A summary of the webinar of 20 January 2022 entitled Security token markets need issuers and traders even more than investors.
Security token markets exist but are not yet thriving. Their advantages for both issuers (lower costs of capital and capital servicing plus greater flexibility in the instruments that can be issued) and investors (access to previously unattainable asset classes even for modest savers) are plain. Yet interest is so far confined largely to market insiders (many raising funds on their own security token exchanges) and the wealthier castes of retail investors. In short, the security token markets need the issuers, traders and investors that will create the liquidity that will attract more issuers, traders and investors. Perhaps regulating crypto-currencies and NFTs would help.
What part does regulation play in impeding progress?
Regulatory uncertainty is often cited by institutional investors as an inhibitor to investing in security tokens. However, this is routinely exaggerated.
In Switzerland uncertainty was removed by the passage of new laws to govern tokens. The same is true of smaller financial centres such as Liechtenstein and Gibraltar. In both the United States and the United Kingdom, regulators have made clear that security tokens are regulated under existing securities laws.
The State of Delaware, where the vast majority of American companies are domiciled, has passed laws allowing securities to be registered and held on blockchain networks. True, this does not preclude conflict with Federal laws. For example, publicly traded securities issued in the United States have to be fully registered with the Securities and Exchange Commission (SEC) and eligible to be held and settled at the American domestic central securities depository, the Depository Trust Company (DTC).
DTC eligibility raises further obstacles. Applications can be filed by existing DTC members such as investment and custodian banks only, and the successful applications must meet demanding legal, documentation, compliance and operational requirements.
Public securities issued in the United States also need to be traded on regulated Automated Trading Systems (ATSs) accessed by regulated brokers on behalf of regulated institutional investors that have passed stringent Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks.
This combination of centralised issuance into the DTC and centralised trading on an ATS is inimical to the decentralised issuance and trading of security tokens on blockchain networks. Which explains why security token issuers in the United States, which has seen the highest volume of issues, tend to opt for exemption from full registration of offerings with the SEC.
Instead, they have placed tokens privately under Regulation A (offerings of up to US$75 million to sophisticated or “accredited” investors only), Regulation D (offerings of up to US$10 million to sophisticated or “accredited” investors only) or Regulation S (offerings to investors of any kind outside the United States, provided they have cleared KYC, AML, CFT and sanctions checks).
However, INX Limited – which owns a cryptocurrency trading platform, a digital asset broker-dealing business and ATS – did register its issue of security tokens with the SEC.
At issue in August 2020 the INX token became the first public offering of a digital security on Ethereum to be registered with the SEC. A year later, it was listed on the ATS owned by INX as well. Because the concept is so novel, the company estimates its discussions with the SEC to secure registration consumed more than 900 man-days.
900 man-days are an expense few issuers – or investors or traders for that matter – can afford.
Many participants in digital asset markets prefer not to test regulatory boundaries at all, for fear of having crossed them inadvertently and incurring a fine.
Indeed, the fact that regulators have made clear that security tokens, unlike crypto-currencies, are within the regulatory perimeter, has encouraged potential token issuers to raise funds in the unregulated Decentralised Finance (DeFi) or Non-Fungible Token (NFT) markets instead.
Are the crypto-currency, DeFi and NFT markets helpful to the security token markets?
It is cheaper and easier to participate in the crypto-currency, DeFi or NFT markets than it is to build a regulated securities token exchange or digital asset custodian or acquire a licence to trade security tokens. Until crypto-currencies, DeFi and NFTs are properly regulated, security token markets will probably struggle to take off.
It also pays evangelists for unregulated digital assets to portray the regulatory treatment of security tokens as uncertain (even though it is not). At the same time, they have no interest in matching the willingness of firms active in the security token markets to be regulated.
In so far as crypto-currency, DeFi token and NFT enthusiasts interact with regulators at all, it is to argue that the instruments are not securities and therefore should not be regulated as securities. Naturally, they wish to continue to operate in an unregulated global market, awash with liquidity.
Security tokens regulated at the national level cannot possibly match the accessibility of the crypto-currency, DeFi and NFT markets because differing regulatory regimes fragment liquidity.
It is also difficult for regulated security tokens to match the price volatility (which attracts traders) and returns (which attract investors) available in unregulated and speculative markets such as those for crypto-currencies, DeFi tokens and NFTs.
Outsized performance imparts even to institutional investors a preference for trading unregulated instruments offering high returns over regulated security tokens offering lower but less risky returns. Even the inevitable losses even to financial crime are more than compensated for by gains elsewhere.
A similar incentive applies to issuers, which can raise funds more quickly and cheaply in an unregulated market, while denying investors the same rights as they would enjoy with an issue of conventional equity or debt.
Until crypto-currencies, DeFi tokens and NFTs are regulated in the same way as security tokens that bias in favour of high returns from incurring high risks will persist.
However, any regulatory intervention in the crypto-currency, DeFi token and NFT markets probably awaits a major incident in which retail investors lose money, having discovered that they invested in an asset class that awards them many fewer entitlements, rights and protections than either securities or security tokens.
How can the security token markets develop an adequate infrastructure to support growth?
