Tokenized securities were a disaster in 2018. Investors didn’t want them, regulators didn’t like them, and issuers used them to offer scammy small-caps. All of those things need to change before we can use a tokenized format for attractive securities offers.
The SEC has admitted that tokenized securities are likely to become important. Currently, we use complicated organizations and mainframe systems to deliver financial products. If we can do the same thing with simple scripts, we can improve efficiency, innovation and risk-management. Maybe that’s why I’m getting a lot of new questions about tokenized securities.
Exchanges are obsolete
I get pitched that exchanges are the missing link. Maybe a new generation of “digital” securities exchanges will take care of pesky problems with regulation and liquidity, and investors will throw money at their crappy small-cap offers.
This is unlikely. Digital securities exchange is a terrible business. Many startup exchanges have already failed. They cannot make money doing exchange, because the turnover on small-cap securities is low, and it doesn’t generate enough trading fees. So, they are trying to make money selling securities, but they are expensive (5%) and they don’t have investors anyway. They attract burdensome regulation. Now they are obsolete and being replaced by software.
An exchange essentially does three things: 1) It collects and matches bids and offers; 2) It manages settlement of trades; 3) It qualifies investors as being legal holders of securities and able to settle trades. In a networked market, traders can match bids and offers using simple bulletin boards or full-featured systems like Uniswap. These software applications are cheap and easy to run. In a blockchain system, exchanges and member brokers aren’t needed to settle trades. The settlement is built into the on-chain transactions, and anyone can do it for any OTC transaction. That leaves exchanges in the role of qualifying investors. They are essentially selling customer lists.
Active trading is not a necessary part of the value of digital securities.
- Many digital securities will fit in the gap between partnerships that last for ten years, and securities that are traded daily. These assets don’t have enough size and liquidity and disclosure to justify an exchange market. They may be damaged by an exchange market, which tends to drive down prices of low-volume securities because of a lack of bidders. “Secondary” trading of these assets is important and is growing rapidly. It results in a small volume of trades that are easily handled by an OTC market. That OTC market will be simpler for participants if they can use “digital asset” programming to qualify investors, distribute information, distribute money, and settle trades.
- Some higher volume products to do not need a secondary market because they are redeemable. Consider a mutual fund, a money market fund, a callable loan, a bank product, or any other redeemable investment product. If users can buy and redeem the product from the issuer, they don’t need to trade with each other. Digital securities are a useful format for these products because they make distribution and redemption more efficient, and because they can be remixed through scripts into new types of funds, derivatives, and structured products.
Qualifying investors is important
Qualifying investors is the only way to deal with securities regulation.
There are two broad types of digital assets: Unregulated crypto, and securities. Buyers and traders like crypto BECAUSE it is unregulated. In the edge cases, like stablecoins, they prefer the less regulated versions, such as Tether. Tether may be borderline illegal, and it may even be worthless, but it lowers the burden of compliance and increases the speed of moving money around.
To qualify as unregulated crypto, you will need a token that is created and earned by a community, and not by an issuer. True open source community crypto is a small and fascinating use case. Bitcoin is the perfect case. It was never sold by an issuer. Every bitcoin was earned through mining.
For almost anything else, you will need securities. You will need issuers that build and manage products and infrastructure. When those issuers ask for investments, they are creating securities. The issuance and trading of securities is heavily regulated. If you want to distribute globally (which is one of the main points of digital securities), then you will be dealing with several sets of local regulators and rules.
You will need to qualify and classify investors according to which regulators protect them. Securities regulation is designed to protect specific types of investors. If you can target one specific category of investor, then you will know how to comply with the securities regulations that protect that category of investor.
Types of securities investors
Here are some of the major categories of investors.
International Family Offices
Rich people set up family offices that can invest from local and offshore accounts. They are assumed to be sophisticated investors who can take care of themselves. They avoid regulation, and regulators do not worry about protecting them. Regulators will not block sales to this market, and they may even promote sales if they can get better, automated reporting. Technically, these family offices will qualify in one of the sophisticated investor categories below. Because of economic growth and rising inequality, they control trillions of dollars in investable funds.
“Qualified Institutional Buyers” are professional funds with more than $100M in assets. They have special privileges in the US under regulation 144a. They can buy Reg D securities (almost any private offer) even during a lockup period, they can resell them outside the US (under Reg S), and they can trade amongst themselves. This is another category of investors that can take care of themselves. They control a lot of assets, including retail assets. Most retail investors are not expert securities analysts, and they often place their money with professionals in large funds.
Some investors live in countries that don’t have a lot of securities regulation, or explicitly allow securities to be handled as unregulated crypto. In theory, this is the customer base for exchanges like Bitmex that offer derivatives which are illegal in regulated jurisdictions. In practice, most money comes from investors in regulated jurisdictions like the US, China, Europe. It’s not clear if a financial product can be successful by accurately targeting unregulated jurisdictions.
A “Qualified Purchaser” has more than $5M in investable funds. If you are selling a private partnership in the US with more than 100 investors, regulators will tell you that need QPs. There are probably around $4T of limited partnership stakes outstanding with QPs. This is an important category for funds and the rapidly growing market of LP secondary sales.
Regulators outside the US have defined categories of investors that are exempt from some retail security offering rules. This includes “sophisticated” investors in the UK and Hong Kong, “professional” investors in Japan (investing about $5M in assets), and Singapore accredited (about $3M).
Accredited investors have $1M in investable funds. This is the most important category for issuers that are selling private investments in the US.
Non-US regulated retail
“Retail” investors can be anyone, including people that do not fit the above categories. Selling to retail investors removes a lot of restrictions and makes exchange easier. Many non-US jurisdictions apply restrictions that are similar to the US. Issuers selling to retail investors will need securities that are qualified as “public”, with formal disclosures. Non-US jurisdictions usually have fewer restrictions on trading mechanics.
US retail investors can buy and trade securities that are qualified as public securities by extensive offering documents and quarterly disclosures. This process is expensive and it’s usually only worth doing for floats of $100M or more. This regulation works! Securities that qualify to be US public securities are often quite successful in attracting liquidity and selling to a huge investment market. Securities that do not qualify are are often not successful. So, it makes sense to target a US public offering as an endpoint for an actively traded, large cap securities offering. Otherwise, you need to be careful about not accepting US retail investors.
The path forward
You can successfully issue a digital security if you can find a channel to one or more of these investor categories, and qualify them, and control distribution inside your targeted categories.
It’s not an easy task. An upcoming article will propose some mechanisms for finding and integrating these investor channels.