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Security Token elephant in the Wall Street Boardroom

by Bernard Lunn.

Bernard Lunn
Bernard Lunn
This is Part 2/chapter 6 in The Blockchain Economy serialised book. For the index please go here.

In Part 1, two chapters/posts focus on infrastructural questions related to Security Tokens:
Shy XBRL emerges blinking onto the Blockchain Economy stage to power Security Tokens
Digital Cooperatives may become the default corporate structure in the Blockchain Economy
This post/chapter focusses on Security Tokens and describes:
• How is a Security Token different from a Utility Token?
• How Security Tokens will disrupt 2 big cash spigots on Wall Street.
• Why Security Tokens suffer from the blind men describing an elephant problem.
• How Security Tokens could prove Thomas Piketty wrong - phew!
• The blurring boundaries in the battle for control over the tollbooth

Disruption is a much abused word, but applies in this context. The ability to raise money online globally for assets that can be instantly traded disrupts one of the biggest markets in the world - the global securities market that is colloquially known as Wall Street.

Note: Security Token is the accepted term, although the focus is mostly on Equity not Fixed Income; the term Equity Token has not entered common parlance. It is a moot point because for sophisticated/accredited investors it is often some hybrid instrument such as a Convertible Note. Security is also broad enough to encompass beneficial interest in an asset such as a Fund.

How is a Security Token different from a Utility Token?

This is the 101 part of this post/chapter.
Security and Utility Tokens have one thing in common (apart from the obvious which is the common use of the word Token). Both types of Tokens can be traded on Cryptocurrency exchanges as soon as they are issued and listed.
The key difference is that a Utility Token is a right to use something, not a financial instrument. Regulators, investors and entrepreneurs struggle with defining the difference because the concept of a Utility Token is so new and it has some characteristics that make it similar to a Security. The value of a Utility Token may go up and down in value based on the growth of the software/network in which you use that token. Most Utility Tokens have limited supply, which provides scarcity value. So the value of a Utility Token is tied to the success of the software/network in the market. These characteristics sound a bit like a Security.

However here are three major differences. A Utility Token does not give you:
1. Dividends or Fixed Income.
2. Capital Gains on sale of the business
3. Voting Rights.

The simplest difference is Regulation. In a Utility Token, a company sells a license/right to use some software (maybe via an API key). That license/right is expressed as a Token. That Token can be resold and you may make a profit/loss on that Token. That transaction is unregulated. Normal commercial laws apply but that is different from being regulated.

Some Securities Regulators have staked the claim that all Tokens that can be resold at a profit are Securities Tokens. Regulators like to regulate and the bigger the domain they can regulate the better. So it is natural for Securities Regulators to want to regulate Utility Tokens as if they are Securities; but that could be regulatory over reach that has yet to be tested in the courts.

There are certainly examples of utilities that can be sold for a profit that are nothing to do with Securities. Consider a Taxi Medallion in NYC. That is regulated (by the Taxi & Limousine Commission) but nobody is suggesting that Taxi Medallions be regulated by SEC.

Utility Tokens and Security Tokens will coexist in the market. Both have value but serve different functions.

In order to avoid trouble with Securities Regulators, entrepreneurs issuing Utility Tokens often choose to only raise money from accredited investors. Even if the Utility Token is judged by Regulators/Courts to be a Securities Token, raising money from accredited investors has different rules. This raises the question of the democratisation of finance which this chapter/post will return to later.

How Security Tokens will disrupt 2 big cash spigots on Wall Street

The two big cash spigots that Security Tokens will disrupt are:
• Venture Capital aka Growth Equity.
We normally associate VC with Silicon Valley not Wall Street. Somewhere along the road to changing the world, Silicon Valley became Wall Street West. While maintaining the founding myth about funding early stage, huge VC Funds actually became Private Equity Funds that invested later and later in the growth stage. A Series B in 2017 was like an IPO in 1997. Traditional VC Funds were then joined by other big pools of capital playing in the same market- Sovereign Wealth, Hedge Funds, Family Offices. Tokens, both Utility and Security, is a disruptive game changer as it gives founding teams another option. Passive Investors can still get in on the action but have to adjust their thinking in two ways. First, they have to take early stage risk. Second they have to answer the “why your cash?” question; what value will you add beyond cash? Tokens change the negotiating clout of founding teams and that is a big deal.

• IPO.
An earlier chapter/post covered why riders on the IPO gravy train watch the telegram ICO in dismay. Earlier this week, Bloomberg had an update entitled How Telegram's Crypto Coins May Attract $2.6 Billion. IPOs and ICOs now move from the $100m world to the $1 billion world. As the old joke goes “$100m here, $100m there, it does not sound like much but it all adds up”. Wall Street firms that do IPOs will move into the token world but will face more competition than they grew used to from companies that grew out of the token world.

In 1997, $100m was a medium sized IPO. From 1997 to 2017, $100m became a mega big VC round. In 2018, $100m has become a midsize Token round. A few boardrooms on Wall Street have taken notice of this inconvenient truth and a few are still in denial. Many face the truth and are figuring out how to best participate while publicly trashing the market until they figure it out.

Why Security Tokens suffer from the blind men describing an elephant problem

We don’t know what to call the event where a Security Token is offered. Is it a Security Token Offering (STO) or Token Asset Offering (TAO). These are good logical names, but so was ITO (Initial Token Offering) and that did not replace ICO in popular parlance. We maybe referring to ICOs well after the market has moved beyond currencies.

