This article is an introduction to securities and the concept of a security token. Security tokens are a trendy topic in the finance and blockchain communities, as they promise to disrupt how investing is carried out globally. As the security token concept is novel, we hope to clarify it and the surrounding terminology for both technical and finance oriented audiences, professionals and non-professionals alike. The aim of this article is to look at: how security tokens can be defined, how they are different from traditional securities, what kind of tokenised investment deals exist and what regulatory limitations there are.
Clarifying the concept of a security token
There is no such financial instrument as a security token.
The concept of securities has been around for a long time. The first bonds were issued back in 1517 and the first stock was issued in 1602. The modern twist of this, creating a security token, means taking these existing financial instruments and starting to maintain shareholder balances on a distributed ledger or a blockchain. This process is called tokenisation: issuing digital tokens that present the shares of an underlying financial instrument on a blockchain.
When talking about security tokens in the context of investing, it is easier if one refers to the form of an underlying instrument, like a tokenised bond or tokenised stock. The characteristics of an investment deal are defined by the financial instrument and token is just an online presentation of it.
A blockchain is rather different to the legacy way of maintaining owner balances in a spreadsheet or a privately owned centralised database. By having distributed ledger technology we gain efficiencies in transparency, audit recording, shareholders registry maintenance, paper-free transfer speed and cost, interoperability between software systems and global reach. With tokens, it is easier and faster for both buyer and seller to transact when no middlemen are needed.
We believe that the new distributed ledger features offer the potential to make securities easier to manage and trade, driving equal access and better price transparency for investing.
Tokenising an investment deal does not make the investment itself more attractive.
Tokenising does not directly change the dynamics of risk and return of investments. If an investment is not profitable then it won't be profitable after tokenisation. What we aim to disrupt is sourcing investors, cost efficiency of large volume investing and lowering liquidity premium by making tokens easier to trade in the future.
Defining different securities and assets
Securities are generally defined as "tradable financial instruments", although the exact definition and language vary across jurisdictions. Securities are a subset of assets which are resources with an economic value. Outside of the securities definition are non-securities which include real assets, like physical items (cars, art) and intangible assets like copyright and patents.
There are different legal requirements, or regulations, defining how security issuers and investors must act and be treated. Often this has to do with reporting requirements and protecting investors and market integrity.
Securities can "pay out" meaning if the underlying business generates money the investor receives profit in the form of dividends or interest for their investment.
Alongside pay out assets are speculative assets. The most common speculative assets are commodities futures (oil) and forex markets (currencies). Speculative investors receive profits if the value of the asset goes up; the assets themselves do not create value besides capital appreciation.
We may tokenise securities as well as real assets. Tokenisation may turn non-securities into securities. For example, MasterWorks is tokenising fine art paintings by creating one Special Purpose Vehicle (SPV) company to own each painting. You can trade individual tokenised shares of SPV, those being securities, but the painting itself stays as a real asset.
Issuers and the creation of securities
Securities are created by an issuer.
When talking in the context of tradable financial instruments, the issuer commonly has a fundraising motive. For example, an issuer can be a company issuing new shares to fund future expansion. An issuer can be also governmental body like in treasury bond markets.
The issuer specifies in a term sheet that states the parameters, like securities type and price, of the transaction. Investors then take this offer, pay the issuer and receive offered securities.
Primary and secondary markets
When the issuer sells a security for the first time it is called a primary market offering. When the original investor trades with a security it is called trading in a secondary market.
Private and public securities
Private securities are shares issued by privately held companies, loans and more. The number of investors is small. Private securities are called illiquid as they do not have large or public secondary markets and finding a counterparty for a trade is difficult.
Publicly listed securities, or simply listed securities, are financial instruments that are subject to public trading like publicly traded stock and bonds. There exist secondary markets, usually, exchanges, where investors can through their brokers easily offer to buy and sell securities.
Tokenisation with blockchain provides the technology to make anything easily publicly tradable but does not provide rules to govern this activity. As we later describe there are several regulatory requirements for listed securities. Regulators seek to maintain the market integrity by ensuring both issuers and investors follow market rules and that nobody has an unfair advantage. Often public trading is legally prohibited unless the regulatory requirements are fulfilled first.
Crowdfunding, or equity crowdfunding, is raising investments from a large number of unprofessional investors. Individually each investor puts in little money but together investments make a big pot. Crowdfunding is different from crowdsales, like Kickstarter, where one is participating in the presale of a well-defined product. The amounts raised through crowdfunding are capped so that they stay within the range of small and medium businesses.
Jurisdictions, where regulation otherwise would prevent this kind of activity, have lowered limitations for crowdfunding. In the UK the crowdfunding must happen on a licensed platform. In the USA crowdfunded companies need to use lightweight Reg CF filings.
Securities are characterised by, and to a degree named after, their legal owner's rights. These include economic rights, control rights, information rights, litigation rights and, in the case of commodity derivatives, physical delivery rights.
The economic rights are the most defining characteristics of a security. Economic rights define whether a financial instrument is equity or debt like.
In equity, the economic right of an investor is to receive dividends of the company profits. The amount of dividends the company pays out is decided in the company's shareholder meetings.
If investors are unconditionally paid interest regardless of issuer profitability then the security is debt-like. In debt, payments need to happen as agreed, so these securities are called fixed income.
The distinction between equity and debt can sometimes be blurred. Some top line securities, like revenue participation notes and preferred stock, have characteristics of both equity and debt and thus called hybrids or quasi-equity.
Investors, to guarantee the success of their investment, may want to retain the ability to steer the direction of the company. Equity control rights come in the form of shareholder voting rights. Voting rights are exercised in a shareholder meeting. This meeting is held once in a year and can be called an annual general meeting.
