Executive Summary

Security Tokens: Cryptonite for Stock Certificates stat bar

The price of Bitcoin has jumped by over 120% since the beginning of the year, leading many to conclude that the bear market in crypto is over. The market has not been this frothy since 2017, when we witnessed an extraordinary boom in the price of all crypto assets, as investors poured money into the market hoping to get in early with the next Bitcoin or Ether. At the same time, tech teams dreamt up new use cases for utility tokens that leverage blockchain technology and raised money to fund them via initial coin offerings (ICOs). The bubble burst in early 2018, precipitated by the revelations of fraudulent activity, regulatory action and the reemergence of rational thought by investors. Bitcoin fell by 75% and Ether and other crypto assets were down even more.

While the crypto spring may now be upon us, it does not mean we will see a return to the ICO boom. Since 2017, regulators in the U.S. and around the world have cracked down on these token launches, which they often consider to be unregulated securities offerings. This does not represent the end of tokenization, however. Many companies are now focusing on building technology and an ecosystem for security tokens. These new tokens are digital securities recorded on a blockchain and issued in full compliance with the securities regulations in the jurisdiction in which they are offered. In this way, security tokens can be thought of as the convergence of crypto, enterprise blockchain and traditional finance.

This Greenwich Associates research looks into the emerging market for security tokens, identifying the most promising applications, key advantages and leading players in the space.

Security Tokens: Cryptonite for Stock Certificates stat bar

The price of Bitcoin has jumped by over 120% since the beginning of the year, leading many to conclude that the bear market in crypto is over. The market has not been this frothy since 2017, when we witnessed an extraordinary boom in the price of all crypto assets, as investors poured money into the market hoping to get in early with the next Bitcoin or Ether. At the same time, tech teams dreamt up new use cases for utility tokens that leverage blockchain technology and raised money to fund them via initial coin offerings (ICOs). The bubble burst in early 2018, precipitated by the revelations of fraudulent activity, regulatory action and the reemergence of rational thought by investors. Bitcoin fell by 75% and Ether and other crypto assets were down even more.

While the crypto spring may now be upon us, it does not mean we will see a return to the ICO boom. Since 2017, regulators in the U.S. and around the world have cracked down on these token launches, which they often consider to be unregulated securities offerings. This does not represent the end of tokenization, however. Many companies are now focusing on building technology and an ecosystem for security tokens. These new tokens are digital securities recorded on a blockchain and issued in full compliance with the securities regulations in the jurisdiction in which they are offered. In this way, security tokens can be thought of as the convergence of crypto, enterprise blockchain and traditional finance.

This Greenwich Associates research looks into the emerging market for security tokens, identifying the most promising applications, key advantages and leading players in the space.

The Security Token Advantage

Security tokens are digital assets that represent an ownership position, a creditor relationship or rights to such. They differ from traditional securities in one crucial way—they are represented digitally on a blockchain as opposed to in physical certificate form or dematerialized form.

Dematerialization

A blockchain is a distributed ledger maintained by a network of participating nodes. At any point in time, the blockchain contains a complete record of ownership of assets recorded on the ledger and the entire transaction history of those assets. This can allow—as in the case of Bitcoin—for transactions to be settled on a peer-to-peer basis without the need for an intermediary. In addition, smart contracts can be deployed that can automate securities servicing (such as dividend payments) and embed regulatory compliance (such as controlling transfer of ownership.

Security tokens recorded on blockchain technology can confer many advantages. Executives in our study felt strongly that the immutable record of ownership and transaction history is the primary one. The poster child for how this can go wrong in the current system is the case of Dole Food. As a result of a 2013 class-action lawsuit, former Dole shareholders were entitled to a payout. The problem occurred when 49 million shares were submitted as eligible for the payout, while only 37 million shares were outstanding at the time. Theoretically, this would not have been possible if the shares were recorded on a blockchain.

Advantages of Security Tokens

It should be noted that an immutable ledger, rapid settlement and clearing, and some other advantages listed are not unique to the security token industry. Enterprise blockchain initiatives, such as those being developed by entities including Digital Asset Holdings, R3 and Hyperledger, have been working on leveraging blockchain technology in financial services since 2015. The key differences between these blockchain movements is that enterprise blockchain initiatives are focused on deploying and customizing DLT into existing market infrastructures, while security token initiatives are more focused on using the technology in alternative asset classes where market infrastructure is less developed or, in some cases, in entirely new asset classes.

