered with this are the great and difficult problems of demonstrating compliance in the token itself and crucially the tethering of real world assets to a blockchain without obviating the whole purpose of a blockchain: trustlessness.