- 1. Introduction
- 2. Digitization of Securities
- 3. Market Ecosystem
- 4. Digital Securities Offering: Stats and Insights
- 5. Barriers to Enter the Market
- 6. Legal Perspective
Digital Securities Market Research 2019 by Kepler Finance
With the breakneck speed at which the Blockchain industry continues to evolve, keeping up has never been more important. For most investors however, knowing what sources to trust in this respect is where difficulties arise. Here at Kepler Finance, due to our wide range of experience in the space, we believe that we fit the mold of an industry authority.
The Digital Securities market is about to become a big hit, though very little actionable information exists on it at this time. For that reason, we've compiled this research, including facts, figures and insights, for you to unlock their value. In the end, we hope to clarify exactly why they comprise a trusted technical framework and, in addition, what differentiates them from previous industry standards.
Digitization of Securities
Until just now, traditional finance hasn’t gone through massive disruptive changes and industry players need to find innovative approaches to scale.
Asset digitalization (aka tokenization) is creating a whole new user experience. Digitizing an asset and using a smart contract enables the shares’ owners, for example, to sell shares of private securities on complaint exchanges on-demand - and not suffer from their money being locked up in funds for years.
Basically, the new technology improves the ease of creating a transaction - aka “liquidity”. It isn’t doing anything to the financial security itself, but it changes the way ownership is managed and how the activities after the investment are automated.
However, everyone should also be aware that currently, there are unknown risks that the digitization process might bring. That is why we supplemented our fact-finding analysis with series of interviews with some of the leading companies operating in the Digital Securities market. We interviewed Issuance Platforms and Liquidity Providers, Custody Service Providers, Legal Counsels, Issuers and Investors to provide you with additional context. You will find their insights throughout.
Like successful companies, successful ecosystems go through distinct stages. The Digital Securities market has faced these major questions throughout the entire 2018: Could these assets eventually become the new norm in a more reputable ecosystem? Could it attract significant funding? Why are STOs often a better means to raise capital? Based on Kepler Finance’s study, last year conclusively answered these questions with a series of milestones.
The Digital Securities ecosystem is the combination of the several elements that together provide a whole spectrum of activity from the creating to the trading of a Digital Security. These elements include: Token Issuance, Legal Validation, Regulatory Compliance, Asset Custody, Token Trading Liquidity. All of it, including issuance, is going to be automated.
The protocol is exactly what makes the system work. The protocol guarantees that the token remains regulatory compliant according to any exemption that was used to fundraise. It manages who can transact with one another and who can hold the token. The protocol can also reject an attempted transaction more efficiently than in a legacy ecosystem, if it is going to violate compliance.
One of the leaders on the market - Securrency - is developing an interoperable multi-ledger protocol that maintains compliance on-chain and off-chain. It interacts in and with legacy systems and DLTs. In most cases, companies are focused on the development of an issuance platform, a token protocol or means for secondary market trading. Some, on the other hand, have a whole end-to-end platform where all the parties can interact on a global basis.
As digital securities gain steam in the financial markets, a clear infrastructure is beginning to form. Investors are taking action by placing large amounts into projects that support the issuance, exchange, and custody of digital securities. Harbor, which provides a platform and compliance protocol to standardize the way private securities are issued and traded on blockchains, raised $28 million in funding from major Silicon Valley venture capital firms. Securitize raised $12.75 million to digitize legacy securities with blockchain technology. According to the Kepler Finance database, more than $640 million has been invested in companies that are developing the technology that aims to mainstream the digitization of assets and securities. A global network of partners is at an early stage of development.
We will see more broker-dealers, more exchanges, more investment advisors, more lawyers and more crowdfunding portals embracing tokenization of securities. The market will get more professional, and far larger and more dynamic in 2019.
Here is what the market pioneers say about the various roles in the emerging ecosystem:
It’s important to note that Polymath is not an investment platform. It’s a platform where companies can easily create security tokens with built-in transfer restrictions, and use the audited smart contracts we have built to conduct their own Security Token Offerings. The company’s investors do not invest into STOs on the Polymath platform. Instead, they would participate however the company has decided to conduct their sale, which could be through the company directly, a broker-dealer, or an investment platform.
