• Tim Carswell

Security Tokens - Liquidity & Regulation

Security Token Offerings (STOs) are a means for companies to issue securities in the form of a blockchain based digital token.

STOs can be considered as a successor to Initial Coin Offerings (ICOs) but, unlike ICOs, the value of an STO token is linked to the issuing company’s assets and will carry defined rights to, for instance, share in profits and other distributions. STOs are regulated in the UK by the Financial Conduct Authority (FCA) as a specified investment.

The perceived benefits of STOs include the democratisation of assets through fractional ownership, increased liquidity and market depth, 24/7 trading, reduction in costs and rapid settlement. Of those, increased liquidity is the one most widely promoted.

Liquidity arises from the ability of a market to facilitate the easy and quick sale/purchase of an asset without causing a drastic change in the asset's price. So, the premise behind tokenising assets (for instance, a vintage car, a valuable work of art or real estate) into small fractionalised digital units that can be traded instantly 24/7 is that the tokens will attract a large number of small investors and thus create a larger pool of liquidity. Devising investment products that are attractive to investors and building pools of liquidity will be the biggest challenge in the STO space. One of the key drivers will remain the underlying asset which must have an intrinsic worth or value that makes it an attractive investment opportunity.

Due to the limited number of completed STOs the creation of increased liquidity is still unproven and will probably be different from one asset class to another. So, for the time being, the best indicators of the likely demand for STOs remains similar models of more traditional fractional ownership and of these REITs (Real Estate Investment Trusts) are one of the most prominent. They involve publicly quoted shares and are widely used around the world as a means of encouraging small investors to invest in property by means of fractionalisation and tax breaks. In the USA alone some 80 million investors have invested in REITs worth an estimated $3 trillion but, taking a median, at the end of 2018 they were trading at a discount of 18% to asset value. That suggests that simply enabling mass investment in an asset class will not guarantee a value enhancement above the value of the underlying asset.

Other such indicators include the long established Alternative Investment Market (AIM) which is intended as a means of smaller companies raising capital through a public exchange but experience shows these companies often struggle to attract interest from smaller investors and liquidity in AIM listed shares is generally limited.

Even the majority of ICOs were supported by wealthy sophisticated investors and institutions rather than smaller investors. The result was that relatively few cryptoassets achieved an initial volume of more $1m and even they usually diminished quickly to daily dealings of a few thousand dollars. So ICOs also suggest that tokenisation will not necessarily generate liquidity and an active secondary market.

Turning now to the impact of the FCA, and other regulators globally, on STOs. Tokenisation permits the regulators to require the embedding of regulatory and compliance rules into security tokens which would then become a vehicle for ‘programmable regulation’. This is already happening at a basic level with automated blockchain based know-your-client (KYC) and anti-money laundering (AML) functions. In future, regulators could use crypto tokens and blockchain based ‘smart contracts’ to ensure that each element of a financial transaction can only be implemented strictly in accordance with applicable regulations and/or to ensure that any non-compliance is immediately reported to the regulator. For instance, a fund manager may have a limit on the amount of a particular category of security it is permitted to purchase for a client’s portfolio or may only be mandated to purchase investments of a particular type. In today’s world of largely analogue manual systems, breaches of these constraints are common and costly and time-consuming to rectify. Another example is that investors often lose material amounts of income, interest or dividends whilst trading a security due to the inability to precisely track its ownership throughout the often lengthy trading process. A fully automated, integrated blockchain based system would precisely identify the entitlement to such payments and automatically execute them.

The regulators are working with token issuers and exchanges in an attempt to achieve a balance between effective regulation and consumer protection without hindering the development of a properly functioning market in token based products. In April 2019 the London Stock Exchange allowed 20|30, a London based blockchain start-up, to raise £3 million by selling tokenised shares and settling them in a test environment on the LSE’s Turquoise platform. The LSE itself is in Cohort 5 of the FCA’s sandbox developing a product that will integrate blockchain within the LSE’s listing and trading functions for issuing and trading of equity securities.

It will remain up to the security token issuers and exchanges to create the pools of liquidity essential to a thriving secondary market and, as suggested above, that may be challenging. The extent to which the regulatory infrastructure might assist or hinder the process will become clearer in due course. In the UK, the FCA is due to publish its guidance on cryptoassets over the course of the Summer. Watch this space!

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