The general hype circa 2018 proclaimed security tokens as crypto’s killer app. After Bitcoin fell from its $20,000 peak in December 2017, some of the more revolutionary promises of cryptocurrencies had lost their luster — especially after the subsequent collapse of the altcoin market and the mayhem of initial coin offerings.
Security token offerings, or STOs, on the other hand, were billed as a more manageable, if still extreme, way of upgrading the dusty old financial systems that back equity trading. A revolution from within finance.
Two years later, and that revolution in stocks and bonds has yet to happen properly. This is the story of why, as well as a map of where security tokens are and where they seem to be headed.
The distinction between security tokens and cryptocurrencies
Classic cryptocurrencies are decentralized tokens of value that, per their name, resemble dollars more than stocks. Though many crypto assets ended up running afoul of securities regulators who disputed their classification, cryptos like Bitcoin and Ether are widely regarded as not being securities. In the United States, for example, they are regulated as commodities — not the same as currencies, but a status that features no single firm or entity to hold to account.
Security tokens are different. They explicitly claim to be investments in the company that issues them. Consequently, they entail reporting requirements more stringent than those other crypto assets and largely identical to stocks.
The advantage of STOs over traditional securities is that they technologically operate like crypto assets. Trading doesn’t close when night falls across New York or Hong Kong. They also transact quicker and could hypothetically provide liquidity on a global scale. Why would any firm choose to limit its initial public offering’s reach to a specific exchange serving a single jurisdiction when the investor pool could go worldwide?
Where the government steps in
Unfortunately for those looking to issue them, the main advantages of security tokens are the same reasons regulators are wary of them. The U.S. hosts by far the largest equities market in the world; so, the U.S. Securities and Exchange Commission plays an outsized role in governing global securities trading.
Similarly, the SEC’s demands, by default, establish global norms for STOs. As with the question of which cryptocurrencies qualify as securities, a lot of the industry is waiting on the SEC to make its expectations clearer. That applies not just in the realm of disclosures and registration forms. Even when a new token registers and appears to comply fully with existing rules, it is still impossible to trade it at scale.
It’s not fair to accuse the SEC of stonewalling advancement, given the number of tokens that are actively registered with the commission. There remain, however, major hold-ups to mass embrace of STOs, including regulatory uncertainty and resistance among more traditional equities markets. Unfortunately, those markets are where tokenizing securities would make the most impact, but those big markets are also waiting on regulators, who are, in turn, monitoring existing smaller markets for warning signs.
CEO of BRD Wallet and SBI Mining Adam Traidman put the stalled situation down to the SEC’s slow education on blockchain technology broadly, saying of STOs:
“It’s such a no-brainer. And the only thing that’s really holding it back is the regulatory stuff. And it’s not like the SEC is saying no. It’s just that they don’t get it yet. They just don’t understand.”
Though they allow certain security tokens to exist, regulators have been reluctant to open up venues for actually trading those tokens, especially venues accessible to regular Main Street investors. The exchanges working on security tokens are heavily focused on private offerings to institutional investors, or tokens initially offered under exemptions to full-blown securities registration, especially Reg. A.
“A hurdle for adoption is updating the many mechanics of an exchange or other trading platform to accommodate these assets,” said Karen Ubell, who recently joined Goodwin Procter as a partner in its blockchain and digital currency practice. “Disclosure is not a hurdle that can’t be overcome. I think the question is how will digital securities trade.”
Ben Marzouk, a lawyer who specializes in digital asset capital raises at Eversheds Sutherland, agreed: “In terms of objections, I think the SEC’s main concerns are valuation, liquidity, and custody of the digital or ‘tokenized’ assets on the exchange.”
The current scene: Industry side
Many security tokens — even publicly available ones — exist in compliance with the SEC. There is a thriving trade in private offerings that depend on blockchain technology to automate concerns like the number of token holders allowed at a single time or checking sanctions lists. Firms like Blockstack and Props have even used SEC exemptions to offer their security tokens to the U.S. public within the past year.
Platforms tZero and Openfinance, which have been offering security token trading to U.S. investors for years. Openfinance, however, has had a dramatic and perplexing 2020, threatening to pull its STOs from the platform if stakeholders and issuers didn’t pay more in May. The firm subsequently saw some shifts in executive leadership, leaving many observers puzzled as to the exchange’s future.
A passion project of publicly traded firm Overstock.com, tZero is less at risk of collapse. However, the platform only offers two security tokens for public trading, one of which, OSTKO, is a digital dividend in parent company Overstock and has become the dominant such token on the market. This is both because Overstock is a big company within the traditional stock market and because distributing security tokens as a dividend for traditional stocks is an ingenious mechanism — reminiscent of an airdrop — to avoid red tape.