We are not a broker-dealer, an authorized person. We are a technology platform, we simply provide companies with the tools to allow them to do an end-to-end compliant token issuance and to manage those tokens in a compliant manner after issuance. The platform itself, the technology itself, is, in our opinion, far more efficient than the traditional ways of doing it, of conducting an issuance. Because, of course, you’ve got to onboard your users and conduct your KYC, your AML. All of that is going to be automated, and the issuance itself is going to be automated.
Digital Securities Offering: Stats and Insights
Initial discovery about the Digital Securities Offering process should start with the understanding that a security issuance in a tokenized format is not a new evolved version of an ICO. It’s a traditional financial instrument delivered in a new more efficient digital format. A company that plans to issue a token shouldn’t think that it’s going to immediately get listed and millions of investors around the world will rush to buy their token to trade it like they did with ICOs.
You might think that there are lots of completed Digital Securities Offerings since the issue is trending, but that is not the case yet. Token registration and issuance is not that straight-forward - it takes months of work by key stakeholders. Kepler Finance has analysed two completed offerings to demonstrate the main components of a successful Digital Securities Offering.
There is no doubt we’ll be seeing more successfully closed deals. According to the Kepler Finance database, 32 Digital Securities Offerings were announced as being listed on issuance platforms like Polymath, Neufund and others. From the infographics below, we see that most of the issuers that announced upcoming deals are located in the United States, as the infrastructure there is pretty developed by now. Germany has a chance to become the Blockchain Hub in Europe as there are a lot of lobbying initiatives made by the key market players like Neufund, which aims to democratize equity fundraising.
The Digital Securities Offering is a brand new fundraising format, and companies are faced with various challenges - so we asked issuers why have they decided to raise funds this way:
One of the main factors of using STO is the costs of execution and getting all the pieces together. IPOs require a lot of resources (time and money), there are tons of paperwork and it is not suitable for start-up like companies. Because of a programmable token’s nature, we can implement different features which makes tokens more robust. Smart contracts can help us deal with recurring things like automatic dividend payments. We can bake in KYC checks so tokens can only be sent to known persons. Also, smart contracts allow us to eliminate the middleman, cutting the administrative costs even further. Security tokens will be tradable 24/7, with almost instant settlement. Security and transparency of blockchain and ability to audit the system anytime. This will increase trust and credibility, and we believe that these features make companies more compliant. […] Blockchain definitely proved that it is useful for collecting and managing capital.
It is more cost efficient to do an STO rather than IPO. You can reach a broader network, STO is a global product. Digital ledger for investors to track their investment. It's easier to sell fractional ownership through STO.
According to Chris Eberle of Swarm, before commencing the process of capturing and tokenizing an asset on the blockchain, a potential token issuer must consider the following important issues:
Asset Type: The type of asset being tokenized can affect how the token will be structured.
Jurisdiction: The token issuer’s place of incorporation, the location of the targeted investors, the physical location of the underlying asset, and any restrictions related to the location where transactions are processed.
Legal Entity: Determine the ideal corporate structure and legal residence for the legal entity (LLC, SPV, partnership, etc.), which acts as the interface between token holders and the underlying asset.
Regulatory Compliance: In each jurisdiction, offering a security as an investment is regulated by laws that govern who can participate in the offering, the requirement to ensure the legitimacy of the source of their funds and the level of accreditation or investor sophistication they need to demonstrate. [...]
Funding: Will the purchase of tokens (and the allocation of capital) be restricted to cryptocurrencies or will it also accept fiat currencies, and how is this funding going to be raised.
Marketing: It is crucial to promote any fundraising activities to the appropriate target audiences in the relevant markets. A well-planned, strategic campaign is essential to successful fundraising.
Custodianship: For larger and institutional investors, it is important, for security and compliance requirements, to ensure that allocated capital is stored securely.
Secondary Trading: As with token issuance, secondary trading of security tokens is strictly regulated in most jurisdictions. It is important to have a secure trading functionality with exchanges that understand and can ensure regulatory compliance.
