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A Brief History of Security Tokens And Why This Time It’s for Real
Republic | Janine Yorio | Dec 14, 2021
A multi trillion dollar universe of illiquid, privately held assets stands ready to be securitized on the blockchain. Millions in venture capital is riding on the premise. So why haven’t security tokens caught on yet?
The difference between Utility & Security Tokens
Utility tokens are like chips in a casino. They can be used as currency within the casino for playing games, tipping dealers and sometimes buying drinks or hotel rooms. Holders of a casino’s chips do not own a stake in the casino, nor does it entitle the holder to any of the house’s winnings or profits. Security tokens, on the other hand, are like owning stock in the casino, shares in the company itself. When the house wins, you win. Security token holders own something that might pay off through profits or distributions. Utility tokens are used in an ecosystem. Security tokens give you ownership in that ecosystem.
In 2018, when many notable utility tokens nosedived in value, the crypto community rallied around security tokens and declared that their simplicity would be the salvation of the crypto economy. Some were even saying that security tokens would become crypto’s “killer app.” Venture capital poured into security token projects, lured by the prospect of bringing liquidity to private markets, especially real estate, which is the world’s largest asset class--and one where brilliant minds have struggled to bring true liquidity for decades.
See: More regulation coming: SEC Chairman signals stablecoins and other tokens could fall under its rules on security-based swaps
That year, Founders Fund and Andreesen Horowitz led an unusually large ($28MM!) seed round into Harbor, a crypto startup promising to put ownership of real-world assets on the blockchain. The company’s founder declared that Harbor would do to the real estate market what email did to snail mail. Three years later, the real estate market has escaped any noticeable change. Harbor’s slow attempt to mainstream security tokens is indicative of what has happened across the entire security token industry: big promises, disappointing results. It’s easy to see why people might (wrongfully) conclude that security tokens are a bust.
Why have security tokens been so slow to catch on?
In order for security tokens to achieve their full potential, they must fulfill their promise of liquidity. Liquidity requires two things: a regulated exchange and sufficient trading volume. So far, neither of these requirements has materialized.
Most attempted security token exchanges have floundered. In 2018, well-funded companies like Templum, tZero, Coinbase, Openfinance and Sharespost announced that they would list security tokens on their exchanges. Sharespost was particularly well positioned to do so because they were an existing broker dealer with ATS registration. Three years later, the only exchange which has succeeded even modestly is tZero. However, even tZero, a passion project of publicly-traded firm Overstock.com, only offers two security tokens for public trading, one of which is an affiliate of its parent company. Openfinance, although still in existence, offers securities with a combined market cap of only around $50 million–a mere drop in the bucket.
See: WEF Insight Report: Digital Assets, Distributed Ledger Technology, and the Future of Capital Markets
At the moment, no dominant platform for trading security tokens exists. Furthermore, the complex compliance issues have largely discouraged new entrants. But there is hope. Since security tokens are programmable, compliance can be baked right into the token which should reduce compliance hassles. Compliant protocols like Polymath and Harbor have figured out how to collaborate with exchanges to address these issues.
Trading volume has also been thin, but the expectation that digital securities would trade with the volume and frequency of public equities or cryptocurrencies was flawed from the start. Digital securities represent private investments, an asset class that has always traded infrequently. Adding blockchain does not necessarily incentivize owners to trade them any more frequently.
Exchanges don’t exist and trading volume is thin. Where is the silver lining in all of this?
Security tokens are subject to greater regulatory scrutiny than utility tokens (like Bitcoin or Ethereum) from the US Securities & Exchange Commission (the “SEC”). Security tokens require full SEC approval to be sold in public offerings to non-accredited investors or traded on secondary exchanges. This is one of the many reasons their growth and adoption has been more modest.
The SEC (once considered an insurmountable obstacle to compliant token offerings) is finally starting to qualify offerings. Nothing pours fuel on a financial product’s fire quite like transparency and regulatory clarity, and it’s happening now.
