As a securities attorney, when I attend a conference in a rapidly developing area, I come with my own prejudices and beliefs, but with an open mind and open ears – to hear, digest and discuss the latest developments and thinking. The 2018 Crypto Invest Summit in Los Angeles last week was no exception.
The crypto space is not simply evolving – or pivoting – it is spinning. As one speaker aptly described the landscape, there are a lot of signals and a lot of noise – so it is hard to discern where we are or where we are headed.
For those 6,000+ who attended the Crypto Invest Summit, this was likely a step in the right direction toward clarity. Though real clarity is not likely until this current wave of Internet finance has subsided – with the benefit of hindsight.
I have closely followed the gyrations of the ICO (initial coin offering) market over the past 18 months, long since pronounced dead – at least in the US – and watched this creative crypto energy refocus on what is now referred to as security tokens, or digital securities.
In the face of repeated proclamations from the SEC since July 2017 – that most “tokens” or “coins” are, like it or not, securities – subject to a labyrinth of US securities laws – the legitimate US ICO participants and observers were largely undeterred.
In the face of a seemingly insurmountable STOP sign by the SEC, the digital hoards found a new mantra – by dropping the “P” from STOP – originating what is now popularly referred to as the “STO” – an acronym for Security Token Offering (or as some prefer – digital securities).
Implicit in the STO pivot was the embracement of government regulation – creating digital instruments with features of a more traditional security – including in them such things as dividends and voting rights.
To add some context, as far as potential market size, industry participants in the STO space are fueled by the usual industry cheerleaders – proclaiming that there is a multi-trillion dollar market in illiquid assets – assets that could be made liquid through “tokenization.” All that is needed is an established US trading platform for a vibrant security token secondary market. Problem solved?
Was this simply hype – or did the truth lie somewhere else. In my opinion, that largely depends on your time horizon.
New, trillion dollar markets, with new, liquid asset classes are, to be sure, the hope and the dream – likely decades away. But markets in the billions are likely to face a shorter timeline, the horizon measured in years – not decades. And markets in the tens of millions are, in some shape or form, lurking around the corner. But the challenges will not be insignificant – it will take a great deal of investor money, manpower and pivoting – and patience.
The Crypto Invest Summit Security Token Track
I spent most of my time during the first day of the Crypto Invest Summit in the all-day Security Token Track, in a “break out” room from the main event. I estimated there was seating for at least a thousand or so people in the break out room. The room was full most of the day – reflective of the level of interest and the range of speakers and subject matter. Here are some of the things I learned – or reconfirmed.
The Security Token Timeframe
There was general agreement amongst the panelists that security tokens are in the very early stages. According to most, we were not yet even in the first inning of the metaphorical ballgame.
In the words of one speaker: we are at the National Anthem stage; another -the stadium is still being built. No cheerleading here – the panelists were realists, down in the trenches, well aware of the significant challenges ahead – though confident they would, in time, be conquered.
The Challenges Facing the Security Token Arena
In my opinion, the biggest challenges facing the nascent security token industry are both the number of disciplines involved – coupled with the complexity and uncertainty surrounding these disciplines as applied to the security token market. They largely fall into three baskets: technology, finance, and government regulation.
Adding to the complexity: they are inexorably intertwined with each other. All must be addressed in tandem. If not, the goal of enhanced liquidity through digitizing securities cannot be achieved.
The security token market cannot develop and mature without investor money – lots of it.
Contrast STOs with ICOs, the latter being a simple proposition for many – get in early -buy low and sell high – very high and very quickly. Recent ICO history tells us that the goal of achieving large influxes of capital, in some cases virtually overnight, is easily achievable in the absence of governmental regulation and relatively opaque – but sexy – subject matter.
Not so with STOs. Not only has the world gotten smarter in terms of the risks of token investments, but STOs, by definition, are regulated securities. So much for the Wild West of ICOs. The Gold Rush is over.
Many of the earliest, savvy participants in the STO market rightly set their sights on tokenizing assets garnering significant institutional interest: privately held funds and real estate – described by some Summit panelists as low hanging fruit.
And though there are hopes and rumors of STOs rolling out by institutional investors, thus far there is simply no deal flow. There are many factors at play here – some very basic – problems which require solutions – before we can expect to see any significant deal flow in the security token market.
Custody- An Initial Barrier to Institutional Investors
How security tokens are held by institutions is a basic, but critical issue. In the absence of institutional custodians to hold these tokens, Wall Street is faced with the current reality – holding securities in a digital wallet.
No one likes to have their “wallet” picked – or hacked. Institutional money even more so – the bulk of this money being other people’s money.
With this risk, most money managers would prefer, or insist upon, the safety and security of a more traditional central ledger and, in some cases, an independent transfer agent. And if you are a registered investment advisor you cannot even consider holding securities in anything but a financial institution – lest you run afoul of existing regulatory requirements.
Yes, there is an appeal to the prospect of creating a path to liquidity for otherwise illiquid assets. But the risks must be manageable when compared to traditional securities.
There appeared to be a growing consensus at the Summit that the custody issue is a short term problem, well on the way of being solved. Major financial institutions, such as Fidelity, are making public forays into this area, and many are sure to follow.
Government Regulation Meets the Blockchain
The regulatory component of the security token ecosystem is perhaps the most complex – and daunting. One might think that with the issue of whether a token is a security in the rear view mirror, there would be clear sailing ahead on the regulatory front – at least in the area of securities regulation. Not so.
Many regulatory challenges abound – solving these challenges will take time, money and most of all – patience. Though I am confident that the regulatory issues will be solved over time, there will be a number of twists, turns and roadblocks.
