This is the first part of an insight series by Tanner De Witt partner, Pádraig Walsh, in which he gives his legal perspective on security token offerings. In this article, he starts from the basics, and asks and answers what are security token offerings and why we should care.
What is a token?
A token is a digital asset that represents rights in respect of an application built on a blockchain protocol. The owner of the token has the ability to access, use, receive the benefit of or transfer those rights.
What would it look like if I saw one?
Unique digital code.
Is a virtual asset the same as a digital asset?
Digital assets apply across all technologies. Virtual assets are specific to the blockchain and crypto space. So, virtual asset means a digital asset in the crypto space.
Are there different types of tokens?
Here are the broad categories:
- Utility tokens: A token with the primary purpose of providing access to, and buying or using a service provided on a blockchain platform.
- Payment (or currency) token: A token with the primary purpose of exchanging value or payment by users of a blockchain platform, for goods and services offered outside the platform.
- Security token: A token with the primary purpose of being a digital representation of a security instrument, or providing the rights and benefits of a security instrument.
- Asset token: A token with the primary purpose of being a digital representation of an ownership right in an underlying asset, or to revenue or profit generated by that asset. Asset tokens are a subset of security tokens.
- Hybrid token: A token that combines elements of these (and in future, other) categories of tokens.
These are evolving, and within these categories, there are tokens of many different stripes and colours.
What is the big fuss about security tokens?
One of the main problems is regulation. Many “utility” tokens can be classified as security tokens (or another form of regulated token). Also, even if a token is considered a utility token in one location, it could be considered a security token in another. It’s complicated, grey, uncertain and risky. There is much greater regulatory certainty if the token is treated by the project promoters as a security.
Regulation is a pretty heavy burden. Why would I want to take that on?
As the security token environment matures, the cost of a public offering will reduce. There will be disintermediation – less need for lawyers, brokers, registrars and other middle men. The ongoing compliance process will become significantly automated. Think: securities compliance as a service (SCaaS). Regulation could become … attractive.
It is just about regulation then?
That is only one reason. There are quite a few practical benefits to security tokens. These generally arise from the use of blockchain technology in a securities context. These include:
- Increased liquidity: Security tokens reduce friction in security transfer. This increases the ease of selling the security, and reduces the illiquidity discount often attributed to private investments.
- Increased market depth: Security tokens increase the number of people able to participate in token trading. This can be done by fractionalisation of the investment. So, an expensive investment may have an investment threshold too high for many to participate. If that can instead be divided into many fractional interests, the bar to investment can be reduced. Then, there are many more people who can participate. For instance, there may only be a handful of people in the world that could buy an original Andy Warhol. But there could be many more who could buy a security token that represents 1/1,000 of an Andy Warhol. That’s depth.
- Disintermediation: There should be less need, or even no need, for intermediaries who are essential to the current process. The share register will be automatically maintained in an irrefutable record. Transaction processing, clearing and settlement will be automated and almost instant. Assessment of permitted persons to participate will be governed by smart contracts, not lawyers.
We will tokenise the world!
Not quite. The best use case for security tokens is illiquid assets that are sensitive to the cost of capital but agnostic to the identity of investors.
Use English I can understand.
Well, let’s take a couple of examples.
Real estate is illiquid. You invest in it, and it is hard to exit your investment rapidly. Cost of capital largely dictates the attractiveness of the investment. The identity of the investors is not that important. A quality real estate asset is a prime example of a good use case for tokenisation.
On the flip side, take a social enterprise business. The identity of the key stakeholders in the business is a critical feature. The notion that it could be anybody would be shocking to the founders of the business. Not a good candidate for tokenisation.