The Premise and Promise of Digital Securities (DS)

What they are, how they improve on existing models, and what makes them different from utility tokens.

(Part 1 of 3 in a series about Digital Securities)

From the CoinMarketCap editorial desk: Continuing with our exploration of security tokens, we asked the Securitize team to share their facts and opinions about digital securities, the landscape and what challenges lie ahead. This is the first part of a three-part series!

To understand why digital securities (DS), or security tokens, are such a big deal, it’s a good idea to first understand some basics about the securities industry itself.

Essentially, securities are a fungible and negotiable financial instrument that holds monetary value. More specifically, they represent an ownership position in one of two asset classes: equity or debt.

Equity is represented by a stock or share in an asset class such as a business, fund, or real estate. An example of an equity security would be stock in a company like Apple, for instance.

Another example more suited for DSs would be the private placement offering, such as the private company UBER, which has raised $24.4B in private markets (in debt and equity), and yet none of its stock is tradeable on public exchanges or marketplaces.

Debt securities are represented by bonds or fractional ownership in some form of debt (private or public). An example of this would be when a municipality issues a bond to build a bridge where they guarantee a fixed interest rate over time for bondholders.

Note: Because DS and digital securities offerings (DSOs) are most commonly applied to private placements, we will focus on this subset of securities that according to an SEC report the amounted to  $1.7T, with over 40,000 new private placement offerings in 2017 alone. For a sense of how early we are in this process, the Website Security Token Market lists only 63 DSOs and our reviewed of those shows that many are not active and only a handful have actually successfully issued DSs on the blockchain in 2018.

Understanding the securities ecosystem

Without getting more complex, it is important to understand that securities and securities markets like the ones described above have been around for centuries, long before there were computers, blockchains, distributed ledger technologies, or cryptocurrencies. The securities industry has been a massive industry for a long time, with somewhere between 12 and 20 specialized fields all working together to create a functional ecosystem.

The current system for issuing and managing private placements is mostly analog and controlled by any number of insulated legacy systems that do not communicate easily with each other.  A few examples are:

  • Record keeping for private placement markets is obviously key as you have to keep track of who owns what. Today, most of that record keeping is done on an Excel spreadsheet in someone’s office or with centralized databases.
  • Any dividends, voting, issuances, communications, and all other administrative tasks are mostly manual, and therefore susceptible to human error.
  • The entire system is performed and maintained behind closed doors with little or no transparency for the investors, which creates a burden for investors to ensure that the details of the investment contract are being adhered to.
  • Trading a private security is also extremely complicated. It is a very manual, legal-intensive process, and the settlement of a single trade could take months to finalize therefore creating a market that is extremely illiquid.

Today’s markets are a mishmash of legacy systems and inefficient. Overall, it is expensive and complicated for both issuers and investors. The ecosystem is ripe for a revolutionary upgrade and DSs present a well-rounded solution.

Simply put, a DS is a digital version of a paper stock that enables low-risk management, proxy votes, liquidity and seamless dividend distributions among other features. Individuals own digital shares of a traditional security (eg. stocks, bonds and real estate) through tokens which can be coded to allow for instant settlements so there is no counterparty risk, eliminating billions of dollars in intermediary fees.  It’s main selling point is that DSs enables investors to invest in private companies and startups and also have instant liquidity in global markets.

An overview of DS adoption

Enter DSs. Well, almost.

In March of 2016, the ICO explosion was born on the heels of Vitalik Buterin’s launch of the first stable version of the Ethereum blockchain. We all witnessed the power of distributed ledger technology as a platform for issuing, managing, and trading the so called “utility tokens”.

The only problem — ICOs were not being sold as securities; they were being sold and marketed as network incentives or pre-sold rights to products yet to be delivered. Regardless, by definition, they were actually securities (see above) – something the SEC has recently been keen to reconcile.

But ICOs did something else besides causing a lot of heartache for investors and issuers. They proved that private placement markets were ripe for takeover by a new technology that provided easier asset discovery, instant settlements, complete transparency, autonomous ownership, and global 24/7 liquidity. The concept was so wildly successful that the combined blockchain market cap went from $16B in Q1 2017 to $323B in Q4 (2000% increase) in a single year.

Then the value of cryptocurrencies and utility tokens came crashing down.

What does the bursting crypto bubble mean for DSs?

The answer: nothing.

The plummeting price of Bitcoin and any other cryptocurrency has no effect on the DS market. How is that possible, you ask? Because, as we’ve learned, DSs are actually just “analog securities” whose cap tables and trades are recorded on the blockchain.

Instead of the onerous manual processes that the current centralized human-dependent model rely on (think errors and corruption), smart contracts are used to automate processes, making settlements instantaneous and most key transactions completely trustless for both the issuer and investor.

DSs can help to improve transparency measures by providing issuers with an almost real-time cap table and simplify governance processes through voting or payout distribution.

Blockchains are also public, meaning anyone (including regulators) can get a full audit of the cap table and trades instantly. What Bitcoin was to currencies, DSs are to ownership.

So, what happens next?

2019 needs to be the year of increased liquidity of digital securities. DSs offer so many regulatory (automated compliance), administrative advantages and ultimately more liquidity over traditional analog securities (see table), so it is logical that issuers and investors will ultimately prefer the digital version over the analog one. This trend is similar to any number of examples, such as e-mail supplanting snail mail, DVDs scooching out VHS tapes, etc.

And, because all assets, not just private placements, have the potential to be turned into DSs, the true limits of the DS market is impossible to predict.

If the ICO craze is any indication of how investors will react to being able to discover, invest in, and trade private DSs on a blockchain in a compliant and trustless way, we will truly see global capital markets transform in profound ways.

But until then we can look at what’s true today. What’s true today is that DSs exist on public blockchains, have been issued by existing companies (Blockchain Capital, SPiCE VC, 22x, Augmate, Science Blockchain).

They work as advertised, and are very quickly fulfilling their promise to transform how issuers and investors interact in compliant ways across global markets.

About the author:

Carlos Domingo is the founder and CEO of Securitize, an end-to-end platform for issuers seeking to tokenize assets. He is also the founder and crypto capitalist of SPiCE VC the first truly liquid, inclusive and transparent tokenized VC on the blockchain. He was formerly CEO of Telefonica R&D and CEO of New Business and Innovation at Telefonica Digital.