One of the security token panelists aptly framed the importance, and complexity, of navigating the regulatory landscape. Specifically, he noted that typically there are two key founders of any startup: the entrepreneur and the technology expert. But, in his opinion, the security token / blockchain world was different. In his view it was critical to have a third member of the founding team – a regulatory attorney – to navigate the regulatory knowns and unknowns. Yes, there are a great deal of regulatory tripwires, including securities and tax. And even as to securities regulation, the expertise required cuts across a number of areas: initial issuance, secondary market trading and “back office” plumbing issues.
And when two worlds collide – complex laws and regulations, designed for a pre-crypto world – and complex and evolving technology, i.e. blockchain – some of these complexities can be magnified exponentially. Again, I expect that all of these issues are solvable, but this will take time and patience.
Regulation A+ and the Security Token World
For the initial issuance of a security token there is widespread agreement that the path of least SEC resistance is a private placement, either traditional or through general solicitation and advertising, as now allowed by the JOBS Act and the revamped SEC Regulation D.
Utilization of this exemption from a full SEC registration allows an issuer to raise an unlimited amount of money with no SEC approval or review- and no mandatory investor disclosure – so long as all of the investors are accredited. An additional issue: generally, investors acquiring Regulation D securities directly from the issuer must hold these securities for one year before they may be resold.
For those issuers of security tokens seeking immediate liquidity for their US investors, or who wish to sell their tokens directly to non-accredited investors, the paths are less attractive – either a full SEC registration with ongoing full reporting – or a mini-IPO under the newly revamped Regulation A+.
Both require preparation and SEC review of fairly extensive financial and non-financial information. But Regulation A+ offers an issuer the promise of lighter ongoing SEC reporting requirements for at least two years. And outside the world of security tokens and blockchain, Regulation A+ has been met with a lighter touch review, and in a shorter timeframe, than a full registration.
Today, crypto issuers looking to Regulation A+ have yet to meet with any success.
Currently, the SEC has yet to approve a security token offering utilizing the Regulation A+ exemption from registration, though dozens are rumored to be stuck in the SEC pipeline.
One panelist, a securities attorney, went so far as to say that they believe that the SEC intentionally designed Regulation A+ to make it impossible for anyone to utilize – crypto or otherwise. This is simply flat out wrong.
What is true is that an issuer with a blockchain based business model or security token can, today, expect a slow and even arduous review process. However, I fully expect that this problem will resolve itself in the coming months.
Yes, it has been reported that the SEC Staff is taking twice as long to generate initial comments on a Regulation A+ offering circular for blockchain based / security token offerings. And yes, none has yet reached the finish line. But this is not, in my opinion, a function of any hostility by the SEC. Rather, it is simply a function of there being a long learning curve – both in terms of understanding the basic business models and technology, and ferreting out discussion and disclosure of regulatory issues unique to this area.
Remember, Staff reviewers at the SEC are grouped into branches – with each branch focusing on a specific industry. Let’s face it, blockchain, apart from being complex, is a new science – especially at the SEC.
I expect that we are near the tipping point on the Regulation A+ learning curve, as far as blockchain and crypto are concerned. So look for Regulation A+ to be an active part of the cryptosecurity landscape in the very near future.
Investment crowdfunding was not a subject I expected to hear anything about at the Crypto Summit. After all, these raises are currently limited to $1.07 million – and associated by many with bite sized startups as financing of last resort. But there was serious talk about Regulation CF and its utility for issuing security tokens. Some were lured by the ability to reach non-accredited investors – coupled with the absence of SEC review – and the hope that Congress would eventually act to raise the $1.07 million ceiling.
And, of course, hybrid offerings, coupling Regulation D offerings with Regulation CF offerings, have proven useful to issuers who wish to avoid SEC review – but maintain an ability to reach non-accredited investors.
One panelist had another, interesting take on the utility of Regulation CF, which may take root as and when the security token market begins to mature. In the context of tokenizing assets, through the formation of special purpose vehicles (SPVs) to allow investors to invest in otherwise illiquid assets, this panelist saw the potential of “digitizing” securities to hold otherwise illiquid assets in areas which centered around a defined community or affinity group – a key ingredient to crowdfunding success. So not too far down the road we can expect to see micro markets of digital securities, fueled by a crowd community.
Technology and Ideology Begins to Mesh With Regulatory Reality
A number of factors have fueled the interest in and growth of all things crypto. One of these factors is rooted in the underpinning of blockchain – decentralization.
A corollary of this is the belief by many that a benefit of decentralization is that it allows people to bypass traditional governmental institutions and laws. In the world of STOs, government regulation is now an accepted part of the landscape. But for those who might wish to stay true to the decentralized nature of blockchain technology in the area of STOs, a consensus has rapidly developed by savvy participants that blockchain – and decentralization – have regulatory limits which are likely to continue.
As such, there was a consensus by panelists that, like it or not, it would be necessary to integrate a centralized transfer agent function into the security token ecosystem. So too, other back office and market regulation plumbing – in crypto speak: the need for interoperability of security token protocols.
Some Closing Thoughts
Not too long ago ICOs were in vogue – in hindsight a short lived phenomenon of the past, at least in the US. And a year ago the term “security token” was not a term in wide use, if at all – and something to be avoided in favor of the free wheeling ICOs.
So one thing is certain. No one knows what the STO world will look like years, or even months from now. But the growth and utility of this area is inevitable.
For the average person, the security token world ultimately will largely be invisible – as was the transition in our public markets from paper certificates to book entry transfers. But hopefully we can all expect to benefit from the journey and the expected accomplishments – rapid, seamless transfers of securities, in some instances on a global basis, and increased opportunity for unlocking liquidity of largely, relatively illiquid assets.
We are in the second or third wave of a digital finance renaissance. The journey is just beginning.
Fasten your seatbelt.