With the stagnation, if not an outright crash of the ICO market in 2018, the focus of hype in the blockchain space has partly switched to the supposed superior alternative, namely, security token offerings (STOs). In some ways, STO promoters have even outdone their predecessors, claiming at times that the tokenization of trillions of dollars of assets was just around the corner.
A good definition of security tokens was given by Gordon Bernstein from Distributed Labs quoted in Forbes:
A security, whether a blockchain-based token or not, is fundamentally an investment contract recognized by law, typically for either the preservation of capital or an expectation of return. For there to be a security contract, there must be an active counter party, such as a company issuing a stock.
The key implication of this definition is that security tokens are assets whose issuance and trading are subject to the existing regulatory requirements, regardless of the unique features they may have because of their technological underpinnings.
Recently, there has been some pushback to the STOs as the future of crypto-driven finance narrative, as skeptics have started pointing at the slow progress with STOs and the major hurdles they face. The most detailed analysis was published yesterday by Techcrunch based on the research provided by Canary Data. The picture this analysis paints is bleak:
Our database of security token offerings currently has 84 STO hopefuls announcing sales of tokenized securities over a period beginning in March 2017 and continuing through Jan. 15, 2019. Of those, 14 reported raising any funds at all. Only two of the 14 reached a stated fundraising goal. In total, these projects targeted $3.44 billion in fundraise goals. So far, $220.69 million has been raised, a drop in the bucket of private placements. Of that total, $134 million flowed to one project, tZERO, a regulated secondary market for crypto assets. Into this tiny pool of issuers and investors, more than 75 service providers, including tZERO, are competing to offer technology and advisory offerings.
To this it may be added that even the tZERO’s token is not exactly performing well among traders on its issuer’s own much-hyped platform. Its price has fallen off a cliff compared to the one set during the offering and the trading volumes are unimpressive. The CEO of tZERO’s parent company Overstock Patrick Byrne claimed, however, that this situation would turn around when the trading platform is opened to retail investors.
Commentators highlight several major obstacles STOs face. Perhaps, the most fundamental one is that, according to Andy Bromberg from CoinList quoted by Techcrunch, security tokens, by trying to combine the features of both the traditional financial world and the novel crypto space, turn off both crypto and traditional investors.
So far, STOs are also not succeeding at their stated goal at democratizing the access to capital markets. According to Techcrunch, the distribution of token holdings in the three largest STOs to date (tZERO, Aspencoin and The Art Token) is heavily skewed towards a small number of top addresses. The key reason for this, according to Howard Marks from StartEngine quoted by Techcrunch, is that STOs, in order to avoid the high costs associated with public offerings of securities, opt for the private placement channel.
Other issues mentioned by industry participants include the lack of regulatory clarity, in particular, about the custody of crypto assets and how security tokens can be issued at scale, and the absence of mature infrastructure.
Overall, many skeptics agree that it may take several years before security tokens have a chance to become a serious asset category, however, do security tokens hold a fundamental promise, even if the excitement around them has arrived too early?
There are two potential factors that may prove to be security tokens’ saving grace. First, while it may prove a difficult and lengthy process to move a significant part traditional securities (like shares and bonds) to the blockchain, security tokens may (and already do) allow the creation of financial assets that never existed before, that may open new frontiers for finance. Moreover, those use cases cannot be covered by utility tokens because they are still, at bottom, investment contracts, and the regulators are not going to just close their eyes to that fact.
One of the major examples of this are security tokens that can offer investors a share in revenue or profit not with regard to the company as a whole but a particular project or product. This is what U. S. pharmaceutical company Agenus Inc. is already attempting to do.
Agenus’s project involves issuing a security token called BEST, backed by future sales of an experimental cancer drug.
The potential fundamental advantage of security tokens of such type is that they can allow investors to focus on the prospects of particular projects instead of the whole range of activities a company may be involved in. The potential critique well expressed by prominent economist blogger Alex Tabarrock is that this seemingly goes against the idea of risk diversification that is essential in finance. However, it may be retorted that the diversification objective may be achieved even by combining several single project (product)-based tokens.
Finally, even with regard to traditional securities, tokenization may ultimately allow alleviating the fundamental inefficiencies that plague the existing system of handling them. Private securities are currently recorded on company ledgers and transfers involve the delivery of paper certificates to buyers.
For the publicly-traded securities, the red tape bloat is even more spectacular, as an insightful article by Lexcuity PC’s attorneys Michael B. Saryan and Charles S. Kaufman in Crowdfundinsider makes evident:
For publicly traded securities, ownership and transfer records are comprised of a myriad of ledgers among various institutions. First, an SEC-registered transfer agent must maintain the issuer’s stock ledger. On that stock ledger, the entire public float of substantially every publicly traded security in the United States is legally owned by Cede and Company (“Cede and Co.”), a special financial institution that processes transfers of securities on behalf of Depository Trust Company.
Cede and Co. has its own ledgers, which keep track of which DTC-member firms such as clearing brokers, investment advisers, banks, trust companies, and other custodians beneficially own how many shares of a particular security. Each custodian has its own ledgers, which keep track of which investors beneficially own how many shares of a security held by that custodian. Only a few major first-level custodians are listed in Cede and Co.’s ledgers, so there may be multiple institutions and layers of ledgers showing beneficial ownership of any particular security ultimately owned by an investor.
Sarayan and Kaufman’s assessment is scathing, “The current system lacks transparency, is inefficient, and is prone to human and computer error. It involves delay – transfers are typically confirmed two days after being made. A blockchain presents a simple solution for recording ownership and transfer of securities that avoids the myriad of complexities present in the current system.”
All in all, security tokens currently seem to be in much the same position as the blockchain space as a whole, which is, in a way, ironic, given the desire of many players in the security token space to disassociate themselves from the wider crypto world. The technology clearly holds a lot of promise, especially with regard to the opportunities of creating things that are unprecedented. However, there has been a bit too much hype around it than the achievements can justify, and a slew of obstacles of various kinds still need to be overcome.