Research

Block by Block: Security Tokens

Block by Block is a series where we dive into different industries and examine the entry-points for decentralization. 

The term security token has been appearing more frequently in various crypto-channels. Influential members of the crypto-community promote security tokens as the final step in “tokenizing the world.” Investors are taking notice as they pump millions of dollars into projects that support the sale and exchange of security tokens.

The amount of interest is understandable considering the size of the market security tokens is targeting. Security tokens aim to tokenize the ownership of all assets, whether they are public & private equities, real estate, or precious metals. For context, the global commercial real estate market alone is worth ~$4T.

Where are the points of entry for Security Tokens?

To understand the growing interest in security tokens we explore the issues with traditional securities markets.

  • Intermediaries & Fees: In traditional securities markets there are a complex web of intermediaries. For issuers to get their shares into the hands of investors, they must go through investment bankers, brokers, transfer agents, and clearinghouses. These intermediaries often charge high fees for their services. According to PwC, on average, companies planning to public pay underwriters more than $4.2M to complete an IPO.
  • Centralization: It is a misconception that investors truly own their shares. What is actually true is the shares held by an investor represent an entitlement to the shares held by their broker. Those shares then represent an entitlement to the shares held by Cede & Co. which is a subsidiary of DTCC. DTCC is a securities clearinghouse that processes the vast majority of global securities transactions. In 2015 globally, DTCC processed $1.6 quadrillion worth of securities transactions, making it the highest financial value processor in the world. (To comprehend this number, it’s approximately 20 times the sum of the world’s GDP figures, making “Gross World Product a bit under $80T.) This centralization places the global liquidity market at risk. If DTCC’s servers go down or get hacked, it could quite literally bring securities markets to a halt.
  • Illiquidity Discount: Because of their structure, there are many assets in the market that are illiquid — they are not easy to buy or sell like a share in Amazon. Real estate, private equity, collectibles, et al. fall into that group. Because of their illiquidity, these assets often are discounted — selling for less than actual worth. Some researchers estimate that illiquid assets, on average, receive a 20–25% discount on their value.

So how do security tokens solve these issues?

Making it possible to buy and sell interest in these illiquid assets and positive things should happen not only to their value, but also to access. Let’s break down how:

  • Intermediaries & Fees Limited Intermediaries & Limited Fees: Instead of requiring multiple different intermediaries to issue, transfer, and settle assets, security tokens add simplicity into the markets. With tokens, issuers offer shares directly to investors on a blockchain. All activity typically done by intermediaries in the traditional system can, in theory, be replaced by a blockchain. Issuance, transactions, and settlement can be performed by miners and nodes of a blockchain, limiting the need for additional intermediaries¹.
  • Centralization Decentralization: Instead of a single institution controlling shares and settling transactions, security tokens are built on blockchains operated by distributed miners and nodes (servers). If a miner or node cease operating, the blockchain will continue to run as usual. The lack of centralization makes the settlement and transfer of securities more reliable. No more risk of a catastrophic failure at DTCC.
  • Illiquidity Discount → Liquidity Premium: Because security tokens enable the tokenization of any asset. Illiquid assets can benefit from increased liquidity. For real estate, property owners can tokenize shares of their building and issue it to multiple investors. (Today, this can be done only by incurring the complexity of building limited partnerships or real-estate investment trusts (REITs). Instead of a property owned by a single entity, there can be multiple entities owning fractional shares of a real estate property. The ability to distribute small amount of shares — down to fractions of a percent — increases the potential number of members in the liquidity pool . Your average investor may not be able to afford to invest $100M in “Property A,” but they could likely afford to buy “Property A Token” that represents one-millionth of a right to the property for $100. With an increase in potential investors, assets will increase their liquidity, and in turn, benefit from a liquidity premium.

What are the barriers to entry?

While tokenizing the world sounds like next big step for the crypto-ecosystem, there are many disadvantages and risk in the near term for security tokens.

  • Regulation: Security tokens are by definition securities and are regulated under the same laws as traditional securities. As such, regulations can severely limit the advantages of security tokens. One example: Security regulations that apply to one country may not apply to another. If an issuer issues security tokens in Country A, regulators in Country B may restrict investors from investing in these tokens — thus limiting the liquidity.
  • Ownership rights: There is a reason why our current system is centralized. Centralization enables efficiency. The majority of issued securities in traditional markets are registered instruments, that is, ownership of the security is recorded. When Person A transfers their registered shares to Person B, the change in ownership is also recorded. On the other hand, security tokens are quasi-bearer instruments, where token ownership is recorded on the blockchain but not necessarily property ownership. In this case, the ownership of an asset would logically belong to the owner of a token. Following this logic, if a hacker steals a property token, does the hacker now own the right to that property? If not, how do you enforce the right to the property? Do you go full circle and have an intermediary record asset ownership transfers? (There are ways to revoke and reissue tokens to handle thefts and hacking, but these also add complexity at nearly every point in the process.)

Securities laws and markets are extremely byzantine. For security tokens, too, there are many unanswered items because we have yet to see the application of them at scale. These tokens can quite literally change how the current financial system operates, or they could as just as easily be another footnote in the new edition of a business textbook.

 

¹ This argument is a lot more complex. Just because you removed the intermediaries does not mean you remove the need for their services. Removing intermediaries means the issuer will often take on the job of intermediaries.