Security Tokens Mean Public Marks for Issuers and That’s OK

Security tokens will enhance the liquidity of private security offerings, provided there is sufficient on-going information about those companies available to investors, but this liquidity will also have another effect: real-time mark to market. In today’s private securities markets, mark to market is generally done on a quarterly basis as funds analyze their holdings and adjust book value based on things like new financings and comparable company valuations. In most cases, unless these funds are entities that disclose holdings to the public like mutual funds, for example, the private marks stay private. They are only shared with the LPs of the funds, not the public. When security tokens are freely traded on exchanges, as is the necessary intent of most offerings to achieve the benefits of liquidity, these marks will be publicly available as a reflection of supply and demand for the token on security token exchanges.

Without a real-time price that reflects all reasonably known information about a company, as well as human emotion that always impacts the valuation of securities, there cannot be a liquid market for tokens of that company. Even with limitations on what kinds of investors can participate on security token exchanges, there will still be public marks for them to assess. Therefore, any company that seeks to do a security token offering must be comfortable that their token will be marked to market real time when things are both good and bad. These companies won’t have the luxury of private marks when they stumble. This is perhaps one of the few downsides of enhanced liquidity.

Consider Spin, a bike/scooter company that is looking to raise $125 million via a security token offering. The company is competing in one of the hottest venture spaces ever, so demand is high. Prices for scooter companies are aggressive relative to the progress of the industry in total (see Bird). Whether you have doubts about the scooter industry or not, it’s reasonable to wonder if the market demand for the theme will be as strong a year from now as it is today. If it isn’t, and the degree to which these companies can build rapidly scaling businesses will go hand-in-hand with that assessment, investors may look at valuations differently than they do today. Spin’s mark will be public and Bird’s will not, although Spin will be a barometer for the industry in total.

This isn’t to discourage companies from considering security token offerings, but rather to encourage them to go into offerings knowing the realities. Many things in life tend to be a relative tradeoff between freedom and safety, and STOs are no different. Companies must be willing to give up the safety of private marks to enjoy the freedom of a robust, liquid market for their shares and all the benefits that come with that.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio. Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.

Information Asymmetry in Security Tokens

Security tokens provide many benefits to underlying assets, the most important of which is liquidity. However, liquidity doesn’t just happen because you build the technology to tokenize assets and the exchanges to trade them. There are other important parts to the overall marketplace like market making and institutional custody. Another under-appreciated area we expect to impact liquidity is information dissemination.

In the case of traditional equity offerings, public companies are required to disclose information in a fair way to all investors. While there is still certainly some information asymmetry among today’s equity market participants, fair disclosure rules minimize the disparity. Efficient distribution of company information provides the benefit of greater liquidity given reduced concern from investors that the person on the other side of the trade knows more than them. Buyers are less afraid to buy and sellers less afraid to sell. As we consider the potential for security tokens to compliment, and ultimately replace, the traditional equity markets, there will likely be greater information asymmetry issues given current SEC filing requirements.

Required and Elective Disclosure. If you recall our chart about the various SEC registration options available for security tokens from our first note on the subject, there are different requirements for information disclosure depending on which registration option a company uses. Many security token issuances today would fit in one of the Reg D categories, although we’ve heard of ones using Reg A+ or even full registration. While the latter two categories have either highly accepted information distribution requirements (full registration) or adequate ones (Reg A+), Reg D offerings require no formal information distribution. This will cause a liquidity problem where it will be difficult for new investors to make decisions about whether they should buy a security token after issuance and just as difficult for owners to make determinations on when to sell their tokens. Relative lack of information may also negatively impact market making, the opportunity we highlighted earlier, as market makers will likely require a greater spread for the increased information risk.

As the security token space evolves, so too will information dissemination practices. Companies that issue security tokens, in the interest of assisting liquidity in their tokens, should consider voluntary disclosure of as much information as reasonably possible. Reg D exempted companies should provide at least Reg A+ Tier 2 levels of disclosure (bi-annual financial reports, annual audit, significant changes to business). This level of disclosure seems to be a minimum level of good hygiene for any company that wants to create a robust market for their security token offering. Further, if a company commits to voluntary disclosure and misses a report, the market would view this as a negative signaling event and cause a drop in the token price. Thus, commitment to disclosure should be considered an ongoing one.

Using Information Asymmetry. Even with solid elective disclosure policies, there will still likely be some incremental information asymmetry as compared to what we see in security markets today. Relatively more inefficiency in the market will offer more opportunities to take advantage of price discrepancies. There seem to be two core opportunities for monetizing this information asymmetry: leverage the asymmetry to invest or leverage the asymmetry to become an information broker, akin to a sell-side analyst on Wall Street. The former opportunity will likely give way to security token focused hedge funds, perhaps derivatives of the crypto hedge funds that evolved with the emergence of Bitcoin, Ether, etc. The latter may give way to a more important role for independent security token analysts who sell analysis rather than trade on it. Given our firm’s background as former sell-side analysts, we can see how channel checks and other proprietary fundamental analysis could greatly influence how efficiently security tokens are priced.