More importantly we don’t yet know how to talk about Security Tokens. It is like the ancient Indian fable about blind men describing an elephant. A group of blind men, who have never come across an elephant before, conceptualize what the elephant is like by touching it. Each blind man feels a different part of the elephant body, but only one part, such as the side or the tusk. They then describe the elephant based on their partial experience and their descriptions are in complete disagreement on what an elephant is. The moral of the parable is that humans have a tendency to project their partial experiences as the whole truth, ignore other people's partial experiences, and one should consider that one may be partially right and may have partial information.

The parts of the elephant that get most often described are:
• the regulatory part, how a Security Token is different from a Utility Token.
• the market access part, what combination of wallet, KYC, Exchange and broker will build the very lucrative tollbooth between issuer and investor.
• the governance part, how all the analog admininistrivia functions of a legacy securities transaction and ownership can be digitised and automated.

How Security Tokens may prove Thomas Piketty wrong - phew!

Piketty’s best-selling book Capital in the Twenty-First Century argues that growing wealth concentration and inequality is unstoppable (other than through global coordination around a progressive global wealth tax, which does seem unlikely as wealth is very mobile and can easily shift to more tex friendly jurisdictions).

Optimists argue that this bleak future is avoidable thanks to three big trends happening at the same time:
1. The fall in the cost to build new technology thanks to cloud, open source and open APIs.
2. The fall in the cost to bring new technology to market now that more than 50% of the 7 billion people on the planet can be reached digitally via their mobile phones.
3. The ability to raise capital and trade assets online.

I am an optimist, mostly because 3 has been added to the entrepreneur’s toolbox.
1&2 have been true for a while, but the same investors guarded the tollbooth for the ventures capitalising on that trend. For investors paying attention, this was a golden age. The third trend changes the balance of power between entrepreneur and investor. Now entrepreneurs need less capital for game-changing ventures and have more options to raise that capital.

What is that trust fund kid to do? Invest in hotels while they are being disrupted by AirBnB? Or get in on the next AirBnB? They will have to work harder to do the latter. So maybe Piketty will be wrong (and be happy to be wrong)?

The blurring boundaries in the battle for control over the tollbooth

The big market battle is over who will control the tollbooths between entrepreneur and investor. Today the tollbooth is controlled by firms on Wall Street (East and West). These firms in the analog world fall into distinct categories:
• Exchanges.
• Banks.
• Brokers.
• Investment Bankers.
• Funds.

Digital disruption always blurs the boundaries between discrete categories in the analog world. New digital entrants start by adopting the names from the analog world but soon discover that moving into an adjacent category is often as simple as adding another button to click.

For example, Wallets and Exchanges that operate KYC controls have strong tollbooth power in the the digital world and become more like brokers. A Wallet becomes like a Bank, a place you store your money and where money gets “wired” from when you want to do a transaction.

However, “there is an app for that” is not enough even if app becomes a wallet or a service. Automated digital services are not enough for wealthy people. Humans buy from humans if they have the luxury of choice and wealthy people have the luxury of choice. So there will be the equivalent of today’s Investment Bankers/Merchant Bankers, who work on the mantra of “schmooze offline, transact online”. They leave the lunch by sending the ICO transaction service to the investor’s mobile phone.

The money today is in connecting entrepreneurs to accredited (aka wealthy) investors. Thomas Piketty is heard saying “I told you so, the rich get richer”. The regulators maintain this by proclaiming their defence of the unaccredited (aka poor aka dumb) investors. This is a transitional stage because wealth is no guaranty of being a smart investor. Many entrepreneurs are brilliant at accumulating wealth by creating a business and lousy at investing. On the other hand, many poor people are great, disciplined investors albeit investing small amounts.

Regulation should focus on disciplining bad behaviour rather than simply defying an arbitrary boundary of who can invest. That will help protect all investors (including dumb but wealthy investors) and allow for the democratisation of capital markets. Today, the regulators are acting as if public equities markets are the only real market and that Token markets are niche at best and a passing fad at worst. That is like seeing Amazon in 1998 and saying that e-commerce was niche or passing fad.

The tollbooths to the huge unaccredited market include services like Coinbase (more accounts than Schwab) and Robinhood (growing like a weed thanks to zero fee trading).

This trend to democratisation has an added layer because of the new wealth formation in the Rest Of The World where the underlying foundations are not Anglo Saxon Protestantism and where markets need to accommodate Muslim, Confucian and Hindu realities practiced by billions.

In 1997, $100m was a medium sized IPO. From 1997 to 2017, $100m became a mega big VC round. In 2018, $100m has become a midsize Token round. A few boardrooms on Wall Street have taken notice of this inconvenient truth and a few are still in denial. Many face the truth and are figuring out how to best participate while publicly trashing the market until they figure it out.

Bernard Lunn
Founding Partner, Daily Fintech Advisers

Bernard Lunn is a serial entrepreneur, senior executive, adviser and a strategic dealmaker. He worked in Fintech before it was called that with startups, growth stage and turnaround ventures (incl. Misys, Temenos, IMS, ITRS). He has lived and worked in America, India, UK & Switzerland and is adept at cross border deals.

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