2019 saw technology for security token offerings come on leaps and bonds, which promises well for more issuance of these regulated digital assets in 2020.
2018 began with only three Security Token Offerings previously to market, and then saw a boom in infrastructure build-out and applications for Alternative Trading System (ATS) licenses, which are required in the US to trade private security tokens. But, of the three ATSs that were licensed, trade approval did not come until late 2018 and other than the tZero and OFN STOs, there were only two financial institution issuances: JPMorgan Chase’s test of Quorum with the National Bank of Canada and the World Bank’s $81 million Bond-i. Many potential STO issuers faced high upfront costs, while they struggled to stitch together STO technology resembling existing investment platforms.
2019, by contrast, has seen infrastructure technology improve markedly, while costs have fallen precipitously. At the same time, platforms have initiated thoughtful design around end-to-end functionality and compliance, including functionality that broker-dealers need (for example, around suitability data, such as a potential investor’s investment experience and risk tolerance, so broker-dealers can fairly advise them in line with FINRA rules). These developments, along with the emergence of a critical custody and control industry, bode well for the long term maturation of the asset class.
In early 2019, the Satis Group partnered with ConsenSys and helped develop its digital asset platform Codefi. There has been an increasing awareness that issuers need to be able “force” certain functionality on token holders (appropriately disclosed) including forced upgrade, transfer, burn and mint. Burning means destroying the tokens, and minting means creating tokens, in each case in a cryptographically secure manner. Forced transfer, burning and minting need to be available in the event of a court order, but also offer necessary functionality if tokens are lost or stolen. Upgradeability is important because state-of-the-art security tokens continue to evolve at a rapid pace. There are various approaches, but Codefi’s upgradeability function is at the smart contract level via a proxy pattern (a piece of software that allows you to swap one thing for another).
The Security Token Offerings deal flow slowed in 2019, with notable exceptions such as Blockstack’s successful Regulation A+ Security Token Offerings. The 2018 delay in secondary market trading of security tokens on ATSs, as well as the sizable bid-ask, spread once they did start trading, put a dent in the high liquidity dreams that had driven many STO projects. Relative liquidity is a benefit, but not a silver bullet reason for STOs (other than for funds, particularly funds with active, co-investing LPs who want to trade with one another). Custody and control solutions, for individuals, registered investment advisors and broker-dealers, are vital, but still nascent and complex, both practically and legally. Another issue has been poor quality, under-qualified or over-zealous attorneys advising on Security Token Offerings and failing to deliver. In particular, overconfidence on Regulation A+ filings, which have always been expensive and lengthy – and have been particularly so for many STOs – has led to significant delays and failed offerings.
Investors want high growth, high margin, technology-driven investments that private placements have traditionally attracted.
It has also been a year when certain erroneous concepts have, thankfully, been dropped by the wayside. For example, the industry no longer thinks STOs are easier to sell than other types of private placements. While STOs are a great match in many ways for the §506(c) of Regulation D exemption from registration, which allows a certain amount of public marketing unlike other private placements, and Regulation A+, which is a “mini” public offering and doesn’t have an accredited investor test, ultimately it has to interest high net worth investors who have historically been involved in private placements. Offerings that are entirely dependent on relatively unknown management or risky pipelines, creative high-risk projects such as pooled film production, fractionalized single asset real estate, fractionalized commodities that already trade well in other ways, single concept projects in unstable countries and similar, don’t generate interest within this investor base. What we believe investors want to see is the kind of high growth, high margin, technology-driven investments that private placements have traditionally attracted, particularly given the technological learning curve involved in security token ownership. What has been significantly difficult in 2019 compared to previous years is to find this kind of issuers amongst the noise of things we don’t think will succeed. But then this is a classic emerging technology and capital market growth curve and everything ultimately bodes well for 2020.
On the institutional side of STO issuances, there was significant build-out of back-office functionality and overseas infrastructure. July saw the launch of 1X, a first-of-its-kind security token exchange based and regulated in Singapore. It has a third party custodian solution (a significant issue for STOs), with ERC technology provided by ConsenSys. August saw the second issuance of a $33.8M Bond-i by the World Bank, this time with the Commonwealth Bank of Australia as the issuer and TD Securities and RBC Capital acting as managers. In September, Santander issued a $20M tokenized bond transacted entirely on the Ethereum public network (CommBank’s and Quorum were on private networks). September also saw Allinfra, another company partnered with ConsenSys, announce a collaboration with Asia’s largest REIT, called Link REIT. Such notable financial industry interest is a strong signal going into 2020 and ultimately for the larger future for STO technology beyond Regulation D private placements.
If the STO industry is to progress further in 2020, it needs to provide a rationale beyond greater liquidity (i.e. that STOs bring investment to previously illiquid assets). STOs need to be designed by properly qualified FINRA Registered Representatives to provide a better mouse-trap, financially speaking, that is not only financially attractive in and of itself, but adds features or enhanced execution or similar that exceed what traditional capital markets offer. To achieve these goals, issuers need to take advantage of a full suite of DLT technologies. That is why we partnered with ConsenSys and Codefi. Much of the key infrastructure and markets are now in place to a technological standard we could have only dreamed of two years ago. It’s now just a question of finding the right issuers, the right products and the right purchasers. Ultimately, we remain confident given the developments of the last two years that STOs will become commonplace across public and private markets.