To the last point, analyst coverage may be a value-add worth offering for security token issuance platforms; an ongoing service to enhance liquidity. Just as on Wall Street, there will be conflicts to manage (i.e. the separation and independence of the banking/analyst functions), but it seems likely that the analyst function may play an even more important role, at least early on, in the security token market than it does in existing equity markets.

Information Asymmetry Terrorism. Aside from the benefit of greater liquidity, security token issuers have another incentive to selectively disclose and work with analysts: better control of token prices. Without effective information distribution management, rogue investors are likely to spread misinformation, either positive or negative, to correspond with the direction of their trades. Just as famous crypto inventors and investors adorn Twitter bios to note that they aren’t giving away crypto, i.e. “Vitalik ‘Not giving away ETH’ Buterin”, companies may be able to avoid Twitter mania and panic by setting information disclosure expectations up front.

Bottom Line. Companies shouldn’t think of security tokens as a way to avoid reporting requirements, but as a way to enhance the liquidity of equity in their company. Regular and effective dissemination of company information is a necessity to achieve that goal. The commitment in time and money to establish effective information distribution methods may defeat some of the advantages of avoiding a fully SEC registered security via a tokenized offering, but the benefits to liquidity will be worth the price.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio. Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.

By the Numbers: Who’s Investing in Blockchain?

As part of our work on security tokens, we did an analysis to see how major companies are investing in the general blockchain space. The analysis consisted of a search on LinkedIn for how many individuals had listed “Blockchain” or “Cryptocurrency” in either their job title or description of work, whether in their current job or a previous job, across the top 247 S&P 500 companies. While these numbers may not be perfect representations of efforts that companies are making in these fields, as not all employees are on LinkedIn and some projects may be in stealth mode, the data paints a directional picture of efforts being made.

The results tell us that blockchain is still viewed as a technology in its early days at the world’s largest companies. In the 247 companies that we looked at, we found 928 employees related to “blockchain” and 36 employees related to “cryptocurrency.”

Leading the charge by a wide margin is IBM, with 694 blockchain-related employees. While this number seems high compared to other companies, IBM has over 500,000 employees on LinkedIn. In other words, just over 0.1% of IBM’s employees are focused on blockchain technology. Additionally, IBM has arguably made the biggest push to sell blockchain products of any company and some of the employees in the study may be related to sales and operations, not purely engineers.

Another very high-level takeaway is that it appears Amazon is exploring cryptocurrency, perhaps more than most of its peers. This too makes sense given the importance of payment mechanisms to Amazon’s business.

Here are the results of the top 10 companies:

While the raw numbers of blockchain employees at major companies are lower than we would have expected, it’s clear that the world’s biggest companies are at least exploring the technology. We expect that exploration to grow over the next several years.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio. Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.

Security Tokens: An Emerging Opportunity in Crypto

This is the first in a multi-part series analyzing the potential of security tokens in the world of crypto assets. 

2017 was the year of crypto. Bitcoin became a household phenomenon and increased ~13x in value, Ethereum spurred interest in decentralized applications (dapps), and ICOs became the newest speculative rage.

By contrast, 2018 is shaping up to be a year of maturation for crypto. The SEC has made it clear that they intend to oversee the industry. While some may dislike regulation, it does bring with it a sort of legitimacy and it should deter bad actors. In 2018, we expect to see the emergence of the security token.

The intent of this series is to explore the security token market and better understand the use cases and opportunities. In part 1, we’ll outline the basics of utility tokens, security tokens, and what makes something a security. Future parts will dive into specific analyses of opportunities.

From the highest level, it’s useful to delineate coins from tokens, which both fall under the higher-order bucket of cryptocurrency. Generally, coins operate on an independent blockchain with their own set of rules. It may be a native blockchain like Bitcoin and Ethereum or a fork of another blockchain like Litecoin (of Bitcoin). Coins are typically useful as mediums of exchange and/or a store of value. By contrast, tokens are typically built on top of an existing platform, like Ethereum, and add their own rules and functionality to an existing platform.

Tokens can be further broken down into two categories: utility tokens and security tokens.

  • Utility tokens give holders access to a specific protocol or network, oftentimes enabling them to use an associated product or service. With utility tokens, no ownership rights to the underlying company behind the associated product or service are granted to token holders.
  • Security tokens grant holders ownership rights to an underlying asset. In essence, they are asset investments governed by the protocol set forth by the associated blockchain.

Utility tokens are the most common type of token in existence today. Two examples of utility tokens are:

  • Filecoin – a decentralized file storage platform. Users can pay participants in the network to store files on participating computers’ unused hard drive space. Filecoin is similar to Google Drive or Dropbox, but with no centralized storage location.
  • Golem – a decentralized computing platform. Users can pay participants in the network for unused processing power from participating computers. Golem is a decentralized Amazon cloud compute platform.

The important takeaway is that utility tokens grant the right to participate in a network, not ownership of the network.

