The Security Token Market Needs Better Lingo

clicks | 6 months ago | comments: discuss | tags: cryptocurrency

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Feb 9, 2019 at 10:00 UTC opinion
Andrew “Drew” Hinkes is a co-founder and the general counsel of Athena Blockchain, and an adjunct professor at the NYU Stern School of Business and NYU School of Law.
Lost in the ICO frenzy of 2017 was a curious issuance.
In April of that year, Blockchain Capital raised $10m for its third fund, a “tokenized VC fund.” Unlike most ICOs that purposely avoided regulatory compliance, this was a compliant U.S. security, issued as a token.
This was the beginning of an expected wave of so-called “tokenized” securities that will offer legally compliant securities as tokens – a change that will increase demand for and trading liquidity in these securities by leveraging blockchain and smart contract technology to automate aspects of trading, and will enable these instruments to offer new, useful features expected to increase their value to issuers and purchasers alike.
Under U.S. law, a variety of financial instruments are included in the definition of a security, including stocks (i.e. equity), bonds (i.e. debt), and investment contracts (recall that the SEC considers some ICOs to be investment contracts). Although public company equity trading on national stock exchanges like the NYSE and NASDAQ may be familiar to most investors, a variety of regulatory exemptions allow issuers to sell securities without becoming public and subject to expensive public reporting obligations. These so-called “private placements” of securities use regulatory exemptions, depending on the issuance, that may limit the amount of money raised, the universe of potential buyers, and the marketing of those investments.
Despite these limitations, private placement equity “rounds” are a popular choice for start-ups. Fast-growing and capital-intensive companies often use private placements to raise growth capital while remaining private; about 270 “unicorn” companies worth more than $1 billion have chosen to remain private. Most tokenized securities, at least initially, will be private placements.
Private placements accounted for more than $2.4 trillion in debt and equity securities issued in the United States in 2017 alone. This number dwarfs even the frothiest time of the ICO market by orders of magnitude. Unlike ICOs, which provided value as an arbitrage against regulation, which typically failed to provide legally required disclosures to purchasers, and which generally offered a future right to a product or service rights to their purchasers, tokenized securities will comply with the law, and at least initially, fall into one of a few categories or types.
A clear understanding of those types and the rights provided to their buyers is critical to understand why tokenizing securities will improve their utility, features, and marketability. A proposed taxonomy
“Security token offering,” or STO, was coined to distinguish a regulatorily compliant token offering from earlier ICOs which mostly ignored compliance. STO, however, fails to capture the nuanced differences among the types of securities to be sold as tokens.
To clarify the discussion, I propose the following terms to be used to describe the various types of tokenized securities that already exist, or that are expected to be developed:
1. Security-wrapped ICOs, a/k/a SICOs . These are “network assets” or “utility tokens” of the ICO generation that are offered pursuant to registration exemptions so that their offering complies with U.S. law. SICOs typically do not offer debt (an enforceable promise to repay) or equity (i.e. a proportional share of ownership, dividend right, participation in issuer governance) rights to their buyers, and often provide minimal investor protection, offer minimal issuer disclosures, and afford limited recourse against the issuer. These assets are natively digital unless offered as a secondary product to be distributed by the issuer pursuant to a simple agreement for future tokens (SAFT) or similar agreement.
2. Tokenized Equity or Debt, a/k/a TEDs. These are traditional securities (i.e. equity/debt) issued in digital token form. These products are identical to traditional private placements except that they are issued in token form, rather than in the form of a spreadsheet entry, or a piece of paper. These instruments will eventually incorporate new features and functionalities like direct-to-holder data reporting, and interactive governance.
3. Tokenized Asset-Backed Securities, a/k/a TABS. These are digital tokens that represent an ownership claim against, or ownership share in, an asset or pool of assets. This category includes products based on a claim against metals, gems, commodities, securities, real estate, art, unique goods, and other assets maintained by the issuer or issuer’s designee.
4. Transactional Security Instruments, a/k/a TSIs. These assets are securities, issued in token form, that may be redeemed or accepted by the issuer or the issuer’s designee in direct exchange for products or services. The process of red...