Post-Allocation Considerations: Investor Communication and Community Management, Dividend Payouts, Reporting and Updating NAV, Auditing, Tax, Governance
We asked the companies that were among of the first to launch STOs how they promoted their offerings:
We create buzz through content marketing channels. As digital securities is a fairly new term, a, lot of the effort goes into explaining what it is. We use our own channels, like blog and social media as well as media interviews and speaking engagements in relevant industry events. We are targeting not only cryptocurrency communities, but also the gaming industry, to gain base for our community. Because gamers are already familiar with virtual money, there is a lower learning curve and it is easier to grab their attention.
We created buzz around our offering through paying Indiegogo as our marketing agent as well as other media outlets.
Luc Falempin of Tokeny also shared his advice for the companies that plan to issue their tokens on platforms:
Issuers should have a well structured and thoughtful offer to appeal to investors. Firstly, it’s important that they join the right ecosystem of technical and business securities providers. Secondly, for issuers to connect and appeal to their audience, we recommend employing a customer-centric marketing approach. By understanding the value for the different types of investor personas, their characteristics, the channels they operate in - issuers can be sure their marketing campaigns will be highly relevant and effective.
Barriers to Enter the Market
The overall industry overview looks inspiring and promising, but the companies that are willing to enter the market are faced with a variety of challenges. Here is what key market participants are pointing out.
First of all, there is a knowledge learning curve with security tokens that you need to overcome. This applies not only to the team itself, but also to investors. There are some investors that will not feel comfortable in an unknown environment, so you need to pay attention and be ready to educate them. The second major drawback is uncertainty. This applies to multiple mediums. If we look on this from a legal point of view, all the frameworks and regulations are still being prepared. Although it’s a new asset class, it is still operating by old laws, which may create some collisions. We see that this will be a long process for all entities to come to a common conclusion, but it will be worth it. Uncertainty is also on the infrastructure side of this. Although we are reading about security token exchanges being founded and laws finalised, the whole ecosystem is nowhere near ready to fully function. We are in the early stage where everyone is still laying out foundations for the whole of this to work. So lot of things can go wrong.
The main barrier to creating and issuing a security token we are seeing today is fundraising and legal work. With Polymath, you can easily create a security token in 10 minutes so the tech has been figured out, but what still takes a large amount of time is a company’s fundraising and legal work.
Many jurisdictions outside the United States lack the legal and regulatory framework to enable security token offerings, although recent actions by countries intend to change that. In the United States, as security token offerings are by definition securities, STOs must follow the same rules as traditional securities offerings and are regulated by the Securities and Exchange Commission (SEC). Leaving legal and regulatory aside, the barriers to entry are:
● High transaction costs for an emerging fundraising method that are expected to drop as legal, tokenization, and other technology costs drop with more service providers.
● More investor awareness, knowledge, and acceptance of STOs, especially where in many instances, the investors are required to be accredited investors.
The main barrier is no longer technical, as many firms are making that easy for companies raising capital via STO's, it's education. Issuers and investors have to become comfortable with issuing tokens instead of stock certificate. It will take time, but it's where things are heading.
The barriers are significant, and range from blanket bans on tokenized offerings in certain countries, to uncertain regulatory classification in others. Despite the uncertainty that existed in 2017 around ICOs, the United States has actually emerged as one of the most welcoming markets for tokenized securities. The SEC hinted throughout 2017 that most tokenized offerings were securities, which motivated wise participants to explore registration exemptions early on in the ICO boom. This led to the BCAP and Science token sales which provided the blueprint for future compliant offerings. Overall, there is still a lack of institutional infrastructure to allow large money-managers to commit significant capital to the asset class. The recent opening of Open Finance Network's trading system to the general public, NASDAQ's commitment to build a security token exchange, and Fidelity's efforts to create institutional-quality custodial services should begin to remedy these shortcomings.
For issuers, I don’t think that there are any barriers to entering the market that didn’t exist before. In fact, the barriers may be lower; we intend for them to be lower in that the ability to use the technology will help reduce costs and truly streamline the process of capital formation. It’s so much easier for issuers to do it; it’s so much easier for their financial advisors, broker-dealers, or other authorized persons to use the technology to raise the capital, that now, unlike in the past, where if you want to raise 10-30 million dollars, you really needed to work through an investment bank and the fees would be high. Now, the ease, and the efficiency of the technology really should reduce the fees and make it easier to bring these types of smaller offerings to the market.