What makes something a security? The SEC determines whether something is a security under the Securities Act of 1933. The Supreme Court case of SEC v. W. J. Howey Co is often referenced here, which resulted in a structured test whether or not an offering qualifies as an “investment” and requires registration.

An important clarification needs to be made about the use of the word “security.” As an industry, the crypto world has adopted the term security token to represent ownership in an underlying asset as described above, but the SEC uses the word security to define a broad set of investment instruments, which they regulate. This could mean that utility tokens are also recognized as securities according to the Howey Test.

The Howey Test. If a token (or another instrument) meets all of the following criteria, the SEC considers it an “investment.”

  1. The user is investing money.
  2. The user expects to profit from the investment.
  3. The investment is in a “common enterprise.”
  4. Any profit comes from the efforts of a third-party or promoter.

The first part of the test is fairly easy and most tokens pass. Users are always investing money. This part of the test has been expanded to include the investment of other “assets” in subsequent court cases. Some cases have defined money as “any form of consideration with value.”

The second part, whether or not users expect a profit, is often the case in token raises today. Many of the networks and protocols that are offering utility tokens through ICOs aren’t live at the time of the ICO, so the argument that a holder simply wants access to a particular network (and doesn’t expect to profit) is a difficult one. If there were no expectation of a profit on the side of the ICO utility token buyer, it would make more sense to wait until the project is live before purchasing tokens. Where there is risk, there is reward. We’ve seen some tokens ask for “donations” in order to see a project launched. These tokens offer “consideration of allocation” when a project is live. This seems like a semantic workaround that the SEC probably won’t accept, but companies are likely to continue to try.

The third part of the test talks about whether or not the investment is in a “common enterprise.” Different courts have had different definitions of common enterprises. Some federal courts refer to a horizontal commonality and count the pooling of assets for investment in a common enterprise. Other federal courts refer to the vertical commonality and count the efforts of a third-party or promoter. With two broad definitions, it seems likely that most tokens will be considered a common enterprise.

The fourth part addresses whether or not the profit comes from the efforts of a third-party or promoter. This test is often passed by tokens, as there are always individuals working on the project or network. The profit would derive from their efforts in building a better network.

Applying the Howey test, it’s clear that security tokens will be “investments” and require registration with or exemption from the SEC. This likely isn’t a major issue because security token issuers and investors will likely anticipate regulation in this manner. However, if the SEC applies the Howey test to utility token offerings, it may ultimately determine many of those offerings are also securities and regulate them as such.

Regulation and issuance of security tokens. Issuers of security tokens will have several different filing options with the SEC:

While the SEC hasn’t issued much specific direction regarding security token offerings (STOs) or ICOs, we expect many companies issuing security tokens to follow Reg D (Rule 506c) or Reg A+. Some high profile ICOs have moved to only offer tokens to accredited investors, like Telegram, allowing them to file under 506c. We expect this to be a continued trend given current market demand among large investors.

Security tokens face three major problems today. Despite there being relatively more regulatory clarity on security tokens versus utility tokens, there are some challenges that security tokens face before they become a more widespread investment option.

  1. Security tokens have limited liquidity options for investors. Today, investors in security tokens don’t have the same liquidity options as other crypto assets, which is arguably the biggest issue for the asset class. There are effectively no exchanges that exist to trade security tokens. To offer trading of assets that the SEC classifies as “investments,” exchanges must meet strict know-your-customer (KYC) standards and Anti-Money Laundering (AML) requirements. While there are some exchanges (e.g., Coinbase) that attempt to meet these standards, they are often the ones that offer the fewest cryptocurrencies and tokens to trade. Depending on the security token, exchanges may need to be set up to interact with dividends, distributions, or communications with customers about things like proxy voting. Because of the additional regulations imposed on exchanges listing “investments,” many existing exchanges have avoided security tokens. There are a few exchanges under development for security tokens (see tZERO), but it will be some time before these exchanges are launched and have sufficient trading volume.
  2. Current securities laws aren’t easily adapted and pose additional complications. The Howey Test is a good place to start for security token regulation, but there may be additional regulations required for token-based securities. For example, many in the crypto community want transactions to be anonymous or pseudo-anonymous, which makes compliance with KYC and AML standards difficult. The SEC may need to offer additional guidance on what is and is not acceptable when it comes to anonymity and security token ownership. Exchanges that offer trading of security tokens may also require additional regulation.
  3. There are unique technical challenges in creating security tokens. Security token creation faces different challenges than utility token creation. The stakes are not only higher, but additional securities requirements come into play. Beyond the security and compliance issues, security tokens may also need to include instructions on how to handle dividend payments, coupon payments, splits, voting, and other common functions of securities. Finally, security tokens need to be flexible enough to allow for changes in the terms of the security, which may be difficult after issuance.

A few companies like Polymath and Harbor see these technical challenges as opportunities and have set out to simplify these issues and make it easy for companies to issue security tokens.

What’s next? We’re going to dive into what a security token exchange might look like, and how it would compare to existing securities exchanges.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio.  Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.