In practice, this means that enterprise blockchain companies are partnering with established financial markets participants, such as banks, central securities depositories (CSDs) and exchanges, and need to build interoperability with existing workflows and systems—similar to replacing the plumbing without shutting off the water. In markets such as private equity securities (known as private placements in the U.S.), there is no, or very limited, existing trading and settlements market technology, which means the market structure can be built around blockchain.

Indeed, almost 50% of participants in our study rank private equity securities as one of the top three applications. In this market, the challenge is less technological and more about ensuring regulatory compliance. Private securities are often deemed more risky by regulators, who place certain restrictions on investments in these securities, such as the type of investor, the holding period for transactions and other rules around resale. These restrictions and a lack of a public marketplace for these securities means there is hardly any secondary market trading as compared to public equities.

Best Applications for Security Tokens

Liquidity and Beyond

This is the problem that blockchain seeks to solve in the context of security tokens. By leveraging smart contracts, the complex compliance rules can be programmed into the token protocol to ensure compliant transactions. For example, the smart contract can verify that a seller has held the security for the required holding period by simply checking the transaction record on the blockchain. In addition, the smart contract can verify that the purchaser is an accredited investor by checking data associated with that investor’s wallet address. In this way, frictions can be removed from the secondary market trading process, allowing more liquid marketplaces to develop.

This is why we see programmatic regulatory compliance and a liquidity premium from secondary market trading as the two second-ranked advantages of security tokens. The liquidity premium is unlocked when the asset becomes tradeable in the secondary market, as price discovery improves when there are more buyers and sellers. In addition, the liquidity premium may transfer to the primary market. Investors may be more likely to invest in a private security if it’s not a one-way trade. To put it another way, current investors in private securities don’t expect there to be a secondary market and, therefore, require additional expected returns to compensate for the liquidity risk.

Other promising applications for security tokens include start-up capital formation. These types of transactions also raise money privately and are similar to private placements discussed above. This also speaks to the success that the ICO market had in crowd-funding new (blockchain-focused) startups. In a security token world, of course, the tokens would need to be fully regulated, unlike most ICOs. (Note that Regulated ICOs ranked sixth).

The creation of new financial products, such as tokens that pay out a percent of revenue is another potential utilization of security tokens. Other ideas proposed along this theme include taking a dividend-paying equity token and peeling off the dividend stream as a separately traded security token. As yet, however, these ideas are more theory than reality.

Many companies in the security token industry are focusing on tokenizing real estate. Real estate is a huge but relatively illiquid asset class. For example, there is approximately $15 trillion in commercial real-estate assets in the U.S. but only $1 trillion in market cap of equity REITs—93% of the market is privately held. Proponents of tokenization claim that using blockchain and smart contracts will reduce the costs and complexity of issuing equity via security token and allow developers to raise capital by tokenizing, say, a single Manhattan office building. In turn, investors may be more attracted to the asset class by being able to customize their real-estate portfolio and access a liquid secondary market.

Private Securities

Regulatory Challenges

By far, the dominant challenge to security tokens is the regulatory environment. Regulators around the world have been approaching the emergence of digital securities differently. The ICO boom of 2017 was a wake-up call for regulators, who realized that existing regulations were often inappropriate for digital tokens like utility tokens. Consequently, in some jurisdictions, efforts are underway to define a new class of digital asset that is not a digital security.

On the other hand, U.S. Federal regulators are relying on a 1946 Supreme Court ruling to decide when an offering is a security. Under this rubric, a collective investment in expectation of profit is considered a security, which applies to most offerings.

Top Challenges

But even when an issuer decides that their offering is a security and wishes to issue it in digital (blockchain-based) format, the confusion does not end there. Regulators have many questions, such as: How to regulate a security that exists on a global, decentralized network? Should transactions in securities be confirmed on a blockchain by foreign entities where KYC and AML safeguards are not established? How to prevent a blockchain “fork,” resulting in multiple claims on a security? How to reconcile an inherently centralized custody function with an inherently decentralized blockchain?

There can be little doubt that this regulatory uncertainty is hampering the industry, with few successful security token offerings to date.