A company can have several stock series with various different voting rights. Common stock is "normal stock" where one share gives you one vote and a proportion of dividends. Dual share class stocks have different share series which are usually called Class A and Class B. Dual shares are common when an issuer wants to preserve control on early founders over later stage investors.
Usually, debt instruments lack control rights.
Investors need to receive factually correct information to make rational investment decisions. An Issuer has the duty to report certain information to investors. These requirements are often legally binding, being written into the corporate law of the jurisdiction where the issuer is incorporated.
Privately held securities
Private company shareholders have a right to receive an annual report. This includes audited financial statements. Shareholders have a right to see other shareholders in the cap table (shareholders registry). This information may be shared with a Companies House that maintains company records for the government and the public.
Publicly listed companies have stringent reporting requirements for stock and bond holders.
When issuing a public security a document called a prospectus is prepared to contain necessary information and disclosures for investment decisions. The format of a prospectus is closely prescribed by law and regulation on a national and pan European basis.
Once a security becomes publicly traded, the issuer reports information required by the relevant regulatory authorities which includes quarterly and annual financial reports and, if required, profit warnings.
Publicly traded security communications are subject to fair and equal investor treatment. Investors must have any information regarding the possible effect to the security price disclosed publicly to prevent insider trading.
In the case investors feel they are mistreated, they can exercise their litigation rights against the issuer. The term "shareholder litigation" comprises all civil actions brought by shareholders against managerial wrongdoings within companies in order to recover economic losses caused by them. This is called a derivative suit.
For debt instruments, the most common case is that the issuer becomes delinquent and does not pay the interest they owe to the investors meaning the issuer has defaulted. The investors ask a court for a bankruptcy process, where investors take over control of any debt collaterals and force the issuer to liquidate its assets to cover any remaining debt. In bankruptcy, debt lenders are preferred over equity holders, as equity holders take the risk for the issuer business to succeed.
For equity instruments, a common cause of litigation rights is when the issuer misleads or fails to disclose information affecting the securities price or a corporate governance failure, like misusing capital. Investors can proceed to sue the company management for misconduct.
Derivative suits are more common in the USA. In Europe, it is more difficult and uncommon to bring legal action against directors for breach of duty.
Physical delivery rights
Physical delivery rights are exclusive to commodity derivatives.
When commodities are traded, physical delivery is a term in an options or futures contract which requires the actual underlying asset to be delivered upon the specified delivery date, rather than being traded out with offsetting contracts.
Most commodity futures are traded without physical delivery. Commodities are held in warehouses. The buyer may have a "right for pick up", or they can arrange the actual delivery with a warehouse.
Securities regulation is driven by investor protection and market risks.
The goal for regulators is to ensure that investors get factually correct information to make rational investment decisions and different investors are treated fairly. Industry gatekeepers act according to regulation which creates frameworks, legal documents and obligations, for market participants, whether the issuers or investors, to follow. To ensure this, companies must be licenced to operate in financial markets.
The more accessible the deal is to the general public more regulation it is likely to trigger. The heaviest pile of paperwork is a fully formal prospectus that publicly listed companies need to fill in. Regulators also keep a keen eye on the market risk e.g. to ensure banks have enough liquid assets on their balance sheet so that they can keep functioning in a severe financial downturn.
Most regulation does not involve distributed ledgers but is focused on: ensuring fair investor treatment, maintaining the order of a society and enabling tax collection. Regardless of whether securities are presented as tokens or not, these requirements must be fulfilled.
Some examples of regulatory requirements are:
- Limitations on who can sell securities: EU investment firm, US broker-dealer regulation, FCA regulated brokers and corporate financiers
- Limitations on who can invest in securities offerings: EU sophisticated and professional investor rules and US accredited investor rules
- Limitations who can advise on deals: UK requires "investment advertisements" to be approved by an FCA accredited person, AIM listings require an FCA approved NOMAD and Broker;
- Limitations who can run a marketplace: EU MTF license, USA ATS license
- Disclosure requirements at secondary markets: quarterly reporting, audits
Where does the blockchain community stand today
Tokenisation was popularised by initial coin offerings (ICOs).
An ICO is a fundraising method where investors speculate on the capital appreciation of a bought virtual currency. The issuer creates a currency, or a token, to be used as a payment method within an online platform the issuer is building. The currency has a fixed supply. The speculative profit comes from the platform growth that drives more demand for the existing currency supply. Early investors can then sell currency they bought for profit when the overall market grows.
Tokens are immediately tradable in virtual currency exchanges, unlike stock in startup and growth company fundraising. The existence of secondary markets gives additional investor protection, as it is easier to get in and out from the investment.
ICOs and token trading on cryptocurrency exchanges proved:
- There is an unmet global demand for small-scale investments and trading
- Crowdfunding is a feasible alternative to other forms of fundraising
- Tokenisation is an effective way of managing a massive number of investors
ICOs, facing a mixture of regulation and lack of regulation, have their own share of problems. Issuers lack disclosure requirements and investors do not have information rights, making investment decisions risky. Furthermore, with a few exceptions, there are no control rights, so investors cannot steer the project and keep the management accountable.
The value promise of security tokens is to combine the scalability advantages of token sales with the investor protection of regulated securities.
What examples of tokenised securities we have seen
At the writing of this article, the first security token offerings (STOs) have started to become public. TokenMarket lists them on our security token calendar.
Many of these deals are currently private placements and not truly open for public, as general solicitation might trigger the heavy regulation of publicly listed securities.
As the industry is young, security token deals investor communications still need refining. Issuers use the term "security token" but do not necessarily clarify whether it is an equity, debt, or indeed any form of securitised investment, and what the investor legal rights may be.
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