The year 2019 started with plenty of optimism regarding the growth of Security Token Offerings (STOs). Many articles at the start of the year suggested, like 2019 Will Be the Year of the Security Token Offering on TokenMarket, that “it’s looking very likely that 2019 will be the year of the security token offering”. In this blog we look back on some of the key moments of 2019 with regard to STOs and consider whether 2019 really was the dawning of a new era worthy of the revolutionary hype back at the start of the year. However, if you would first like to take a step back and digest a user-friendly introduction to the concept of security tokens, please listen to our podcast Tech in Two Minutes - Episode 1 - Security Tokens or read our earlier crypto assets blog Security tokens: a new class of crypto assets.
Crypto assets building credibility
In January 2019, the Financial Conduct Authority (“FCA”) launched a consultation on the regulatory perimeter for crypto assets which culminated in its feedback and final guidance being issued in July for the benefit of firms dealing in crypto assets as well as professional advisers, investment managers and consumers participating in the market. Broadly speaking, security tokens are considered as being equivalent to traditional financial assets such as shares or bonds. As such, security tokens do fall within the FCA’s regulatory remit.
The FCA’s guidance is an important development in the UK because with clarity comes a greater understanding of risk and potentially confidence for investment and growth. The crypto assets market is fast moving and the FCA has acknowledged the need to work with other regulators to ensure consistent treatment of these assets across national borders as securities markets and legal regulatory frameworks vary between jurisdictions.
The FCA has continuously supported the UK’s crypto assets ecosystem by hosting regulatory “sandboxes” which allow participating businesses to test innovative propositions in the market with real consumers in a controlled regulatory environment. In April 2019, it was reported that 20|30, a London based blockchain startup with the ambition of tokenising equity and other securities (and a participant of the 4th cohort of the FCA’s sandbox), raised £3 million by selling tokenised shares and settling them in a test environment on the London Stock Exchange’s Turquoise platform. This is understood to be the first share issue of its kind using blockchain technology.
A feature of security tokens that distinguishes them from other crypto assets (such as utility tokens issued via initial coin offerings) is that they have to be backed by a tangible asset and this has led to the prediction that ownership of other assets can be tokenised (i.e. fractionalised digitally) including real estate. In this particular example, tokenisation could benefit property developers as in theory it would facilitate the fundraising process for a new building project by creating lower thresholds for minimum investment in tokens that can subsequently be sold on a secondary market. In turn, this boosts the liquidity of the property market and opens up investment opportunities to a wider range of interested parties.
On the downside, it is not yet clear how tokenisation will work with existing property law or, with respect to the tokenisation of shares, company law. In our view, these flaws have limited the expansion of tokenisation beyond firms whose business is to issue tokens. In July 2019, TokenMarket announced that its STO had successfully completed under the FCA’s regulatory sandbox, raising 158% of its funding goal across a two-week period. Whether this early success will prompt companies in other sectors to tokenise equity and assets remains to be seen as very few such STOs appear to have been publicised (possibly due to confidentiality concerns with respect to planned STOs). Likewise there appears to be very limited secondary market trading of tokens in the investment community. This could soon change with strategic investment in security tokens infrastructure. For example, it has been reported that earlier this year, Archax, a developing security token exchange in London, received investment from SPiCE VC (a tokenised venture capital fund).
Overall the paucity of successfully closed STOs in the UK (and trading of such tokens on secondary markets) during 2019 demonstrates that the STO market in this jurisdiction hasn’t developed as quickly as many thought at the start of the year.
What’s next for tokenisation?
One would expect more UK-based startups to experiment with tokenisation as its popularity grows overseas. According to reports, the US is believed to be home to the majority of infrastructure providers (who tokenise assets), issuance providers (who issue tokens on a blockchain), global investors in security tokens (61%) and secondary markets (such as Kraken, a trading platform for tokens).
A curious test case for a niche use of security tokens also recently emerged in the US where it has been reported that a patent was filed in December 2019 by Nike suggesting that the company plans to tokenise the ownership of trainers. The idea is that owners can verify the authenticity of their shoes and track prior ownership using blockchain technology. The technology should help to reduce the trade in counterfeit trainers in the limited-edition resale market and it is also thought that it can be used to grant rights to third parties to mix shoe designs. It remains to be seen whether Nike will exploit its patent and bring ‘cryptokicks’ to the market, thereby thrusting the concept of security tokens into the mainstream.
It’s clear that 2019 cannot be dubbed the ‘year of the security token’ in this jurisdiction. Widespread embrace of tokenisation in the UK seems likely to be dependent on the successful tokenisation of widely used or sought after assets, whether in the investment space (e.g. shares or property) or the consumer product space (e.g. Nike’s Cryptokicks). If, as hoped, tokenisation stimulates the trading of tokens on secondary markets, the breakthrough will be complete. It remains to be seen as to whether 2020 will be the year of that breakthrough.