For token issuers, the biggest barrier is actually having an asset worth tokenizing. Then up-front cost of sound legal/financial counsel. Then real investment in marketing. For service providers in the space, token issuance platforms and the like, the actual barriers to entry are low. It’s the barriers to scale that are quite high at this point. Creating a token is easy. Creating it in an ecosystem where it can be safely held, compliantly traded, with real liquidity is something the industry does not yet have the infrastructure for. We believe that only open infrastructure (vs. walled garden solutions from centralized for-profit companies) can meet this need.
Education. Tokenized securities were born out of the crypto market and so our challenge is to educate people that compliant tokenized securities are are not only regulation-compliant, even better, they are regulation-enforcing, meaning that they don't only meet requirements of existing regulation, but also automatically block any wrong transaction in code.
The first key barrier to enter the tokenized securities market is the deployment of regulated exchanges and trading platforms. There are dozens of such initiatives all over the world, but completing the regulatory process takes about a year, and the security tokens industry is still not a year old. I see this barrier broken in Q1/Q2 of 2019.
The next barrier will be to improve regulations - we can work with existing regulations but they were not designed for digital trade and so regulators can easily improve the landscape for the industry.
And the third barrier is scalability of the platforms, which I know is being addressed by multiple tech companies and will be available when the market reach scale.
Digitizing securities and using smart contracts enable the automatic enforcement of the applicable financial markets’ rules and regulations. The idea that these rules can be coded for either local or global markets is an extremely powerful concept. The blockchain permits this to happen for the first time ever. But the next stage will bring its own challenges. It will take time, but it's where things are heading. Setting out what achievements were attained in terms of legal milestones throughout the entire 2018, we hope helps to show the way to what’s next.
In an evolving market, it is also important to understand which countries' legislative frameworks are the most STO-friendly. We asked Adv. Ziv Keinan, the Co-founder at Security Token Lawyers, to bring clarity to the issue:
STOs are very different from ICOs in the sense that if done correctly there is little regulatory risk in issuing a security token. You might say that STOs are private placements in an electronic wrapper. The result is that you can issue a security token in every jurisdiction which allows the sale of private securities, including the US and EU. With STOs there is no need to travel to the edges of the world looking for a friendly jurisdiction. With that being said, there are many other considerations aside from securities law compliance. For example, some banks won't work with crypto related funds, that means that if your STO is accepting crypto then you should find a Crypto friendly bank. Other consideration is tax. Trading and liquidity of STO tokens is raising some questions that, to this date, have not been fully resolved.
We asked the experts what countries would likely see the most STOs in 2019. Here are their thoughts on the matter:
STO structures can be complex and companies should evaluate carefully the jurisdictions to incorporate in because of the potential tax and accounting issues to the company as well as to potential STO investors. In addition, if the security token is not just a financial security token (such as a limited partner interest in a REIT), but the financing for a company that plans to use blockchain technology as an integral part of its operations, then picking a jurisdiction that is supportive of blockchain technology is essential. Is the country offering incentives to blockchain companies, working on proactive legislation and attracting the essential service providers to support a blockchain ecosystem? Right now the leader appears to be Malta.
We might see some STO's coming out of the US. The infrastructure there is pretty developed by now. Also, Singapore, Cayman, Swaziland, the UK and Germany.
We see these happening all over the place, and people coming with great ideas. I happen to think, though, that most of the activity will be in the United States.[...] What I’m talking about is a traditional security and we’re talking about mature, traditional financial markets. So I believe that you’ll see more of these coming out of the United States, along with other mature markets. So what we’ll see is more real security tokens being issued out of the traditional financial centers like, initially, the US and the UK, Hong Kong and Singapore and places like that. The real point of this technology is to allow what used to only happen in these traditional financial centers to happen all over the world, and happen in smaller markets with smaller financial professionals who are able to service their local community. But it won’t start there. I think it will still develop through the traditional markets and then it will expand from there.
The Millbrook Accord
In order for the Security Token movement to grow, companies need to agree on an unbiased standard. With this in mind the high-profile companies spearheaded by Techemy formed a working group The Millbrook Accord at the Blockchain South 2018 Leadership Summit in New Zealand. Their cooperation has resulted in the creation of a common framework to facilitate market interoperability of security tokens called Verified Token Framework (VTF).