See: IMF asks Financial Stability Board to develop a global framework for standards for regulation of crypto assets
In July 2019, the SEC qualified the first Regulation A token offering (a $23MM offering for Blockstack) setting precedent for the sale of tokens that are immediately tradable to both accredited and non-accredited investors. They also provided clarity around secondary sales.
In July 2020, Arca Labs began trading its digital security token, the ArCoin, which is registered with the SEC and represents shares in Arca’s U.S. Treasury Fund.
In September 2020, the SEC finally registered an $85 million security token offering from INX, a foreign crypto trading company. This became the first ever security token IPO qualified by the SEC, marking a major milestone.
In April 2021, the SEC qualified a Reg A+ token offering for Exodus, marking the first digital asset security which conferred equity in a US-based issuing company. Exodus subsequently raised $75 million from 6,800 individual investors.
Security tokens aren’t strictly a US phenomenon. In May 2021, a Singapore-based bank issued its first security token offering, a $11.3MM digital bond that pays a 0.6% annual coupon.
These movements may appear relatively small, but they mark an important transition for the crypto industry, as it evolves from the Wild West of the dark web to navigating the daunting obstacle course of regulatory scrutiny. All of these changes pave the way for massive mainstream adoption.
See: Your Complete Guide to Security Token Exchanges
Given all of these positive developments, I have become very bullish on security tokens, but let me be very clear: my enthusiasm has absolutely nothing to do with fractionalization or liquidity. Both of those things are already widely available in the stock market. Tokenization adds very little on either of these fronts.
Instead, let’s be brutally honest about what people love about crypto. (Hint: it’s not their stability or their SEC compliance.) Crypto’s popularity is entirely attributable to its insane volatility--so volatile that 20%+ intraday swings are not atypical. Previous attempts to tokenize stable, income-generating assets have failed to acknowledge this fundamental truth. If the carrot of fractionalization alone were seductive enough to encourage people to invest, then REITs would be as popular as Shiba Inu coin. But they’re not.
The problem with early security tokens like Aspen Coin or the RealT coins is that they seem like they make sense but they offer absolutely zero potential for the kinds of meteoric returns that Dogecoin fans love. Security token advocates point to the stability of underlying assets as an important attribute and one that should breed a strong affinity. But stability contradicts the very ethos of crypto. If security tokens are ever going to induce full-fledged crypto mania, it will be because their issuers finally embrace their volatility rather than try to avoid it.
The perfect security token is one that is secured by real assets--but where the underlying assets themselves offer the potential payout for a moonshot return.
I believe that security token alchemy will occur when an insightful issuer finally creates a SEC-qualified digital security token that has potential moonshot returns. Why?
See: The era of security tokens has begun
Combining the legitimacy of SEC qualification with the rocket fuel of crypto-style returns would be like the gateway drug for all the crypto-curious conservative investors who have dabbled in Bitcoin but are too timid to invest in the types of highly speculative utility tokens which might turn out to be completely worthless. A truly compliant crypto asset backed by actual, quantifiable and verifiable assets with the potential for exceedingly high returns would break the internet--and maybe Coinbase, too.
For investors attracted to the high returns but deterred by an investment backed by nothing more than a white paper and a promise of future utility, the allure of such a security token would be irresistible.
Authored by: Janine Yorio, Managing Director, Republic.co
Republic Realm is a metaverse innovation and investment platform and among the largest owners of digital real estate NFTs in Decentraland, Sandbox and Axie Infinity and among the most active developers of in-metaverse content in Sandbox and Decentraland. Republic Realm is the creator of the Fantasy Islands master-planned community NFT project. Republic Realm is backed by strategic financial and crypto investors and Galaxy Interactive. Republic Realm is based in New York City, and is an affiliate of Republic.co, the alternative investment platform. For more information, visit www.republicrealm.com.
This article is featured in NCFA's digital magazine, Fintech Confidential (Issue 4 Oct 2021). Click to read the latest thought leadership, insights and trends about Fintech in Canada:
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