Security Tokens – What comes next
January 7, 2019
Security tokens could be the next big thing but there are a lot of issues that are standing in the way of what could potentially be a relatively large wave. Last year we saw an onslaught of utility tokens, the majority of which have some very questionable economics or business models. It’s been argued that security tokens will be the next major technological iteration that will change the way that business is done. Considering the securities frameworks that are already in place in most countries, it’s going to be more difficult for security exchanges to create the same kind of regulatory arbitrage that we saw with Binance.
What will be securitized?
I don’t believe that we will see an exodus of companies currently listed as equities transferring and applying to be listed as security tokens. At the moment there is more institutional capital that is mandated to invest in equities. Absent a large run up in crypto prices, which would drive down the cost of capital, it’s likely that the cost of capital in crypto would normalize. However, as the market cap of the whole crypto complex is only $140bn (not considering the fiat that has been on-ramped into crypto), it is significantly less than the value of fiat that can be invested in equities globally. The whole of the crypto economy is a similar size to the top five largest endowments in the US presently. I accept that we might be in an abnormally low patch for crypto prices but the fact remains that there is more fiat money in a small pocket of institutions than the total market capitalization of the crypto complex.
There are two ways that we could see the security token market develop. Firstly, we could see assets which are typically securitized through equity structures being securitized through token structures. Secondly, we could see new projects that would benefit from additional governance or that require lower cost structures securitized through tokens. The path we take depends on who is able to influence social norms to create changes in human behavior. I believe it is more likely that we will see the latter occur because of the vested interested that will prevent equities from shifting into the token realm easily.
It’s more likely that we’ll see new and different projects securitized through tokens. We’ll see projects that would have been securitized but for the cost structure become tokenized. By this I mean that, we could see a floor in a building or a small commercial building tokenized. Previously, this would have been unimaginable because you would have had to install an investment manager to oversee the project. However, if we overlay what’s happening with the Internet of Things (IoT) with what’s possible with smart contracts, it’s likely that a floor or small building could be managed by IoT sensors to determine who comes and goes with smart contracts to manage the payouts to utilities and security holders.
To be successful, the first projects that are tokenized will likely need to be different from what we presently see securitized through equities. Recently, it was announced that Harbour issued tokens to securitise a college dorm. This is an interesting start. I wouldn’t be surprised if we saw water rights from different regions tokenised, with South Australia and Victoria being the natural first movers as they already have a tradeable water rights system. We might see taxi fleets or mobs of self-driving cars tokenized. It might be that we see music rights wrapped up in tokenized securities. There’s room for small groups of assets that can be electronically monitored and have their cash flows siphoned off to be managed through smart contracts on security tokens.
It’s likely that we see a proliferation of securitization before we see the securities exchanges spring up and provide a venue for liquidity. Harbour is making some important steps in the right direction as they move to securitise assets prior to being able to trade them actively on an exchange. Again, I see a number of companies that are aiming to create security exchanges. This is probably putting the cart in front of the horse as we’ll need to see a general acceptance of security tokens before there will be a sufficient need for secondary liquidity.
Local regulations are one of the key hurdles standing in front of security token exchanges. Securities token exchanges will need to be regulated as they’ll likely need to have fiat pairs. This means it is less likely that there will be the same opportunity for regulatory arbitrage as there was with Binance. This means that we’ll either see security token exchanges pop up in various jurisdictions to service each set of regulations in a similar way to how we have equity exchanges or security exchanges will attempt to use stable coins in their pairs and attempt to claim that they are exempt.
Another hurdle that’s facing security exchanges is liquidity. It’s a real chicken and egg problem because people won’t trade on security token exchanges unless there’s sufficient liquidity and there won’t be sufficient liquidity until people trade. If security token exchanges were to launch with only a few listings, it’s likely that liquidity wouldn’t be sufficient and we’d see spreads, or the gap between the price you can buy at and the price you can sell at, blow out. If investors have a poor initial experience with security tokens because of wide spreads or woe betide security tokens trade at a discount to their net asset value then it’s likely that investors will shun security tokens until the retail market develops further.
Presently, institutional investors don’t even have mandates that allow them to invest in security tokens. They will need to see sufficient underlying market structures before we see any demand coming from that corner of the market. Overall, it’s important that we have a proliferation of security tokens before we have a proliferation of security token exchanges. As new security tokens are developed the underlying infrastructures will continue to strengthen. Sketching it out in this way makes it feel like the rise of security tokens will be glacial as opposed to a violent eruption of innovation. I hope that the transition is somewhere in between but I’m cautious on the pace at which human behaviors will change to adapt to the new normal.
It’s likely that we see new the era of security tokens ushered in with new and interesting projects being tokenized as opposed to seeing traditional equities shifted to token exchanges. There are still a number of issues of securities exchanges to solve. New developing protocols will solve some of these issues. However, it’s likely that we need to see a propagation of security tokens before there’s a sufficiently deep market for them to be traded on security exchanges.