With trading launching at the beginning of July, Arca’s ARCoin (AR) managed to appease the SEC after two years of negotiations and seems poised to open up a wider range of similar tokens.
Absent, however, are the colossal markets making security tokens available to the public at scale à la Nasdaq or even Coinbase. Despite the best efforts of the industry, there is no secondary market with the scale and liquidity to allow security token trading in such a way that shows it off as a technological marvel.
The current scene: Regulation side
Take the example of Coinbase. The crypto exchange initially acquired an alternative trading system license in 2018 by purchasing Keystone Capital Corp, which was already registered. Presumably, due to miscommunication with regulators, the firm fumbled a series of public statements two years ago as to exactly what the SEC had approved when Coinbase made that acquisition. To date, they offer no security tokens for public trading.
The process for getting an ATS license has changed in recent years, especially in terms of the SEC’s relationship to STOs. The SEC has largely paused ATS applications — different from an outright ban, but part of the broader hesitance among regulators, especially in the United States.
Platforms like tZero and Openfinance — the largest that cater to retail clients — are, relatively, legacy entities. Their ATSs predate heightened SEC scrutiny in 2018. So, to some degree, they have been grandfathered in. The central document on the SEC’s stance dates to November of that year. To offer security tokens, potential exchanges need to register with the SEC first as a broker-dealer and then under Regulation ATS.
These platforms live and die before regulators on the basis of embracing old-school regulation, often needing to distance themselves from the chaotic reputation of crypto. Alan Konevsky, the chief legal officer of tZero, emphasized that distinction as a preface to a conversation with Cryptox:
“Let’s not conflate crypto and digital assets with securities. […] We’ve always been focused on being very clear that what we deal with are securities in full compliance with federal securities laws.”
The list of registered ATSs has been growing, but slowly. North Capital just got approval in April but mentioned no plans of public offerings.
Given limited venues for trading, STOs available now are stuck in their own portals, siloed off from broader markets. Part of Arca’s notable success is that it got the SEC on board with peer-to-peer trading. That’s a big deal, but it’s still a far cry from a Nasdaq. The scale of available trading portals is a chokepoint.
Abrupt shifts in regulation leads to a shell-shocked industry
Here is where regulatory scrutiny and mainstream hesitation feed into each other in a vicious cycle. Bigger established firms shy away from STOs because the regulators haven’t provided a clear roadmap, and these big parties have more to lose by throwing resources into a dead end.
Those bigger parties also staff platoons of lawyers with access to regulators, and their names invoke more public attention. If Apple were to initiate an STO, that’s an automatic and unignorable headline providing public pressure on regulators, not to mention a legal team with the resources to fight a long battle. See, for example, how much Facebook’s announcement of Libra over a year ago forced global figures to debate stablecoins in a new way.
Funnily enough, part of the appeal of tokenizing securities is that it simplifies traditional compliance measures, especially for privatized offerings. Currently, different requirements in different countries for firms looking to keep their offerings private are tracked through more traditional ledgers. That means that firms periodically have to go public because they lost track of things like the number of shareholders in traditional markets.
Securitize is a licensed transfer agent that digitizes securities for private markets — including compliance practices that CEO and founder Carlos Domingo said blockchain technology helps expedite:
“Digital securities are just a way of digitizing everything around a security. Tracking ownership, restrictions on trading — It just so happens that blockchain lends itself particularly well to this type of digitization because it is already a global distributed ledger that’s public, that everybody can see, that is immutable, that has a very simple way to represent ownership of tokens. These tokens are also trading through smart contracts that happen to set rules that you can enforce. So, it just happens to be a very nice technology for solving this problem.”
However, the confusion among dedicated industry players obviously spooks potentially interested parties used to working with classic securities, even though many see the benefits.
Where is progress coming from in the U.S.?
Many companies are currently chipping away at the complications involved in expanding the trading of security tokens in the United States. Muneeb Ali, the CEO of Blockstack, told Cryptox that, having completed its Reg. A+ offering in the U.S., the firm is now working on expanding trading within the country. Its STX tokens are, however, already available to international purchasers on crypto exchanges.
Arca clearly took a different approach with its token, prioritizing U.S. trading over a fundraise. And, having started on the basis of assets backed by the U.S. Treasury, they are looking to create more of such tokens. According to Jerald David, the president of Arca Capital Management: “The Arca U.S. Treasury Fund is the first of a suite of products that Arca Labs seeks to develop.”
Attorney Susan Gault-Brown of Morrison & Foerster, the firm that worked to get Arca’s token into compliance, noted the importance of these first steps. “Whenever something is an issue of first impression with a regulatory agency, I think it tends to get more scrutiny,” Gault-Brown told Cryptox, continuing:
“Once you have one product that’s gone through registration, and you’re going to use the same framework — and I don’t think it’s necessarily just Arca. If you had another fund that’s looking to use the same framework, they’re going to have an easier time.”
