The dialog around crypto has been dominated by a few main players. Everyone knows about Bitcoin and Ethereum, but I'm sure if you asked people to name an example of a security token many would struggle to find an example.
At its most basic level, the notion of a security is a financial interest that represents some type of ownership. Functionally speaking, securities are a mechanism that many organizations use to fundraise projects. Over time, various markets have developed for trading these financial interests. As technology has enabled more efficient forms of record keeping, securities are increasingly traded on digital platforms.
The idea of a Security Token is an evolution from the legacy financial instruments interfaced on Web2 applications. Just as securities traded on Web2 applications enabled more efficient and granular control of a given underlying security, the concept of Security Tokens – the Web3 flavor of securities – promises to go even further. As cool as this sounds, there remains a limited understanding around the way tokenization can benefit existing financial products like securities.
Check out some examples of Security Tokens in this post!
In this post, we explore security tokens in two important contexts. First, we look at the macro trends within securities, noting how technology is continually used as a mechanism to provide more efficient trading, more granular access to capital, and more creative products for users. Second, we identify a few areas within the traditional finance space that would benefit from the use of security tokens.
Securities are a type of financial product that have been around since the 17th century when stock in the East India Trading Company became available for purchase. Broadly speaking, a security refers to a tradable financial asset. Modernly, however, the concept of a security has developed a more loaded meaning. Some of the most popular types of securities today include financial interests in stocks, bonds, mutual funds, and exchange traded funds.
In the United States, we know a given financial instrument is an investment contract and, thus, a security when it meets a set of criteria laid out in the court case SEC v. W.J. Howey Co. The Howey test is fulfilled when there is an investment of money in a common enterprise with the expectation of profit to be derived from the efforts of others.
Looking at the way various technological means have been used to register, trade, sell, and issue securities, there have only been a few innovations that have meaningfully advanced the form of securities beyond paper contracts.
The big innovation with modern securities applications is the proliferation of online marketplaces that led to brokerage accounts and enabled electronic trading.
This development was very significant because it democratized access to securities, increased liquidity for security issuers, and enabled more granular trading of securities through the sale of fractional interests in an underlying security.
This seems like a good outcome. So why is the Web3 version of a security better than the legacy version of a security?
Imagine taking the ideas around efficiency, fractionalization, and accessibility of securities one step further. What would that enable?
The fundamental nature of securities is closely aligned with the fundamental thinking around blockchain and smart contracts. Both have a propensity for programmatic rule making, automated compliance functions, and configurable financial products.
A big challenge with the administration of traditional securities is costs. There are numerous intermediaries involved at various steps in the process of issuing, managing, and transferring securities. A more efficient type of securities – Security Tokens – use programmable rules to structure investments in ways that reduce the total number of required intermediaries
This means that the underlying operational expense of a given security will go down, and the value for the issuer and other investors will go up. While there will be some costs associated with the modernization of securities – going from Web2 apps to Security Tokens – this move will result in improved efficiency and transparency in the long term.
Perhaps one of the biggest strengths of Web3 is that the cultural phenomena of Decentralized Finance (DeFi) caused many people to realize that our legacy financial products are necessarily limited by the institutions that trade them. The same programmatic rules that enable the hyper-fractionalization of financial interests and the use of liquidity pools and staking for DeFi are already starting to be applied to the fractionalization of securitized interests and configuration of custom liquidity pools for Security Tokens.
Platforms like INX and tZero enable the trading of digital securities in a way that allows continuous trading from different types of investors all over the world. This increases the market size and availability for trading securities beyond the capabilities of legacy securities trading.
In the rest of this post, we outline some of the biggest areas of immediate opportunity for Security Tokens:
As a practical note, the examples we identify here can be configured under different types of American securities regulations. Our discussion does not dive into the specific types of issuances that take place; they could be issued to the public in the US under Reg D 506(b), Reg D 506(c), Reg CF, or Reg A and issued internationally under Reg S. Any given offering of securities could be issued in accordance with one or multiple of these offering types.
Microfinance, as a concept, has been around for a very long time. The 30 year, self-amortizing mortgage was a byproduct of necessity following the Great Depression, when only the wealthy could afford to purchase a home. By creating financial products that expand the market, technology offers a new type of access to the economy that enables more people to fully participate. As macroeconomic conditions have continued to see the prospect of homeownership and real estate ownership fall further out of reach, Security Tokens offer a mechanism for implementing fractional ownership of real estate to meet an unmet and underserved area of the economy. In this context, Security Tokens allow for coordination of multiple interests in an investment and create more liquidity for previously illiquid assets. This may sound simple, but the consulting group BCG estimates that the tokenization of global illiquid assets will be a $16 Trillion business opportunity by 2030.
Project finance is another area where Security Tokens bring improved reliability. Essentially, when a project is financed, some amount of money is contributed before it starts and the rewards are shared after the project is completed. This is the case for financing projects as diverse as blockbuster movies, construction projects, infrastructure maintenance, etc. While Security Tokens in this context are useful for tracking vestings and issuing dividends, they offer a degree of flexibility as well.
Alternative financing mechanisms are another macroeconomic phenomena that has seen a renaissance of the concept of patronage, the rise of crowdfunding, and the emergence of secondary trading markets. Now, instead of only having a couple of tools to raise funds for a project, there can be custom configuration of multiple tools to fundraise for a project. This provides new options for entrepreneurs, and greater access to investments for investors.
Building on concepts popularized by DeFi, Security Tokens can also provide liquidity to previously illiquid markets. In the case of a tokenized fund, this could make the process of administering a fund with a long time horizon simpler. An ability to understand, at an atomic level, the performance of the underlying assets of a fund, a fund's performance, and the potential value of shares in a fund means there is a new opportunity with tokenized funds to trade or provide liquidity within a fund.
This example is a bit more esoteric than the previous two examples, but the structure of a tokenized fund that is built using security tokens directly enables a new structure for managing assets, as well as a new type of action that can be taken with existing investments – the creation of a new form of liquidity in investments.
While the era of Security Tokens is relatively young, history promises that markets will embrace new technologies that make the process of issuing securities more efficient and that expand the market for those securities. Each new technology that has been used to issue securities also creates a new set of market behaviors that were previously unavailable. At Upside, we are excited about this potential and eager to work with businesses looking to build the financial infrastructure of the future.
If you would like to learn more about launching a Security Token with Upside, reach out here.