I was listening to a panel about Security Tokens last week and couldn’t avoid thinking that I somehow time-travelled to 2029, scratching my head in an attempt to remember what Michael J Fox did to go back in time…
While some of the content was deep, it generally felt like a(nother) missed opportunity to talk in more detail about the practicalities of security tokens, the current limitations and constraints, what they are good for at present, and what does it take to fulfil the real premise of this transformational piece of technology.
In my mind, Distributed Ledger Technology (DLT) and its application in the form of Security Tokens and Smart Contracts, is the most important development in financial services since the invention of coins, and will inevitably transform financial services beyond anything we can even envisage. However, it will take (a lot of) time, and whenever such nascent technologies’ future is wrongly mixed with/ mistaken by present, then fantasies are wrongly taken as vision, and (as we’ve all seen across the FinTech industry) founders, investors and FIs lose serious money/ wasting precious time and resources while trying to chase unrealistic dreams, and ultimately corroding the premise of such new technologies.
On my way back to 2019… I wrote a short summary based on my own experience, that will hopefully provide a more realistic view on security tokens and help investors, founders and FIs with assessing this technology through a more pragmatic lens.
What are Security Tokens (or tokenised assets?)
A Tokenised Asset (or as most people, including myself, inaccurately refer to as a Security Token) is a digital representation of underlying rights in an asset, over a distributed ledger.
Such underlying assets may include shares/ equity, debt, the derivative of which (e.g. options), any type of tangible or intangible assets, contractual rights, and so on. In simple terms, any legal right that may generate future cashflows to its owner should be considered as an asset. Hence, any digital representation of such right over DLT should be considered as a security token.
The financial services industry as we know it today has evolved over the last hundreds of years as a trusted (and licensed) intermediary between buyers and sellers, whose primary role was to create trust between parties to a transaction, across all asset classes. Over time, those intermediaries became too big, cumbersome, inefficient and insufficiently focused on their customers. Security tokens can change this:
Security tokens have the potential to eliminate the need for/ dependency on intermediaries to execute transactions, and consequently to reinvent the role of financial service providers – central/ retail/ commercial/ investment banks, brokers, lawyers, accountants, etc. – as we know it today.
This premise relies on the following attributes of security tokens, that should underpin the decision to use security tokens (vs. traditional alternatives):
- Fractional holding – security tokens allow you to split assets ownership/ attached rights in a way that was not possible before, and give smaller investors access to new asset classes and support more complex ownership/ governance structures, while creating new sources of liquidity for those who seek funding. For example, security tokens would allow small investors to own a fraction of Da Vinci’s Mona Lisa (at £8,000 a token for 100,000 tokens…), to invest in a £4B 160-MW renewable energy project in Morocco, or to lend to first-time home buyers
- Price discovery through better (and ongoing) visibility to the underlying asset(s), and as a result (in theory) a more efficient and liquid secondary market. Some argue that the 2008 crisis could have been prevented (or significantly less harmful) if the infamous CDOs were DLT-based and aggregated real-time information about the underlying properties, non-performing mortgages and the credit score/ affordability of the home owners. Such information would allow investors to better price the CDOs, spread the risk across the value chain and identify much earlier the evolving toxic nature of those assets
- The commercial terms can be codified into a legally-binding smart contract, and be verified/ monitored/ triggered automatically by Oracles, or (at present) through trusted third parties e.g. accountants/ lawyers/ independent inspectors etc. A smart contract is a piece of code that translates the commercial terms between parties into a legally-binding executable/ electronic contract, and should simplify/ streamline the execution of commercial terms/ legal rights of the parties to the transaction. Anyone who has ever invested in a company, purchased a property, taken out a loan or experienced a commercial dispute, would appreciate the appeal and potential of this wonder solution, that would save time, money, simplify the execution of contracts, prevent disputes and so on. For example, a smart contract that is connected to a borrower’s accounting system/ bank accounts would allow lenders to monitor in real-time different KPIs and breach of covenants by the borrower, and automatically trigger different contractual mechanisms to protect the lenders
- Lower transaction costs
- (Near) real-time transfer of ownership and settlement.
So what is still missing for a security token utopia?
In the decentralised utopian world I just returned from, any asset could be securitised and directly distributed to many different buyers in a matter of seconds. The intermediaries-free, many-to-many utopia.
