Waves of a New Financial Internet
Bitcoin started the movement. The crypto zeitgeist began with Bitcoin along with a technical foundation of blockchain, also called distributed ledger technology (DLT).
Ideological and social foundations based on decentralization, disintermediation of traditional government or corporate organizations has become part of this movement. While financial services is the first “killer app” of blockchain technology, the concept of a distributed ledger has a large number of applications.
Indeed enterprise and inter-enterprise blockchain applications may be able to improve operating efficiencies of established financial services organizations in banking, investment, and capital markets.
At the same time, applications of blockchain are creating new opportunities to the users of the financial industry.
We have been witnessing an evolution of newly emerging applications that can support what some would call a new financial internet.
Wave 1 — Cryptocurrency Payment and Money Transfer foundations:
Bitcoin and an initial blockchain. This initial wave primarily powers a new payment mechanism as well as fund transfers. In traditional online systems, a consumer enters a number, such as a credit card number, into a web browser to effect an online payment. In the new world, a consumer enters other numbers, relating to wallets and digital currency.
In the traditional system centralized servers, often owned and operated by centralized financial intermediaries (payment and credit card processing companies), effected transactions between stores and banks.
In the new world of online payments, digital currency via blockchain can enable payments directly between consumers and stores — bypassing credit card companies and banks.
Pragmatic benefits of lower costs, as well as opening up banking by cell phones to people around the world, become a motivational factor for the underbanked globally. This payments and funds transfer stage will continue to grow as more and more establishments accept Bitcoin, and perhaps other digital currency, as payments.
Wave 2 — Raising Money via Cryptocurrency and Initial Coin Offerings (ICOs).
Although Bitcoin and basic blockchain were fine for payments, investing in new companies often involved conditionality relating to escrow, lockup rules, and more. A new generation of blockchain enabled this conditionality via smart contracts.
Ethereum, and their ERC20 tokens, provided the initial technical foundations in late 2016. Other vendors followed with their own solutions.
As a result of smart contracts, companies began raising money in 2017 via Initial Coin Offerings and associated white papers. Larger numbers of ICOs evolved in the first half of 2017 — many in Asia Pacific — but most did not comply with U.S. regulations.
By the summer of 2017, the turning point began.
The amount being raised started to compete with the amount raised by U.S. venture capital companies. Additionally, the U.S. Securities and Exchange Commission (SEC) investigated and published their landmark DAO Report that addressed the topic of unregulated securities and ICOs.
Through the fall of 2017, even more was raised (up to $3.5 to $5.6 billion by the end of 2017), and regulators around the world increased their scrutiny and enforcement. China took an extreme approach shutting down ICOs and cryptocurrency exchanges in September of 2017.
In the United States, the SEC was increasingly viewing most offerings as being securities.
In the spring of 2018, many subpoenas were sent to out to industry participants including attorneys engaged in the facilitation of ICOs.
Wave 3 — Enabled by Security Token
Today, there are increasing pressures for issuers to comply with existing regulation, and to seek improved efficiency and returns. This is driving a third wave of a new financial internet. This wave is starting in 2018 and may be over over in just a few of years.
The Five Dimensions of Security Tokens — The Third Wave of a New Financial Internet
The Security Token Industry is evolving very quickly — but there remains a great deal of confusion.
There are definitely gray areas in both the marketing messages of vendors as well as the underlying business models. Futher, the messaging and business models mean are not at all “immutable” but rather are evolving as part of the larger security token ecosystem.
So what then are the key dimensions?
A key aspect of the third wave is the maturation of the industry, and the integrity of its practices and operations.
1) What are security tokens?
There are currently two definitions that you will hear about in the media and at events. The Security Token Academy codifies these definitions, generationally, as:
- a) Security Token 1.0 (ST 1.0) — Regulated token offerings. From a U.S. perspective this often means using a regulatory offering “exemption” from the U.S. SEC. Most of the ICO offerings are using exemptions for “accredited” or wealthy investors — called Reg D (for the U.S.). Reg S are being used for international investors. From this point of view then ST 1.0 began in 2017.
- b) Security Token 2.0 (ST 2.0) Some industry players are focusing on a new generation of security tokens that will streamline processing of identity management.
Specifically, KYC (Know Your Customer) and AML (Anti Money Laundering) mechanisms will be automated to different degrees based on a new layer of technology that can sit on top of smart contracts. Through the electronic codification of KYC and AML rules on a country by country basis, cross border transactions become more efficient and more viable. The Security Token 2.0 generation begins in 2018 and will evolve in future years.
