Simplifying Blockchain and Tokenization

In the early days of cryptocurrency, capital raises were generally referred to as Initial Coin Offerings (ICOs). These offering, while initially and frequently successful, were plagued by the lack of sophistication of the “White Paper” description of the offering, their lack of meaningful and detailed information, the absence of investor disclosures and protections, the glutted market for such offerings, the lack of underlying asset and business value, the speculative nature of the “buying frenzy” and perhaps most importantly…the increasing likelihood that the Securities and Exchange Commission (SEC) would step in and regulate ICOs as an offering of securities. 

Thus, the nature, legality, compliance, due diligence, quality, asset basis, costs, efficiencies, intermediaries and targeted investors...many interested in the simple speculative upside of buying “something” with the potential to appreciate...were faced with realities related to both their accredited status and the regulated quality of the investment opportunity.

Historically, most ICOs avoided being classified as securities, essentially taking advantage of the unregulated nature of cryptocurrencies, at the peril of investors. However, in recent months, the SEC has indicated it will regulate cryptocurrencies just like any other security. As a result, most ICOs have converted to Security Token Offerings (STOs) in which the quality of the offering is improved, in an effort to attract accredited and institutional investors to regulated securities.

In a "twist" on STOs, some issuers are defining their security offerings as an investment in Certificates of Ownership (AKA Certificated Fractional Interests or Ownership Certificates). Such developments are moving the crypto market closer to traditional Initial Public Offerings (IPOs) in which shares of stock (ownership) are offered as securities. It is significant in that 84% of all U.S. crypto fundraising efforts in 2018 were based on STOs, following a virtual collapse of successful (fully subscribed) ICOs in 2017.

Because the market of end-users such as real estate firms, financial services providers, retailers, professional services, hospitality and other such industry segments have recognized the value of blockchain technology for its transactional, dis-intermediating and cost reduction efficiencies, investors have flocked to start-ups claiming that their blockchain-based coins, tokens or ownership certificates will lead to significant future value. 

Notwithstanding, it appears that, not unlike the early days of dot.com investments, speculation in such coins, tokens and certificates have been the sole driver that has given a perception of value, and the potential of investment appreciation. The challenge is for the offering firms, frequently under-capitalized technology start-ups, to demonstrate underlying business value; and a market attractive to both customers and investors.

Advisory firm Integrated Growth Strategies has reviewed hundreds of blockchain and cryptocurrency-based startups. Historically many start-ups claimed not be offering securities offerings, but rather "CryptoAssets" employing unsophisticated White Papers to promote speculative coins or tokens that were essentially the actual "product" being sold. These so-called White Papers generally neglected legitimate plans for product, service and process development, which is naturally the basis of creating underlying business value.

This value is the basis by which a business plan sets forth implementation that provides a Return On Investment (ROI) desired by legitimate investors...rather than through temporary and often-harmful speculation. Investors seek appropriate disclosures and protections, traditionally prominent in investor-grade business plans, pursuant to SEC rules set forth in regulation D (and A+).

Moving in the correct direction of blockchain transactional efficiencies and tokenized securities, that represent customer and investor values, are a number of banks, retailers, and even automobile companies. Real estate professionals are demonstrating the ability and cost efficiencies of tokenized blockchain-based Real Estate Investment Trusts (REITs), and income producing properties such as apartments, medical, office and industrial buildings, and in certain rare occasions, the purchase of a single asset. The key to the future use of "CryptoAssets" will be a dramatic increase in buyers, sellers, lenders and investors accepting the concept of being "points of sales" for cryptocurrency transactions...that are based on contractual and transactional data gathered, stored and accessed via blockchain technology.

So, lets take a brief look at definitions of key terms required to understand the nature of blockchain technology and tokenization:

BLOCKCHAIN is a “distributed network of computers” existing between permitted parties that utilize the underlying infrastructure of the internet to validate and process transactions. These transactions are validated and added to secure “blocks of data” that are processed in a pre-determined interval of time (seconds or minutes). 

Cryptography designs append new blocks to previous blocks, in a manner that blocks are never overwritten or destroyed…just appended…thereby forming a “chain” of blocks of data. Contributed “nodes” of data receive economic compensation for solving complex mathematical tasks. Each node on the public blockchain network maintains the same chain of blocks, providing public transparency, that cannot be changed, modified or eliminated. 

Therefore, is referred to as “immutable”. The chain of blocks is referred to as a “ledger”, similar to an accounting ledger of records. By design, servers will not allow double spending, forgery or access to unauthorized parties. It is fast, inexpensive and cannot be changed as a recording device of data.

Blockchain software and hardware requirements are complex. Due to cost considerations most, public agencies elect not to take these responsibilities in-house, which is why there has been a proliferation of Infrastructure and Software as a Service models (IaaS & SaaS). These models allow parties to purchase servers and software on a subscription basis instead of making substantial initial capital investments.

Blockchain as a Service (BaaS) is expanding, fueled by a change in common financial models, that reflect market segment budget implications. Namely, upfront costs are avoided, and replaced with recurring costs. The maintenance and troubleshooting costs, however, shift to the vendor, which must be able to guarantee a very low rate of failure.

And, while public proof of work blockchains have proven robust, secondary software like wallets, exchanges, and smart contracts can be soft targets for hackers. A professional level of quality assurance and quality control will therefore are required.