The more players come together the better. Work in synergy with the VTF could pave the way for the next step in the evolution of crypto and blockchain powered finance.
Experts' Advice for Issuers and Investors
Understanding the regulatory compliance requirements in their jurisdiction and the obligations a token issuer has in this regard. Convincing management of the requirement to allocate a serious marketing budget and undertake a professional campaign for the token. Managing post-sale investor relations and communications. Building investor trust in their team and project, particularly if they do not have a public history of expertise and success. Liquidity - the ecosystem is just being created so there are limited exchanges and other liquidity sources as of yet.
For issuers and their financial professionals, they really need to understand that they’re going to have to do a better job of two things: number one, explaining to those traditional investors that the fact that its tokenized is not a scary thing, that it’s actually better for them, and two, more importantly, that they need to understand that they need to reach out to a wider investor base [...] who have historically not participated directly in the capital markets. Make sure that they have structured their deal properly […], and that they have worked closely with their lawyers to structure it legally and understand the compliance requirements not just in the jurisdictions in which they are issuing but also those in which they are marketing the securities. (For the investors) My suggestions would be around understanding and trusting the technology. What you’re receiving as an investor is no different than what you would’ve received if you had invested in a company in a traditional sense except that the format, one: makes it more efficient, two: because it’s blockchain-based, records transactions immutably, and three: the format makes it easier to trade the token subsequently, so the prospect of liquidity is much greater than it would be with private equity or private debt instruments in the pre-blockchain world.
2019 Forecast from Experts
Tokenization of Securities and Tokenized Securities will continue to grow at a steady rate. It will accelerate when the following conditions are met: Major branded stock exchanges start listing tokens (e.g. NASDAQ, NYSE, LSE, Deutsche Borse, Hong Kong, Singapore, etc.) Major Wall Street firms enter the fray as underwriters, and distributors and their retail customer holdings are accessible from their securities accounts. Custody is solved In the meantime, we will see many smaller entrepreneurial entrants in investment banking (e.g. Weild & Co.) and ATSs (e.g. Templum, INX) that embrace regulation (e.g., SEC and FINRA). These entities may ultimately be acquired by larger companies who are risk-averse, established and later entrants. We are leaving the anarchist and libertarian phase of these markets and seeing this technology for what it is - evolutionary, not revolutionary, promising significant cost savings and the ability to innovate securities (token) structures.
Next year looks very promising for the security token space. We can see that crucial ecosystem parts are being built, especially institutional services like custodial, loans and banking services which results in more interest from institutional players. The SEC and other regulatory bodies around the world are forming commissions to solve and define how it all should look and work. After we get legal confirmation, investors will feel more safe and will start to look in to working with this kind of digital asset. Overall, we will see more traction next year with all the platforms and exchanges launching.
I anticipate there will be a tremendous amount of change in the coming year for the digital security market. The energy around the budding innovations as it relates blockchain and finance is palpable, but there is also trepidation from issuers and investors alike as so many uncertainties remain. However, the “crypto winter” has given companies time to focus on building and developing better codes, systems, teams and products. I predict the pace of change will accelerate significantly when the big finance firms continue to follow firms like Fidelity and announce their involvement and commitment to digital assets.
The key development of 2019 is the deployment of regulated exchanges and trading platforms all over the world. Once this important infrastructure piece is in place, the market can start to grow rapidly. I also see the first generation security tokens mature and the market choosing the de-facto leader, so that it becomes a lot easier to deploy tradable security tokens. At the end of 2019 we'll start seeing second generation protocols improving security tokens even further. We see the learning curve among institutional investors improve month by month - people at the highest levels now begin to realize the massive potential in making securities digital - the potential for opening completely new markets, which until now where completely illiquid. In 2019 I see digitization of equity and debt securities (and their combination) across all types of companies. More specifically, real estate tokenization will be a major area.
