25/01/2021 by Dominic Hobson 1 Comment
We have seen the future of securities, and it is tokenised
Security tokens are coming. In fact, they are here already, and have been for a while. Though most of the security token offerings (STOs) in the last three years were hard to distinguish from Initial Coin Offerings (ICOs), several corporates and banks (Banco Santander, Bank of China, BBV, Daimler, Deutsche Bank, Société Générale) have tokenised bonds or loans on public as well as private blockchain networks.
A number of blockchain-based tokenisation platforms, many of which began in the ICO market, have survived and evolved. Their initial targets are illiquid assets such as corporate bonds, real estate, fine art, collectibles and private securities or private equity, but they also have the conventional equity and bond markets in view.
They have good reasons to be optimistic. Blockchain technologies have evolved to overcome the speed and security concerns that used to make it easy for incumbents to dismiss the idea of blockchain-based tokenisation platforms. The obvious advantage tokenisation brings to illiquid assets – namely liquidity, achieved by fractionalisation – is valid for existing securities as well. Tokens are also flexible enough to be applied to any income stream, bringing the predictable cash flows of infrastructural and energy projects within the scope of tokenisation.
On-boarding issuers and investors can be accelerated through automation of Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks. Tokens can be traded on automated platforms 24/7/365. Settlement by delivery against payment can be instantaneous rather than postponed for three days. The register of token holders will be updated in real-time. Fee-deducting intermediaries, such as central securities depositories (CSDs) and custodian banks, can be replaced by digital wallets.
Issuance, trading, settlement and custody costs will all be lower. The use of smart contracts can automate the servicing of tokens, in terms of income collection, voting rights, pre-emption rights, tax reclaims, takeover offers and redemptions. Tokens can even be programmed to meet regulatory demands, such as distributing to eligible investors only.
These benefits are increasingly well-understood, but the security token markets are still nascent. Liquidity is a self-fulfilling trend, but hard to achieve. In fact, one reason tokenisation platforms focus on illiquid assets is that any degree of liquidity is an improvement there.
At this stage in their development, without the transactional volumes and price formation needed to fuel the indices and derivative instruments that drive professional trading activity, the best way to grow security markets is simply by attracting institutional investors. That means lowering their risk of participation. The Initial Coin Offering (ICO) boom of 2017-18 discredited tokenisation in the estimation of many potential issuers, investors and advisers, and the current DeFI token boom looks like a re-run of the ICO bubble.
However, both bubbles have accelerated technological developments, not least by attracting high calibre developers. Indeed, the ICO and DeFi booms have, alongside a great deal of waste and wasted effort, driven the improvements to blockchain technology. Like any investment mania, DeFi is a magnet for talented people and a residue of useful innovations will remain long after the errors of optimism and the scams are forgotten.
Rising institutional interest in Bitcoin indicates investor attitudes have grasped this. At a time of deep monetary uncertainty, Bitcoin is attracting institutional money as a hedge against inflation, an uncorrelated asset and as an alternative to buying gold. Investing in Bitcoin is simultaneously habituating investors to the operational demands of taking delivery, booking and holding tokenised assets.
Multiple platforms now offer a digital wallet to investors that do not have one, plus automated asset servicing. Payment tokens (including Stablecoins) provide a stop-gap solution to settlement of the cash leg of token transactions on tokenisation platforms until Central Bank Digital Currencies (CBDCs) become available.
The need to pre-fund settlement accounts is being alleviated by collateralised credit. Military-grade custody solutions are available, dissipating institutional folk-memories of the notorious hacks of crypto-currency exchanges. Tokens that are stolen can now be destroyed before their value is realised. There are regulated (and even listed) intermediaries available for institutional investors to work with. Asset managers are providing vehicles that allow institutions to invest in tokens indirectly, obviating the need for third party service providers at all.
For trading houses, technologies that link existing sell-side trading applications to multiple token trading platforms are available. For issuers, origination, structuring and syndication groups that look like old-fashioned corporate finance teams at an investment bank are available, while platforms automate issuance and distribution to the wallets of eligible investors. There is even a technical standard for token design features (ERC-20) and it is widely used, not least because it makes new issues easier.
Law firms have developed teams that understand the evolving legal and regulatory environment. Indeed, the main obstacle to institutional interest – the uncertain legal and regulatory status of security tokens – is now being cleared. Regulators in Europe, Asia and North America are positively encouraging STO experimentation. Several jurisdictions have adapted securities regulations to accommodate tokens or passed full-fledged security token laws. Sufficient experiments have taken place in progressive jurisdictions to prove that the technology can work within the rules. All that remains is an issuer and an investor bold enough to risk starting an avalanche.