Some of course may quibble about this 2.0 terminology believing it should be 1.5. But the elements of what will be in 2.0 are not necessarily all developed by vendors. Automation of dividend management, lockups, and more are also becoming part of the solution set. A key issue will be what will be the difference between 2.0 and a possible 3.0 generation of security tokens.
2) What are the Driving Forces behind Security Tokens?
- a) Reducing regulatory risk. Using regulatory offering exemptions (e.g. Reg D or Reg S exemptions) was the initial step via ST 1.0. The ST 2.0 will facilitate compliance with KYC and AML.
- b) Searching for a higher return or alpha. This dimension is more related to the (future) generation of KYC/AML enabled security tokens (2.0) and associated facilitation of cross border trading and potential higher liquidity premiums
3) What are the high level applications of Security Tokens?
- a) Raising money for companies. Certainly, using security tokens to raise capital for startups and established businesses is a logical extension of ICOs and also of IPOs. In the U.S. alone, more than 650,000 companies are created each year. Wall Street, Silicon Valley and Angel investors have not provided enough capital for startups. So regulated and compliant “Security Token Offerings” or STOs may enable a new source of needed capital. Although as much as $5.6 billion was raised world wide by ICOs in 2017, the size of the 2017 U.S. IPO market was about $36 billion.
- b) Using Security Tokens to help tokenize or securitize existing assets. The tokenization or crypto fractionalization of global assets is a huge potential opportunity. Global equity assets are valued at about $70 trillion, debt around $100 trillion, and real estate about $230 Trillion (about $180 Trillion in residential, $32 Trillion in Commercial, and the balance in agricultural, etc.) Raising money via ICOs has been a 2017 phenomena. Tokenization of existing assets via Security Tokens is a brand new area that will start to emerge in 2018.
4) What are the benefits of Security Tokens? (ST 2.0)
- a) Efficiency. Some argue that replacing current paper-based systems and older technology (such as faxes, file transfer, email) could reduce the cost of administrating our financial systems. A 2016 Goldman Sachs report suggests that up to $6 Billion a year could be saved in the cash equities market.
- b) Time. Reducing settlement times for stock trading has been an industry challenge. The industry is currently moving toward a T+2 (2 day) settlement time. Meanwhile, new Security Token Trading organizations will try and effect same day trading. Some people suggest that longer settlement times may provide an opportunity for manipulation and therefore a shorter, or same day settlement, might reduce the risk of practices such as naked short selling.
- c) Liquidity. For many people improved liquidity is the key opportunity. For people locked into deals — such as long term real estate deals — getting out of a deal can mean taking a “haircut” or incurring a liquidity discount. On the positive side, the industry hopes that improved liquidity (ie liquidity premiums) could be enabled in part due to more viable cross border trading and investing powered by Security Tokens (2.0)
5) Industry Operations, Timelines, and Ecosystems
- a) Market participants include companies that help in the creation of tokens. Some tokenization companies may be advisory firms which are retainer based. Other advisory firms may be registered broker dealers charging a success fee, perhaps a fore runner of what might be considered to be “security token investment bankers”. There may be other tokenization organizations have provided technical platforms, or will provide technology based solutions and protocols. In addition there will be Security Token trading organizations such as new Security Token ATSs and and Security Token Exchanges will enable both institutional and individual investors to trade these new tokens.
- b) Timing — Much of the potential $5.6 Billion that was raised via ICOs in 2017 was raised in the U.S. by issuers using regulated ICOs using “Reg D”. Reg D offerings are only available to U.S. accredited investors. These Reg D offerings often have a 12 month lockup period although some do enable buybacks originating from the issuer and sometimes from other investors. Because many of the 2017 lockups will be expiring in the second half of 2018, Security Token Trading organizations will start to emerge and operate (U.S. focus to some degree) starting in the second half of 2018.
- c) Operational Issues — to be addressed by Security Token Trading organizations will include issues of custody, interoperability, backup, and industry cybersecurity.
Conclusion — Security Token Industry to officially begin in 2018.
Although some early aspects the security tokens appeared in 2017 through a few Reg D offerings compliant with SEC Regulations, the broader Security Token enabled third wave will really starting in 2018 for three key reasons.
First, in 2018 we will see more and more U.S. token offering being compliant with SEC Regulations.
Second, the evolution of newer generations of Security Tokens will better enable identity management, cross border trading via KYC and AML mechanisms.
Third, the emergence of security token trading organizations in the second half of 2018 that will enable the trading of security tokens that are unlocked from 2017 Reg D restrictions.
So the key pieces of the Security Token industry are starting to fall in place in 2018. More components will need to be addressed, but 2018 is the year when major foundational elements will be established.