Indeed, the often-spectacular returns available in unregulated markets divert the attention not just of retail investors but the venture capital and private equity funds whose investment monies are needed to build the security token market infrastructure.
Funds naturally conclude that it is cheaper and easier to build a crypto-currency trading application than it is to secure a licence to trade security tokens – and it is more likely to yield a quick return too. Likewise, it is easier to provide digital wallets to crypto-currency investors than digital wallets for institutional investors to hold security tokens.
True, security token exchanges exist, and usually provide – on the model of the crypto-currency exchanges – issuance, trading, settlement and custody services. Independent crypto-currency custodians exist too.
But institutional investors are looking to investment banks, custodian banks, established stock exchanges, central securities depositories (CSDs) and leading brokerage firms to engage with the securities token markets. At this point, none is ready to do so.
In the absence of support from venture capital and private equity, some believe the investment and custodian banks should take responsibility for building an institutional grade infrastructure. They could start with the pre-issuance and issuance processes, particularly in the bond markets, where manual and paper-based processing persists.
Settlement is another area which needs attention promptly. In some Asian markets settlement is still paper-based. And in every market the cash to fulfil the cash leg of delivery versus payment is not yet available on blockchain networks.
The eventual answer to this problem is of course Central Bank Digital Currencies (CBDCS), which will put fiat currency on-ledger. However, even CBDCs cannot solve payment in cross-border transactions unless domestic CBDC systems are linked, as mooted in papers published by the Bank for International Settlements (BIS).
But any institution investing in issuance, trading, settlement and custody infrastructure for security tokens has to be prepared to think afresh about what is needed, and not simply reproduce for security tokens the infrastructure which exists for securities today.
Instead, exchanges must make it as easy to invest as it is to shop on Amazon – especially for retail investors. That, plus improved post-trade processes, are the obvious areas where security token infrastructures can deliver true innovation.
If crypto-currencies have retarded the development of infrastructure to support the growth of the security token markets, it is probably inescapable that their success will also strongly influence – if not dictate – what infrastructure is eventually built. That infrastructure is likely to have a retail focus.
Crypto-currencies – and the DeFi and NFT markets they have spawned since – are the province mainly of retail investors, chiefly because they make it so easy to invest. Institutional investors trade in size, but retail investors provide the flows that aid price formation and attract liquidity providers.
The crypto-currency, DeFi and NFT markets are all many younger retail investors know. They might hold half their portfolio in crypto-currencies, or the whole of it in NFTs. So successful security token platforms will need to copy the issuance, trading, settlement and custody models these asset classes have pioneered.
Which asset classes are most likely to help security token markets to take off?
Even the finest and most robust infrastructure cannot drive security token issuance and investing. To really take off, the security token markets need respectable issuers that make available to investors a range of high-performing asset classes.
Real estate was an early candidate for tokenisation because it is intrinsically illiquid and hard for retail investors to access. Issues have taken place but expectations of rapid growth have been disappointed.
Bonds have emerged as the likeliest successor, and tokenised bonds have been issued successfully. In April 2021 the European Investment Bank (EIB) issued a €100 million two-year bond on to an Ethereum blockchain. In November 2021, the SIX Group issued a CHF 150 million bond in tokenised as well as traditional form.
Funds are being tokenised successfully too, notably in Singapore. Fine art is also being tokenised, albeit largely in the form of NFTs. Sporting “moments” are being sold in the form of NFTs too.
INX Limited, which runs blockchain-based trading platforms for security tokens as well as cryptocurrencies, is working with the owners of Burnley Football Club to list a publicly traded digital security token linked to specific club revenues.
But the asset class most likely to spark security tokens into a long period of sustained growth is equities.
Here, again, the cryptocurrency, DeFi and NFT markets have proved unhelpful. When cryptocurrency exchange Coinbase went public, it chose a conventional initial public offering (IPO) rather than a Security Token Offering (STO). NFT marketplace OpenSea has run into resistance from users after senior management speculated about an orthodox IPO.
Security token trading platforms have redressed this lack of enthusiasm for STOs when raising funds to support their own investments, by selling security tokens tradeable on their own platforms.
INX, for example, raised US$85 million from 7,250 people in 74 countries in its STO. Asian security token platform Fusang has raised equity capital by the same means. But such issues have tended to highlight the lack of third-party equity issuers.
Which is why one target group – OTC-traded or “pink sheets” companies – are of particular interest as pioneers of token-based equity.
By tokenising their equity, smaller companies whose shares are traded OTC can escape the negative effects of being relatively illiquid, such as shorting and pumping-and-dumping of their stock. They ca also reach new classes of investors (which can also be or become customers).
Importantly, tokenising traditional equities will increase the appeal of security tokens to traders.
For traders, tokenized equities are likely to attract the retail and institutional investors that can provide the volumes of trading activity that guarantees the liquidity traders need – without suppressing the price volatility traders also need to make a profit.
Equities are also the area in which security tokens haver the best chance of eclipsing crypto-currencies, DeFi and NFTs.
Crypto-currency gains are now being taxed in some jurisdictions, and plenty of other jurisdictions are planning to follow their example. If security tokens can offer higher returns plus clear regulatory status plus a more generous tax treatment, their future is assured.
Highlights of 20th January Webinar
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