Back in 2019, a proper analysis of the role/ number of actors who take part in (almost any) asset’s lifecycle, and (as a gap analysis) the extent to which security tokens and smart contract can replace/ automate those actors, will reveal the very limited applicability of security tokens as a vehicle of value transfer/ ownership, due to the following constraints:
- Transfer of ownership – at present, most assets’ ownership can’t be transferred digitally and requires a manual intervention/ reporting. While there are some workarounds in the form of shadow (decentralised) ledgers’, where changes in ownership are recorded, these solutions are not sustainable and entail material risks, in particular if the same asset’s ownership can be transferred manually
- Smart contracts are (to say the least) not-so-smart and (are still) very far from substituting ‘real’ contracts, or being anywhere near the point they could be considered as a reliable solution that addresses commercial/ legal challenges of mainstream asset classes/ transactions
- Oracles – the fuel that runs smart contracts and allows security tokens to aggregate information. Smart contracts’ applicability, adoption and usage are directly correlated/ subject to the availability of independent/ reliable/ verifiable data sources that can feed the smart contract and allow to verify identity/ underlying asset’s ownership/ performances, monitor covenants and other commercial terms, and trigger different (automatic/ manual) legal mechanisms upon occurrence of certain events. It’s hard to imagine how smart contracts will be widely used without compatible public Oracles/ DLT-based infrastructures like (to name a few) Companies House, CRAs, Land Registry and HMRC
- Digital identity – KYC and AML regulation still applies, even (more) in a decentralised world. In addition, in many cases parties to a transaction will not have any other way to know who are they doing business with. The adoption of Digital Identity will be an important milestone in the transition to a DLT-based financial services, and will reduce the reliance on third parties to do/ approve KYC/ AML between parties and the associated friction, time and costs
- Regulations – financial services are run by regulators. Simply put, as with any other change in financial services, it comes down to regulators (and regulators only) to decide if/ how changes happen. Assuming regulators do understand the strategic value of security tokens in promoting their objectives (effective competition, market stability, consumer protection, etc.) and support their wide adoption, they will need to address the new challenges security tokens and smart contracts present, including (a very partial list): clear definitions of attributes/ conditions for smart contracts’ enforceability, smart contracts audit requirements, the terms under which a transfer of ownership can be done via a smart contract/ using security tokens, new standards for digital transfer of ownership/ Oracles/ wallets, secondary market restrictions, and amongst all other challenges, regulators will need to have a more balanced approach/ set more progressive regulation to ‘Public Offering’ and respective prospectus/ information disclosure requirement, to unlock the real potential of security tokens
- Distribution – between now and the many-to-many, intermediaries-free decentralised utopia, the premise of democratising investments/ value transfer and giving the mass affluent market access to alternative assets, is constrained by/ largely dependent on traditional distribution channels that are not fit-for-purpose.
Show me the (tokenised) money
Security tokens, smart contracts and decentralised financial services open up a world of new opportunities to build meaningful technologies and propositions, which will address some of the limitations and shortfalls I mentioned above, and (coupled with regulation) will ultimately fuel the wide adoption and applications of DLT in financial services. That said, I can hear in my head Lindsey McMurray’s reminder that
‘Real disruption is doing the same thing, better’
This is more true than ever for DLT and its application in financial services, and should be the overarching theme for entrepreneurs, investors and FIs. With that in mind, some of the lower hanging fruits in the space include (vertically focused) enabling technologies for assets’ tokenisation, different custodian and trust services, STOs rating, smart contracts audit and Oracles’ enablers/ services.
Is the future already here?
The Back to the Future II (1989) writers imagined we’d have Hoverboards by 2015. As of today, we hardly have working prototypes… can we expect the same with security tokens? probably not – when 39% of the companies who participated in the last FCA cohort focus on assets’ tokensation, the London Stock Exchange lead an £18M investment round in Nivaura, the BIS publishes a paper which topic is How to build regulation into blockchain finance and European regulators already approved several prospectus of real estate-backed STOs, 2029 could be closer than one may think.
Gilad Amir, is an entrepreneur in residence at Pollen Street Capital and a FinTECHTalents 2019 Steering Committee Member.