Precedent plays an important role in all elements of U.S. law, like all systems derived from British Common Law. With the SEC recently adopting rules to expedite approval of new investment company proposals based on similarity to earlier proposals, it’s clear that they are working to remedy their own backed-up system. Gault-Brown agreed:
“I don’t think anyone, probably even the agency, thinks they’ve been keeping up, just because typically technology will move quicker than a regulatory agency.”
Consequently, the new proposal alongside the growing number of new tokens available could result in a virtuous cycle: As more proposals are approved, there are more precedents to call upon to approve more new proposals.
In terms of markets, while trading on, say, the Nasdaq, it is unlikely to incorporate security tokens anytime soon; however, major exchanges are certainly looking at the technology. Most ahead of the game among American players seems to be the Boston Options Exchange, or BOX, whose affiliate BOX Digital partnered with tZero back in 2018 to onboard STOs.
BOX was certainly aware that it was getting into a long legal back-and-forth with the SEC. In keeping with the general tone of the status of STOs in the country, the SEC is not overtly rejecting BOX Digital’s proposals for public trading. The commission has, however, kicked the can down the road repeatedly on any final determinations, most recently delaying decisions on two proposed rule changes on July 16.
…what about internationally?
While a lot of forward progress is happening within the U.S., many players have been focusing on building out trading outside of the country despite its coveted capital markets, precisely to avoid its highly vigilant regulators — at least for now.
In December, Tokyo-based SBI Group announced investments into new STO-focused branches of 160-year-old German exchange Börse Stuttgart. In conversation with Cryptox, executives at SBI Digital Asset Holdings alluded to further plans to launch STO platforms in Singapore and throughout Asian markets.
Fernando Luis Vázquez Cao, the CEO of SBI Digital Asset Holdings, told Cryptox that the nature of STOs is that you need to have revolutionary technology combined with a willingness to be “boring” and engage with regulators in the way that established institutions do. Alluding to a conversation with the CEO of Börse Stuttgart on the subject of getting the platform off the ground, Vázquez Cao explained:
“It should be the incumbents disrupting themselves. Because only the boring entities like us, only the boring institutions like us, understand compliance, understand what it takes to do proper KYC checks, AML checks, risk management. That said, you have to have someone running such a boring entity that also knows technology.”
It is, in this case, interesting that SBI is more willing to deal with Germany’s Federal Financial Supervisory Authority, or BaFin, than the SEC. As a jurisdiction, Germany’s financial laws are by no means lax, and BaFin’s vigilance is famous. Vázquez Cao agreed but saw BaFin as highly interested in technological updates to existing systems, partially based on competition with neighboring Switzerland.
Looking forward
While alluding to timelines, Vásquez Cao said up to several decades but saw blockchain-based technological upgrades as essential to putting together global securities markets:
“It will reduce all this friction because people keep talking about global markets, but there’s no such thing. You have all these different silos. Nothing can be shared even in the European Union.”
Konevsky of tZero explained that in some form or other, there is no doubt that the current system of transferring securities needs to change:
“I think it is inevitable that there is going to be an evolution in the industry. If you had to design a system for moving securities or fiat currency or other things of value globally using the technology you have now, you would not build the system that we have now.”
Nicholas Losurdo, a partner at Goodwin, who recently returned to the firm after having served as counsel to SEC Commissioner Roisman, noted the shift in tone on STOs since the hype of 2018 but interpreted that shift as a good sign for long-term progress:
“I think the hype is long gone, but in a good sense. I don’t think anything has fizzled out. […] The players that are still in the space are legit, focused and committed to implementing the technology that holds so much promise. So, I don’t think they’re operating based on hype anymore.”
Traidman was even more confident on the future of STOs:
“In 20 years, there won’t be anybody going public on Nasdaq anymore — Well, they might be going public on the Nasdaq, but they’ll be doing it through security tokens.”
Tech moves quickly. Accustomed to this pace, many tech innovators are frustrated with the perceived regulatory holdup on STOs. But in the grand scheme of things, it’s a brand new concept poised to fundamentally change how investments happen, how people hold their money. The laws need to adapt, but it’s reasonable for regulators to be cautious about what they allow. Moreover, it’s reasonable for them to want to see how smaller experiments with tokenized experiments play out.
What we’re seeing currently isn’t an abrupt revolution, but it is progress. The initial players involved in tokenizing securities are in some way tasked with setting the stage for grander projects. The development of new platforms and markets; the establishment of more coherent regulatory expectations; and the growth in the number of major securities issuers willing to put out their stock in the form of tokens — these are all processes that make up a unified ecosystem. Each is dependent on the other two.