CRYPTOCURRENCY is a digital asset designed to work as a medium of exchange that uses cryptography to secure financial transactions, control the creation of additional units and verify the transfer of assets. Also referred to as digital currency, virtual currency or alternative currency.

Cryptocurrencies use decentralized control as opposed to centralized funds on which the nation’s central banking system is based. The decentralized control of each cryptocurrency works through distributed ledger technology, typically a Blockchain, that serves as a public financial transaction database. In 2009 Bitcoin, as the first “open-source” software-based currency, was generally considered the first decentralized cryptocurrency. At this time there are over 4,000 “alternative coin” (variants of Bitcoin).

SECURITY TOKENS are digital assets subject to federal security regulations D and A+ (and S in non-U.S. countries). They are essentially the intersection of digital assets (tokens) with traditional financial products (shares of stock). As an example, tokens in real estate assets allow owners to convert the rights of individual properties or fractions thereof onto blockchain.

Security Tokens have the potential to transform capital formation by allowing private securities to be issued and automatically traded between a qualified investor base, and as an economic currency. It is a mechanism to raise permanent capital, while accredited investors can freely trade the tokens on a secondary market with other accredited investors.

Security Tokens reduce professional fees, decease costs, marginalize middlemen and increase transactional security and transparency. Security tokens essentially allow for the tokenization of any asset, as long as all trade partners are accredited investors. These tokens constitute an investment contract, where the main "use case" and the appeal for contributors to buy the tokens in anticipation of future profits in the form of dividends, revenue shares, and, more commonly, price appreciation.

Utility Tokens differ from Security Tokens in that they do not represent an ownership interest. Rather, they are issued in order to fund development of a firm's native cryptocurrency and can be later used to purchase a good or service offered by the issuer of the cryptocurrency.

DISTRIBUTED LEDGER TECHNOLOGY is a database that is consensually shared and synchronized across network spread across multiple sites, institutions or geographies. It allows transactions to have public "witnesses," thereby making a cyberattack more difficult. The participant at each node of the network can access the recordings shared across that network and can own an identical copy of it. Any changes or additions made to the ledger are reflected and copied to all participants in a matter of seconds. Underlying the distributed ledger technology is the blockchain which is the technology that underlies cryptocurrency.

DECENTRALIZATION is the process by which the activities of an organization, particularly those regarding planning and decision-making, are distributed or “delegated” away from a central, authoritative location, group, entity or individual. Concepts of decentralization have been applied to private business, political science, law, economics, technology and public administration.

The general conditions to define if a project is decentralized, are censorship resistance and immunity to authoritarian management, dictating and modification. A major benefit of decentralization is that there is a “trustless” aspect of it, where it is impossible for a user to renege on a transaction or modify the mechanics of transaction put in place.

SMART CONTRACTS are self-executing contracts using computer protocol to facilitate performance of a contract. They are also referred to as digital contracts and blockchain contracts. Smart contracts (documents and professional or financial agreements) are converted to computer code and stored and replicated on an authorized computer system and “supervised” by a network of computers that run the blockchain. 

This allows the immediate performance of contractual transactions without third parties. Ideally suited for transferring money and receiving products and services, smart contracts are performed automatically without the need or services of middlemen. Transactions are trackable and irreversible.

Multi-signature digital documents, or “Smart Contracts” can help prevent wire transfer fraud and ensure the proper flow of funds at closing. To further strengthen defenses against fraud, many firms aspire to establish a Smart Contract wherein the funds cannot be released until more than one party has entered a password for approval.

A records system at the government-controlled clerk’s office is public and purportedly accessible to everyone. The alternative to recording a document is private record keeping, which means attorneys, lenders, or title companies are responsible for holding and maintaining records. These cumbersome private records include loan agreements, debentures, notes. Certain legal documents may fit the criteria and can be included as unrecorded contracts or or side letter agreements for future inclusion in blockchain records. Other documents that may utilize blockchain technology in the future includes wills, identification documents, birth and death certificates.

By contrast, today's transfer of cryptocurrency can be instantly verified. To further strengthen defenses against fraud, many technology firms with expertise in blockchain technology can establish a “multi-signature” escrow account wherein the funds are instantly verified and cannot be contractually released once more than one party has entered a password for approval. If the funds are not authorized within a set amount of time, they are automatically returned to sender. This concept can be built into closing mechanics to protect parties from funds transfer fraud. 

PROOF OF STAKE (PoS) was created as an alternative to the Proof of Work (PoW), to tackle inherent issues in the latter. When a transaction is initiated, the transaction data is fitted into a block with a maximum capacity of 1 megabyte, and then duplicated across multiple computers or nodes on the network. The nodes are the administrative body of the blockchain and verify the legitimacy of the transactions in each block. To carry out the verification step, the nodes or miners would need to solve a computational puzzle, known as the proof of work problem. The first miner to decrypt each block transaction problem gets rewarded with coin. Once a block of transactions has been verified, it is added to the blockchain.

Theodore Sprink, is Managing Director of the advisory firm Integrated Growth Strategies and can be contacted at [email protected] or 866-494-3727. His personal web site is www.tsprink.com and his LinkedIn site is www.dhirubhai.net/in/TheodoreSprink.

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