Security Tokens: Blockchain Goes Exponential

From stocks and shares to real estate holdings—security tokens have the potential to exponentially reshape the way we think about cryptocurrency, federal compliance, and portfolio management.

A version of this article titled "Crypto That Doesn't Suck" originally appeared in The Daily Dirtnap on July 12, 2018, and this version appeared on the ExO Works blog on August 03, 2018.

What do you think when you read this headline:

“A scooter company is turning to cryptocurrency to raise $125 million instead of getting traditional investors”

It has to be a scam, right?

Wrong!

You’re actually looking at the future of Wall Street.

It turns out that Spin (the scooter company) is raising the money using a new generation of crypto, called “security tokens.” Most people don’t understand them yet.

Security tokens answer the question of what happens if we make crypto fully compliant. It’s the opposite of what we’ve seen so far, where people have been trying to avoid the U.S. Securities and Exchange Commission (SEC) and other regulators.

The STO is the new ICO

The security token offering (STO) is replacing the initial coin offering (ICO). Axios reports that: “Security token offerings are similar to initial coin offerings, except that they're explicit securities (i.e., not utilities) and backed by real assets (in this case, Spin [the scooter company] itself).”

The security tokens that Spin are issuing represent ownership in the company and are convertible to common stock in the event of a change of control. The $125 million has been raised through private placement with accredited investors, each of whom has been verified and run through know-your-customer (KYC) and anti-money laundering (AML) checks.

Once you purchase security tokens, you hold them just like the shares of stock you own today until the company you’ve invested in is acquired or goes public (or bankrupt). You also have the option to sell them once your lockup expires—and this increased liquidity is one area where security tokens start to look more attractive than traditional startup investing.

We’re Going to Tokenize Everything

But security tokens aren’t limited to shares in new companies. They can represent assets like real estate—but with increased granularity—so an owner can tokenize either the titles of a portfolio of buildings, the cash flows from those buildings, or both. Ownership can then be easily fractionalized and shared across all token holders.

Tokens can also represent participation in an investment fund. "Tokenizing" a hedge fund, for example, would allow the holders to either participate in the fund’s performance or sell their shares to other investors—without the hassle of lockups or long redemption periods. Meanwhile, the fund is free to invest in illiquid assets without fear of a liquidity crunch.

Josh Stein, the CEO of tokenized securities company Harbor, points out that tokenization allows funds to “lock in the capital without locking in the investors.” I know of big-name hedge funds who are considering tokenization, so keep an eye out for announcements from Coinbase and other players in the space.

Security tokens can—and will—represent ownership in traditional assets like equity, debt, derivatives, real estate, investment funds, and more. Centralization is a key feature, meaning that you’ll be able to hold all of your tokens in a single account, even though they represent completely different asset classes.

Security Tokens Are Smart Shares of Stock

Another advantage to security tokens is that they’re intelligent. If there’s a one-year lockup, then the tokens can be programmed to literally refuse to trade themselves until the time is right. Tokens can restrict themselves to only trading within or between specified countries—and can adjust their behavior automatically to the appropriate governing laws. It’s also possible to view the ownership history of an individual token, just like you would a Carfax.

And we’re only scratching the surface of what smart contracts can do.

A registered token trading platform called Templum just announced that they’re assigning a CUSIP identifier to every security token on their platform. All of this makes regulation easier to enforce, and I recently read an article titled “The SEC will mandate Security Tokens” that says it all: Embracing this new breed of crypto will actually save regulators time and money, while increasing compliance.

Remember that every exponential technology goes through a “Deceptive” phase, where people stop paying attention because it appears to have failed. This is where we are now with crypto altcoins and the crash in market value for the six months following December 2017:

The phase that follows is “Disruptive,” which is where security tokens will take us.

Get Ready for Security Tokens

Bernstein released a report stating: "To see the [crypto] fund-raising landscape as scam prone and with regulatory skepticism failing to recognize it as a market-based innovation experiment to build out a new financial system...With size and scale, we will witness mainstream talent and then eventually capital diverted towards” this new system.

And because security tokens are smarter and more efficient, they will become the way we do business on Wall Street. Settling a trade of public shares is a complex process, and the SEC was excited to announce a T+2 settlement cycle last year—shaving 33% off the time required. That means it still takes two full days to settle each transaction. There are a bunch of people involved in this manual process, which the CEO of micro-finance investing app Robinhood recently claimed still involves fax machines in some cases.

Settlement will continue to require multiple parties, but security tokens promise to improve efficiencies and reduce the time per transaction. Parts of the process can be automated, and smart contracts can be put in place to ensure smooth operation in most instances. Humans will only need to get involved to handle exceptions. And we can ditch the fax machines.

There’s Still Work to Be Done

To be fair, there are still a number of important pieces missing. Real, registered, SEC-compliant security token exchanges are just starting to come online. Also missing are custodian services, prime broker services, true portfolio management, tools for hedging, and more. We’re also waiting for regulators to issue clear guidelines.

Investing in security tokens feels like the Wild West right now. I’m holding private tokens in a wallet (which is simply a homemade piece of software), and I’ve had to enter codes into a command-line to manage it. If I wanted to avoid this, I could move my tokens onto a USB drive that I would then have to be careful not to lose. It’s neither easy nor investor-friendly at the moment. But we’ll get there.

None of this requires Bitcoin or Ethereum to rise in value—and the success of security tokens has nothing to do with whether or not every altcoin on cryptocurrency exchange Binance goes to zero (although many security tokens are built on Ethereum’s ERC-20 infrastructure). All of existing crypto can collapse, and these new security tokens will do just fine.

Security Tokens Are a Massive Opportunity

The implication is that trillions of dollars will move over to security tokens, which dwarfs the current $300 billion crypto market (and even the $800 billion peak crypto valuation in December 2017).

In fact, Wall Street firms are much-better positioned to take advantage of security tokens than startups. Big financial firms already have broker dealers, certified financial analysts and planners, alternative trading systems, friendly relationships with regulators, and everything else required to take advantage of security tokens. Startups like Coinbase are working quickly to acquire these things—and it will be interesting to see when the big players start to flex their muscle.

As I write this, SIX, the owner of the Swiss stock exchange, just announced that they’re launching a fully regulated cryptocurrency exchange. Expect to see security tokens listed on this platform—and expect to see a wave of similar announcements from big names you recognize. When you see these articles in the news, try to ignore the existing crypto market and instead ask yourself how this helps solidify the future of security tokens.

We’re witnessing the digitization of the share of stock, and it will disrupt the finance industry as we know it.

Mike Lingle is the Chief Growth Officer and Crypto Lead at ExO Works and is focused on making sure that ExO is there whenever clients, partners, and agents need help building exponential organizations. He also leads the ExO Works crypto practice, including promoting the CivX token economy.