We foresee more companies and investors entering the space in 2019 in a big way. There will be more security token trading venues, along with service providers like legal firms that specialize in security token offerings, custodians to safely hold investor’s security tokens, and advisors helping to raise capital for STOs. Based on the demand we see, there will be many companies raising large amounts of capital via STOs. Security tokens represent such an improvement over the legacy financial tech stack that it is only a matter of time before there are trillions of dollars worth of security tokens.
Development. I see healthy infrastructure and issuance development. On infrastructure, continued institutional investment and talent involvement in tokenization, issuance, exchange, and custody will drive technology improvement. On issuance, high issuer interest and increasing broker-dealer involvement will combine to produce interesting deals.
You’re not going to see the crazy spike like you saw in 2017 with ICOs. What you are going to see is the market grow in a much more meaningful way. [...] The amateurs are kind of pushed off the playing field, but not the professionals – and by that I mean not just the traditional banks, because I think there are going to be a lot of new players, but new and very mature, in terms of their view of the market. [...] In most jurisdictions, when you issue a security token, when you issue a private equity or debt instrument, it’s not tradable for some period of time. In many jurisdictions, there’s a hold period. So if I buy that security, I can’t trade it for at least six months or a year. [...] As these things trade, they won’t trade with the frequency that these cryptocurrencies trade. [...] It will be a much, much less dynamic market, but it will still be rich and deep, and it will still create the kind of liquidity that’s necessary for these types of assets.
Financial Securities - are tradable financial assets that gets their value from a contractual claim on an underlying asset that may be real or intangible. For example, commodities and property are real assets, but commodity futures, exchange-traded funds (ETFs) and real estate investment trusts (REITs) constitute financial assets whose value depends on the underlying real assets. Financial assets are usually more liquid than other tangible assets, such as commodities or real estate, and may be traded on financial markets. Generally, securities represent an investment and a means by which companies and other commercial enterprises can raise new capital.
Derivative - is a financial instrument whose value is derived from the value of an underlying security. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset. The most common derivatives include options, futures contracts, forward contracts, swaps, collateralized mortgage obligations (CMOs), rights and warrants.
Digitization of Securities (also referred to as Securities Tokenization) - is the process of the creation of a derivative instrument in the form of a blockchain token representing the rights to a financial security (underlying). Digitization targets increasing liquidity and efficiency in capital formation, enhancing transparency and reducing administration costs.
Digital Securities (also referred to as Security Tokens) - are derivative instruments in the form of a blockchain tokens representing the rights to a financial security (underlying). Transactions with the token recorded on the distributed ledger cannot be undone or erased. Access to the information is customizable based on the ledger setup (public, private or hybrid).
Compliant Ecosystem - the entire set of procedures, actions, activities, processes and parties ensuring that a financial services business adheres to statutory rules and regulations and internal controls. Digitizing securities and using smart contracts enable automatic enforcement of the applicable financial markets’ rules and regulations.
Digital Securities Issuer - a legal entity that offers its digital securities directly to investors to finance its operations. Issuers are legally bound by the offering rules, representations and reporting requirements, and other covenants relating to financials, material developments and any other operational activities as required by the applicable regulations.
Digital Securities Offering (“DSO” or Security Token Offering, “STO”) - the type of fundraising using Digital Securities as a instrument of raising capital within a fully compliant ecosystem.
Digital Securities Issuance Platform - a technology platform providing issuers with the tools to conduct a DSO, based on such platform’s security token standard.
Liquidity - is the degree to which an asset or security can be quickly bought or sold in the market without affecting the securities' price. There are market makers for enhancing securities’ liquidity in the secondary market.
Market Maker - is a bank, brokerage company or a person that always stands ready to buy and sell securities. Without market makers, it would take considerably longer for buyers and sellers to be matched up with one another, reducing liquidity and potentially increasing trading costs as it became more difficult to enter or exit positions.
About Kepler Finance
Kepler Finance is dedicated to providing comprehensive data focused on the DLT and digital asset sector for investors. Our own research into blockchain companies shows us how fragmented blockchain investment data is at both the company and industry levels. We believe that solving this problem will increase trust and unlock value in the sector.
The data shown in the research should not be considered investment advice. No one should make any investment decision without first consulting their own financial advisor and conducting their own research and due diligence. This is a non-exhaustive list. It is important to discuss these with legal and tax experts in the relevant jurisdic.