Blockchain Technology for Security Tokens

Security tokens are different from crypto. In most cases, they are not utility tokens that power the operation of a decentralized network, and regulations in the jurisdiction in which they are offered place significant constraints on how they may be issued and transferred. As such, it is appropriate to consider what is the most appropriate blockchain technology to use.

On one hand, the open-source public blockchains like Ethereum have the most developers working on the codebase and a large number of open-source applications readily available, including specific security token protocols (e.g., ERC1400, which has many of the restrictions around identity, jurisdiction and asset category already built in). Public blockchains also offer the most reach, as they are accessible to everyone.

At the same time, these advantages can be seen as disadvantages in a security token context. With a decentralized developer base, there is a risk that the blockchain could fork (as happened with Ethereum in 2016 and to the Bitcoin blockchain on several occasions). When a blockchain forks, an identical copy is made at a point in time, and future development continues on both forks independently. This leads to the digital assets also being forked—for example, Bitcoin forked into Bitcoin and Bitcoin Cash. Theoretically, SecurityToken1 could fork into SecurityToken1 and SecurityToken1a.

Another concern would be a so-called 51% attack, where a majority of bad actors take control of the blockchain. There is even a petition to the SEC asking if the verifying of security-token transactions on a public blockchain network is akin to a broker confirming trades—in which case miners could be considered subject to broker-dealer regulation.

Technology and safeguards can be designed to prevent tokens being forked, and the Ethereum blockchain, due to its size, is highly resistant to a 51% attack. Nevertheless, these issues represent meaningful risk factors for regulators and institutional compliance officers.

Use of Public or Permissioned Blockchains

Permissioned blockchains, as are being used in enterprise blockchain initiatives, are a potential solution to these issues. Indeed, major financial institutions decided to build permissioned DLT precisely because of these and similar concerns. Our data reflects this consensus, with over 60% of respondents favoring a permissioned blockchain—perhaps not surprising, given the strong representation from regulated financial institutions within our study.

When it comes to the specific blockchain technology that should be used, there is no such consensus. In fact, the most popular response was that it “doesn’t matter.” This is important, as it tells us a couple of things. First, there are a number of different blockchain solutions on the market that are fit for this purpose. Second, the technology selection is not the determinant of success in this business.

Most Appropriate Blockchain for Security Tokens

The preferred blockchain as selected in our study is Ethereum. Note that this could refer to the public Ethereum blockchain or a permissioned version. Ethereum is the original blockchain with smart contracts built in and many relevant apps and functionality available via open source. In addition, permissioned versions of the Ethereum network can be created that contain many of the benefits of a public blockchain, while also addressing regulatory compliance concerns. Corda and Hyperledger are other permissioned blockchains that are recommended.

Security Token Leaders

The security-token ecosystem is global and diverse. Participants include securities exchanges, crypto exchanges, fintech companies, and broker-dealers. Representing this diversity, the top four rated participants in this market include:

Leaders in Security Token Space

Notable Security Tokens

Leading Security Token Companies

Final Thoughts

Security tokens represent the latest innovation in the field of crypto. Borrowing functionality from enterprise blockchain, crypto and traditional securities markets, security tokens may finally represent the “killer app” for blockchain. Just as digitization has improved efficiency and transparency in other parts of the economy, the same will occur when capital markets move from issuing securities in dematerialized format to natively digital.

Security tokens are not applicable for every market or asset class. Most developed equity markets are already very efficient—with market infrastructures having been built up over many decades (or even centuries)—and are highly liquid, transparent and capable of processing billions of dollars of trading value every day. But for alternative, less-liquid markets, applying blockchain and building new market structure around this technology has the potential to deliver significant benefits to market participants and to investors everywhere, who will gain a wider universe of opportunities to choose from.

Richard Johnson

Methodology

Between March and April 2019, Greenwich Associates interviewed 114 executives active in the blockchain and financial technology space across all of North America, Europe, Asia Pacific, and the Middle East & Africa. Seventy percent of respondents were actively involved in security token initiatives. In addition, this paper leverages data from the Greenwich Associates 2019 Equity Portfolio Manager Study, including interviews with 56 portfolio managers and analysts located in North America, Europe and Asia.

Respondents by Region and Organization Type