May Xth 2019
Although blockchain companies have traditionally sought capital through initial coin offerings (ICOs), security tokens are now shaping up to become the de facto method of raising funds with equity or debt for start-ups and SMEs. They are also becoming a great tool to digitalize securities beyond the case of fundraising. Here, we look at the benefits of tokenizing securities, and how these benefits will affect the traditional securities markets.
Some of the most novel applications for security tokens are emerging from the tokenization of those assets which experience traditionally limited liquidity, which is how easily an asset can be bought or sold. Many assets, especially non-fungible assets or shares in private equity funds, require investors to hold for relatively long periods of time (8 years on average) before they may sell their position.
Instead, trading on secondary markets facilitated through asset-backed tokens allows investors to take an earlier exit. This is particularly beneficial for start-ups and SMEs, where greater liquidity for their early investors could result in a higher initial valuation and attractiveness, as investment exit costs for investors selling their securities are reduced.
Similarly, as security tokens are based on blockchain technology, and therefore borderless in nature, the pool of available investors is greatly increased compared to traditional securities. Access to a global pool of potential investors, and multiple secondary marketplaces worldwide, will likewise increase liquidity and provide enhanced price discovery for tokenized securities.
Additionally, just like their counterpart cryptocurrency markets, there is no requirement for security tokens to cease trading when traditional markets close, allowing for 24/7 round-the-clock trading.
Obtaining an accurate valuation for one’s business is important and can be required in many different contexts such as equity sale, partnerships, taxation, and so on. Getting a valuation for a small business is often difficult and may require the intervention of experts, which can incur high costs.
By selling equity backed tokens directly to investors, even for a small amount of equity, business can obtain an instant valuation straight from the market and the lowest possible cost.
For start-ups launching a security token offering (STO) or businesses selling any type of tokenized security, access to global capital pools and highly diversified investor profiles may drive a faster sale than would have been possible through traditional, geographically constrained markets. Furthermore, a tokenized security existing on a blockchain, it becomes possible to accept contributions in both fiat and cryptocurrencies, opening up an entirely new avenue of potential participants.
In addition to these benefits, tokenized securities may also create opportunities within new markets. For example, although not fungible assets like traditional securities, there is a trove of wealth that is untouched by Wall Street, such as fine art, vintage wine, and exotic asset investments, which can now be more effectively accessed through tokenization.
Smart contract based security tokens may also relieve time for fund managers and asset issuers, as well as create new markets for oracle providers who verify that the underlying asset actually exists.
For example, issuers could code security token contracts to automate dividend payments, time revenue share pay-outs, set vesting periods and token lock-ups, price in product discounts, and create innovative new tokenomic models or additional utility functions.
Likewise, start-ups issuing equity through security tokens can automate capitalization table management to track their largest equity holders, enjoy automated record keeping, and reduce physical office hours spent on administrative tasks. These features make reporting and auditing STO raises significantly easier than their traditional counterparts.
Because security tokens are powered by blockchain technology, they subsequently provide a greater level of transparency for participants, who can view the security token smart contract terms on the blockchain. Similarly, tokenized assets’ immutable nature provides implicit ownership rights, provable on the blockchain.
STO organizers and issuers of tokenized securities are in the unique position of shedding costly intermediaries, such as brokers or financial intermediaries, and by proxy avoiding high intermediary fees.
Following traditional fundraising events, each share transfer incurs separate management costs, however with security tokens which can be distributed to contributors via the blockchain, the fees are limited to network transaction costs, removing middlemen.
Smart contracts and automation, as discussed above, can in many cases eliminate the need for fees associated with costly intermediaries which are unavoidable today, such as notaries and lawyers.
Other liquidity enhancing effects of security tokens include the fractionalization of assets. Assets which were traditionally difficult to divide, for example a gold bullion bar, may now be more easily represented as fractionalized assets through tokenization, bringing previously unrealized liquidity into such markets.
Likewise, as assets which traditionally had high barriers to entry due to practical complexity, such as debt, can now be fractionalized among many participants through tokenization. There are increased opportunities for retail investors' portfolios to gain exposure to a wider array of assets.
Secondary markets also enable micro-ownership of assets, such as equity in a start-up. This increases brand awareness, expands the ownership base, and meaningfully involves the wider community. Onboarding a large degree of micro-equity owners was previously impossible, due in part to the heavy burden of manual administration costs.
With the security token ecosystem maturing and finding stable footing through convenient and comprehensive platforms facilitating issuance, custody and trading, the already long list of benefits associated with securities tokenization will surely grow.
This could likewise be consolidated by a stronger differentiation between the cryptocurrency markets, which have typically been approached with caution by institutions, and the security token markets, which represent an entirely new regulated asset class.