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.