The Security Token Market Needs Better Lingo
Andrew “Drew” Hinkes is a co-founder and the general counsel of Athena Blockchain, and an adjunct professor at the NYU Stern School of Business and NYU School of Law.
Lost in the ICO frenzy of 2017 was a curious issuance.
In April of that year, Blockchain Capital raised $10m for its third fund, a “tokenized VC fund.” Unlike most ICOs that purposely avoided regulatory compliance, this was a compliant U.S. security, issued as a token.
This was the beginning of an expected wave of so-called “tokenized” securities that will offer legally compliant securities as tokens – a change that will increase demand for and trading liquidity in these securities by leveraging blockchain and smart contract technology to automate aspects of trading, and will enable these instruments to offer new, useful features expected to increase their value to issuers and purchasers alike.
Under U.S. law, a variety of financial instruments are included in the definition of a security, including stocks (i.e. equity), bonds (i.e. debt), and investment contracts (recall that the SEC considers some ICOs to be investment contracts). Although public company equity trading on national stock exchanges like the NYSE and NASDAQ may be familiar to most investors, a variety of regulatory exemptions allow issuers to sell securities without becoming public and subject to expensive public reporting obligations. These so-called “private placements” of securities use regulatory exemptions, depending on the issuance, that may limit the amount of money raised, the universe of potential buyers, and the marketing of those investments.
Despite these limitations, private placement equity “rounds” are a popular choice for start-ups. Fast-growing and capital-intensive companies often use private placements to raise growth capital while remaining private; about 270 “unicorn” companies worth more than $1 billion have chosen to remain private. Most tokenized securities, at least initially, will be private placements.
Private placements accounted for more than $2.4 trillion in debt and equity securities issued in the United States in 2017 alone. This number dwarfs even the frothiest time of the ICO market by orders of magnitude. Unlike ICOs, which provided value as an arbitrage against regulation, which typically failed to provide legally required disclosures to purchasers, and which generally offered a future right to a product or service rights to their purchasers, tokenized securities will comply with the law, and at least initially, fall into one of a few categories or types.
A clear understanding of those types and the rights provided to their buyers is critical to understand why tokenizing securities will improve their utility, features, and marketability.
A proposed taxonomy
“Security token offering,” or STO, was coined to distinguish a regulatorily compliant token offering from earlier ICOs which mostly ignored compliance. STO, however, fails to capture the nuanced differences among the types of securities to be sold as tokens.
To clarify the discussion, I propose the following terms to be used to describe the various types of tokenized securities that already exist, or that are expected to be developed:
1. Security-wrapped ICOs, a/k/a SICOs. These are “network assets” or “utility tokens” of the ICO generation that are offered pursuant to registration exemptions so that their offering complies with U.S. law. SICOs typically do not offer debt (an enforceable promise to repay) or equity (i.e. a proportional share of ownership, dividend right, participation in issuer governance) rights to their buyers, and often provide minimal investor protection, offer minimal issuer disclosures, and afford limited recourse against the issuer. These assets are natively digital unless offered as a secondary product to be distributed by the issuer pursuant to a simple agreement for future tokens (SAFT) or similar agreement.
2. Tokenized Equity or Debt, a/k/a TEDs. These are traditional securities (i.e. equity/debt) issued in digital token form. These products are identical to traditional private placements except that they are issued in token form, rather than in the form of a spreadsheet entry, or a piece of paper. These instruments will eventually incorporate new features and functionalities like direct-to-holder data reporting, and interactive governance.
3. Tokenized Asset-Backed Securities, a/k/a TABS. These are digital tokens that represent an ownership claim against, or ownership share in, an asset or pool of assets. This category includes products based on a claim against metals, gems, commodities, securities, real estate, art, unique goods, and other assets maintained by the issuer or issuer’s designee.
4. Transactional Security Instruments, a/k/a TSIs. These assets are securities, issued in token form, that may be redeemed or accepted by the issuer or the issuer’s designee in direct exchange for products or services. The process of redemption or acceptance of these instruments allows an issuer to directly retire debt or redeem equity in exchange for the performance of services or provision of goods for the investor. Although these products do not yet exist, and would require updates to certain securities laws to implement, they represent a new asset class which may be enabled by tokenization of securities.
STOs != ICOs
Leaving aside the types of tokenized securities expected, the market should understand other significant ways that tokenized securities vary from ICOs.
1. Most securities are not bearer instruments. Tokenizing a security will not make it into a bearer instrument. Issuers of securities are obligated to track ownership of, and in certain cases, replace lost or destroyed shares of securities; this obligation will continue for securities in token form.
2. Private placements are not freely traded. Transactions of securities require the participation of either (a) broker dealers, (b) alternative trading systems (ATS), or (c) national stock exchanges. The issuer of securities stands to potentially lose its exemption from registration and to be forced to become a public reporting company if its securities are traded in violation of these restrictions. Thus, tokenized securities will be created on either (a) private blockchains that are controlled by the issuer, or (b) public blockchains subject to restrictive code that allows an issuer to control and track transactions of these assets.
3. “ICO advisors” or “ICO consultants” should not participate in the structuring or offering (i.e. marketing for sale) of securities unless they have appropriate licenses. Generally, consultants who previously designed “token economies” or the “tokenomics” of ICOs will be replaced by Registered Representatives of broker-dealers who will perform “structuring” or the design of the security, and placement of those securities in compliance with relevant law. These Registered Representatives are licensed to perform these services by passing FINRA and or NASAA financial securities exams (i.e. “Series” exams). Issuers of tokenized securities may rely upon technical service providers and may obtain assistance for internal technical design but generally should structure, market, and place their securities through Registered Representatives of broker-dealers to avoid violating US law.
Although STOs are often hyped as the latest coming of ICOs on crypto social media, they are different products that must be handled differently.
Dictionary image via Shutterstock.