The (il)legality of security tokens
By George Salapa, Bardicredit
Published: 31 January 2020
Crypto has gotten a bad rap with people. Strangely, the biggest issue seems to be that people don't trust crypto in general, which is outright strange given that trust was supposed to be the 'main thing' about blockchain.
Sometimes too good is not good at all. Billions have flown into crypto during the ICO heyday, but to what use? Flawed business models have been built on a pre-mature technology. Arguably, this all but hurt blockchain
Question: has crypto been an overtly complex plan by techies to loot the poor?
Anytime people come up with a new use case for blockchain, it is burdened by the negative reputation. Security tokens, for one, have had a hard time to not look like a last-ditch effort to raise money by those who failed during the ICO bubble.
Not fair? Security tokens are a digital representation of investments like stocks and bonds. Unlike traditional financial instruments, security tokens can be pre-programmed to 'automate away' many functions that are currently undertaken by institutionalized middlemen. I have covered this subject in much more detail in , but in essence: whenever someone buys a stock, in order for the transaction to take place, a convoluted network of custodians, brokers, clearing houses and central depositaries goes to work to record and execute the transaction. And all along, they all maintain their own record of truth in their own ledger which they try to reconcile between each other. It is a system that has evolved naturally and historically from paper stocks and bonds. In some more complex situations, this system is beginning to show signs of age.
But that is besides the point. The bigger question: how long can the financial infrastructure stay analog? Nothing that has ever gone from analog to digital reverted back. That's why security tokens are important they have shown the world that it is possible to automate functions that have always required verification by some form of institutionalized authority.
A security token is a digital record of ownership. It is a line of code that keeps track of who owns how much of some total balance, and that gets continually updated whenever a transfer of that balance takes place between parties. The transfers themselves can also be restricted depending on certain conditions which can be written in code, so that for example a particular security token cannot be sold to investors before they undergo checks to prove their source of wealth, the results of which are recorded on blockchain only to be picked up by the code to decide if the transfer can take place.
Similarly, dividends can be automated using a line of code. A smart contract can be deployed alongside the security tokens to execute certain action when specific conditions are met. For example, the smart contract can be fed information from the internet through an oracle about the date, so that on 31 December 2019, it can automatically send out dividends to all owners of that particular security token. It can also automatically withhold a portion of these payments to account for the withholding tax (for each tokenholder the amount withheld would be different, depending on the tax domicile of the tokenholder, which will be picked up by the code from the record of the checks mentioned above).
Consider for a moment the efficiency that can be achieved with securities that are pre-programmed in this way to remove the need for human work. It is just as impactful that none of these actions - trading, voting, dividends - require approval of centralized authorities because they are performed by a computer code. And since everything will be recorded on one immutable ledger, any errors that could be caused by human factor are completely eliminated.
Derivatives are financial products whose value is derived from some underlying asset or relationship. The level of complexity (and hence the need for institutional involvement and oversight) is much higher with derivatives than traditional financial primitives like equity or debt. This is where the discussion gets really exciting. High-value derivatives are in the form of legal agreements between two parties that may last many decades. The oversight and management of these legal relationships can be very expensive and paperwork-heavy. Smart contracts on blockchain can automate the execution and performance of the derivatives by converting operational aspects of the legal contracts to computer code. This can include rights, prohibitions and obligations, any related calculations, as well as the execution of actions depending on certain conditions (e.g. time or change in interest rate). A computer code can easily observe time, and automatically exchange payments between two parties on an interest rate swap.
History shows that financial innovation tends to be extremely impactful. The rise of stock market catapulted Brits and Dutch to become dominant global superpowers in the 17th century. Security tokens may seem like the obvious next stage in the evolution of finance, but their adoption is (and will continue to be) slow and problematic. This is partly due to the fact that the technology is still far from perfect. Discussion of the technological challenges would deserve an article of its own, but in essence there is the a) lack of interoperability between different protocols, b) limited scalability given the size and complexity of smart contracts.
Technology can be improved, and most of these challenges can be overcome. Several projects are already underway with a mission to develop blockchains dedicated to security tokens, albeit if in different forms.
A much bigger issue is that security tokens attack the institutional establishment of today's financial markets. New technologies tend to face slow adoption. People don't like to get out of their comfort zone, learn and test new things. But, in the case of security tokens, the change is not only uncomfortable, but downright hard.
By its very design, a security token eliminates the need for middlemen, but this is a contradiction to legal systems of most countries of the world, which requires exactly that: oversight by institutionalized middlemen like custodians. Few countries outside of Europe have embraced security token, and some, like the U.S., prefer to somewhat ignore their existence.
Most security token offerings in the U.S. have indeed been restricted to private investment rounds offered to accredited investors only. Few have attempted to register a full public offering with SEC, and those that have, ended up paying dearly for the process and costs. Blockstack, which has filed under RegA+ exemption notes that the fees for the process amounted to $3M, including the development of a new blockchain just for that.
And not even that gives the company full clarity. The offering simply doesn't add up with the current regulatory framework. Blockstack explains some of those uncertainties in their Offering Circular. Because their securities (tokens ... sorry) do not need, for example, a central depositary (because transactions are cleared automatically on blockchain as a consensus of computers), they could be classified to perform the function of a transfer agent.
It is evident that wider application of security tokens requires rewriting rules, and that is not easy. Some European countries have done better than others. Several European countries will soon adopt their versions of a 'blockchain act', which gives firm legal grounding to many elements of the blockchain technology. Legal systems of some countries, like Liechtenstein, for example, are technology agnostic, which means that security tokens are recognized by law as just another alternative form of financial instrument, so that the local regulators accept and can also approve full public offerings of security tokens in accordance with European Prospectus Directive.
Even where the law is more welcoming and progressive, security tokens remain for now a more efficient instrument for crowdfunding and capital formation at a lower cost to the issuer thanks to the inbuilt automation and digitalization of the process.
But, this is nothing to scoff at. Public markets are a fraction of the global wealth. There are trillions (and more) of private assets in the world that could be securitized with tokens. Common (retail) investors have very limited choices of what they can invest in, which is especially frustrating in the current negative yielding market environment.