Tokenized securities have finally hit the radar screen in the wider world of capital markets and finance. For the uninitiated, a tokenized security is a securities instrument that is designated by a programmable, digital token on a blockchain that serves as an electronic, certificated record of the unit of account. Even though blockchain technology is involved, the underlying asset is still a security, and the token is ascribed with securities qualities and must be treated the same.
Traditional capital markets are only able to achieve efficiency through radical centralization into monolithic organizations that embody the concept of “too big to fail” as institutions. These literal monopolies are now facing the same fate as other industries as technology-driven decentralization threatens their very existence — which is a good thing (unless you’re a stakeholder in one of these legacy institutions, of course).
The technology represents an opportunity to architect an entirely new market infrastructure. And with over $1 billion in assets presently trading in the secondary market as digital securities on a blockchain through regulated institutions, it’s no wonder people are realizing the potential.
Yet, there are some significant problems digital securities face as the market advances.
Crypto Startups Moving Into Digital Securities As Unlicensed Brokers
Usually it’s easy to detect the orientation of a particular individual or firm with the language used. STO or Securities Token Offering, or any language that places the emphasis on the token and the technology instead of the financial offer and securities is an indicator of a crypto-focused firm with a potential lack of capital markets sophistication.
Due to the interpretive nature of the Howey test and enforcement, many solutions providers and adjacent firms in the space are operating as unlicensed brokers. This can simply include things like how a particular security offering is being promoted and amplified across the market. Claims of “SEC approval” (the SEC doesn’t approve offerings) and further marketing hyperbole about returns are fertile areas for violation enforcement.
These things are securities, not cryptocurrency tokens. While the technology may be the same underneath, securities are very distinct and clear in the law.
User Experience and Adoption
Even though blockchain and distributed ledger technology represents a great opportunity to drive more efficiency, inclusion, transparency, and compliance into financial services and capital markets, there’s no easy way for market participants to seamlessly interact with tokenized securities – even with standardized public blockchain networks like Ethereum running underneath.
Popular trading venues like Robinhood have added cryptocurrency trading to their feature sets. But at present, none provide access to tokenized securities markets and alternative asset trading on an equal basis. This forces a reliance upon each trading venue’s user experience, or lack thereof, and the limitations of each market’s application features.
The promise of greater liquidity through decentralized markets is massive, especially for otherwise traditionally illiquid assets like alternatives and real estate.
Being able to register and list the same security on multiple global exchanges provides issuers and investors with tremendous choice and opportunities to find better price discovery and compress illiquidity discounts.
However, at present no single tokenized security is listed and trading on more than one exchange or trading system – failing to fully deliver on the much touted promise of better liquidity.
While more new Alternative Trading Systems (ATS) are coming online with a particular focus in the blockchain-based digital asset space, the market is fragmented and disconnected with the only commonality being some of the core underlying technology — for example, the public chain and smart contracts used to create the tokens (Ethereum).
Lack of Standards
This brings us to the next issue: the industry lacks common information governance, risk, and compliance standards to connect the new technical infrastructures to traditional securities issuance, settlement, and clearing processes.
As digital securities offering issuers attempt to expand the market availability by listing on multiple trading venues, is there any assurance any public chain smart contract code representing a digital securities token will be considered to be “compliant” by a diverse set of Chief Compliance Officers?
Especially those with traditional views of market operations and centralized operations favoring each individual trading pool?
Or will trading venues instead still require a separate, localized token within their walled gardens under their own control?
This presents a quandary for public blockchain networks actually ever becoming the true, single source of truth – even though they represent a common technical layer touting transferability.
Expensive and Confusing Custom Development
The efforts to connect to the market infrastructure are still enterprise-level development and offering projects at scale.
Similar to other large scale enterprise information technology initiatives, the process to understand the technical layers and distinctions in jargon-heavy environments represent significant risk to non-technical offering sponsors. The nexus between the deeply complex technical stack and the similarly complicated world of regulated securities hasn’t fully been reconciled.
Much like the early days of the internet, progressive organizations who recognize the potential as early adopters are often confused by vendors who cut corners with cheap technology like progressive form-based smart contract token generators wrapped in a lot of hype.
Code generators aren’t new, we old enterprise software folks were using 4GLs in the mainframe era.
Emerging Industry Vendors Offering Incomplete and Risky Solutions
Don’t buy your financial technology solutions from technology companies run by financial people. Especially those who have never shipped enterprise software product.
Quite simply, few of the surface feature-based providers in the blockchain space offer end-to-end solutions for digital securities offerings that incorporate traditional enterprise grade information governance, risk, and compliance (GRC) programs at the foundational core.
Nearly every vendor in the space started with Github repositories of code that powers cryptocurrency and blockchain, and launched their own branded versions without consideration of the rest of the market infrastructure requirements for securities vs. non-security cryptocurrencies.
Securities require a very comprehensive paper trail. Hard stop. While much of the underlying technology is blockchain, which also powers non-securities intangible property assets like Bitcoin, digital securities are NOT Bitcoin, and require a comprehensive layer of workflow and recordation to ensure compliance.
Simply making a token and pushing it around on a blockchain network doesn’t work in a market where we don’t have “bearer shares” any longer. Just because you have possession of the token doesn’t mean you own the security.
Instead of starting with the law, and then subsequently working backwards into the tech, many vendors rushed to create products and platforms starting with the technology, and then attempted to back their way into legal compliance after the fact with no acclimation to the very traditional world of actual regulatory governance, risk, and compliance process.
Prospective digital securities offering sponsors should understand the creation of a public blockchain token for a securities offering comes much later in the development cycle. Your code generator vendor isn’t going to tell you that, they’re going to run some scripts and produce an ERC token in a wallet and send you an invoice with no regard to the rest of the equation — one that can and will potentially land someone in Federal court.
Traditional Wall Street Behaviors and Data Lockups
Many service providers in the blockchain digital securities, and even the non-blockchain crowdfunding space force offering sponsors to use their proprietary portals. It is remarkable to observe the many attempts to control investor data and information within their silo.
In fact, many digital securities solutions providers were founded by traditional financial industry people, and have only sought to make a more efficient Wall Street v 2.0 but with the same centralized (and sometimes mafioso) business approach.
This leads to a disconnect between offering sponsors and investors and a fragmentation of information across many sources – the very antithesis of decentralization and transparency. It also increases the risk for offering sponsors when their offering and investor data is locked into many different 3rd party systems without a path to ownership and control of their own data.
Massive Wall Street firms were founded upon the premise of data silos and aggregation, wherein the data provider acquires market data and sells it back to the very people who created the data. The stage is already being set in the digital securities market for the same.
The technology is providing an opportunity to re-imagine market infrastructure, yet the market is already dismissing the ultimate beneficiary of a decentralized ecosystem, sell side offering sponsors and investors.
The XDEX Solution
10XTS has sought to overcome many of these problems with the development of XDEX as a securities offering issuer-focused Information Governance, Risk, and Compliance (GRC) and Master Data Management (MDM) market infrastructure solution for the emerging digital securities industry.
Our goal is to provide offering issuers with an independent approach to owning their information and data before they even create a token and list it on a portal.
XDEX is a metadata layer that can be consumed by any public network smart contract and token to ensure consistency of records and data across multiple trading venues and brokers.
We provide offering issuers and their investors with the confidence of owning their own data within their own information stacks and portals as they move into the very exciting and promising future of decentralized capital.
If you’re considering a digital securities token offering, we’re here to help.
Contact the team to get started!