Asset Tokenization: Fact vs. Fiction
There are lots of myths floating around about asset tokenization. Let's clear the air with what the facts are.
By Vertalo Team
We recently came across an article about how tokenization would revolutionize the securities industry. The vision was outstanding - more accessibility, broader audiences, faster settlement times, expanded trading windows, all of the talking points you’d expect to see for blockchain-based assets that have been tokenized.
Without putting the author or their piece on blast, we were very surprised to find that every point that was made was wrong in some way or another. This post is an attempt to clear up some of the existing misconceptions with blockchain-based securities and highlight how this industry behaves, and how it hopefully unfolds in the future as well.
Myth: Security Tokens rely on blockchain technology and require crypto exchanges for their sale and distribution.
Mostly incorrect. While security tokens do rely on underlying blockchain technology, security tokens…are securities! They are not, nor should they be conceived as, digital bearer assets, and thus they have to be treated differently than cryptocurrencies. In the United States, in order to sell a security you have to either be the issuer of that security, or be a registered broker-dealer who can sell the security on behalf of the issuer.
To be fair, there is some grey area here, you do have the capital advisor distinction which can get involved and add consultation for the sale and placement of securities, but generally speaking, a brokerage license is required for the recommendation and offering of a security. If you want to trade and settle private tokenized securities, you’ll need to attain an ATS license from FINRA. ATS operators are Broker-Dealers that are typically SIPC members as well.
Coinbase purchased KeyStone Capital, a FINRA member broker-dealer, to add Prime Brokerage services to their product line, Gemini also has an ATS for trading of tokenized assets on chain, but beyond that we don’t know of any crypto exchanges that can legally offer securities to US-based investors. Outside the US however, there are definitely places where this might be possible.*
*For example, we know that tokenized securities can trade peer-to-peer on decentralized exchanges in Luxembourg. Vertalo has prospective clients seeking to take advantage of this by enabling dex trading of private tokenized assets within that jurisdiction. we look forward to making it a reality.
Fact: Security tokens must be offered and placed according to securities regulations, since the underlying asset is a security and is subject to regulation. The trading of security tokens must occur within regulatory frameworks and not through a crypto exchange unless that entity is a FINRA-registered BD with an ATS license.
Myth: Security token offerings are more liquid than public offerings.
False. This just might be the most mind-blowing claim of all of the false claims we’ve ever seen, our jaws almost actually hit our desks when we read this on our computer screens. The security token industry is still in its infancy, which means the bid density and depth simply isn’t there in the same way it is for public markets or NMS securities. These assets are not fungible or globally sought after, like a Bitcoin, Ethereum, or other crypto assets might be.
Further, unless the security token raise is done under an exemption with no seasoning period (like Reg A+ for example), the assets will not be able to trade until the seasoning has ended. Typically with a private placement like a Reg D 506(c), the asset must season for 12 months before any sort of secondary activity can occur.
What about existing shareholders? Yes, to be fair, existing shareholders on a cap table who were there for the primary issuance can buy and sell with one another, if the issuer approves it, during a seasoning period, but that’s almost always an exceptionally small buyer pool, and is typically left off the table for considerations like this.
By contrast, public market liquidity hit $30 Trillion in 2019. We’d wager that, with the stimulus and pent up demand we saw from the COVID-19 lockdowns, that 2021 public market liquidity was north of $40 Trillion. The DTCC settles trillions of dollars worth of securities each year.
Fact: Security tokens are still fairly illiquid instruments outside of being listed on an ATS, although the industry shares a vision of producing more liquidity for private assets.
Myth: Tokenized assets trade 24/7, just like cryptocurrencies.
False. Remember - this market is young! This means that stretching out the trading to include all hours is not practical nor would an issuer want their security to trade in a 24/7 environment. The bid depth simply isn’t there yet, and since there are no market markers (yet) it means that functionally we’re seeing the opposite of what is being suggested here.
Most issuers, in order to produce bid depth and density actually restrict their trading hours. The ASPD coin only trades for a few days per month on tZERO, for example. Additionally, ATS operators have strict reporting and compliance standards that make 24/7 trading completely impossible currently. Much of trading restrictions for public markets include these compliance processes, for example reporting on failed trades, that make 24/7 trading not possible. There’s a reason that large and well known brokerages like Chase, Fidelity, or Merrill Lynch don’t allow 24/7 trading, but instead books orders and places them at market open the next business day. Compared to these large public brokerages, ATS operators and their liquidity is quite small. They can’t currently trade blockchain-based assets in the same manner as cryptocurrencies on crypto exchanges.
Fact: We are years away from all security tokens being enabled to trade in 24/7 manner, because of market size, bid density, and regulatory requirements. That said, blockchain does hold the technical promise of intraday trading & settlement.
Myth: You can trade and settle tokenized assets instantaneously on-chain.
Incorrect. The vast majority of all purchasing, trading, and settlement of security tokens is done via fiat using existing payment infrastructure. The reason being that using cryptocurrency for securities purchases is extremely difficult and risky from a regulatory standpoint. We will probably write about these challenges since they are extensive, but the crux of this issue comes down to running Anti-Money Laundering checks on the source of the funds you receive in a securities transaction. There are blockchain analytics companies like Chainalysis or Elliptic that do this very well, but that’s just the tip of the iceberg. You also must run KYT (Know-Your-Transaction) and KYW (Know-Your-Wallet) checks before accepting or distributing funds.
Crypto as payment for securities is simple in theory but quite complex in practice.
We know of only one ATS in the United States that carries regulatory sign-off to trade and settle security tokens via stablecoins, and that’s Oasis Pro Markets*. Their blockchain-first approach has led them to drive innovation in this space, but it’s still cloudy since the regulation of stablecoins remains unclear. With regards to stablecoins:
Are they currencies to be regulated under the OCC?
Are they cash derivatives that would fall to the CFTC?
Are they securities that simply have their value manipulated to maintain parity with the US Dollar, putting them under the jurisdiction of the SEC?
Again, it’s cloudy to say the least, and we certainly don’t know how the stablecoin debate will shake out or what agency the regulation of these assets will fall under. Assuming that all blockchain-based securities can trade and settle instantaneously does not reflect current reality. The theoretical implications are fascinating to consider though.
*Figure’s ATS may also settle via their stablecoin on the Provenance blockchain, but we don’t know that for certain.
Additionally, Broker-Dealers are subject to net capital requirements, just like banks and other financial institutions. Daily net settlement practices give banks the ability to model and plan for their capital requirements, which should, at least theoretically, remove the risks of bank runs or currency drains, but if assets are settling and clearing instantaneously, this presents as potentially problematic as far as these capital requirements are concerned.
Fact: The trading, settling, and clearing of blockchain-based securities is almost entirely based on traditional fiat processes. Blockchain and stablecoins hold the promise of intraday settlement and clearing,
Myth: Blockchain and security tokens open up your prospective investor base to global investors.
False. Vertalo’s co-founder and general counsel, Gautam Gujral, is someone we respect deeply, he’s taught us so much about this industry, including the regulations in this space, and how to approach things overall. He’s become a trusted sounding board for our ideas when we have questions about the legality or feasibility of those ideas.
When Vertalo was looking at the ICO craze in fall of 2017, Gautam looked at all of the companies hosting non-dilutive raises with liquidity windows that were immediate via the initial coin offering and clearly felt like many of them were unregistered securities offerings. Amidst these observations, he uttered this magnificent quip:
“It’s like they took the rulebook for how to raise money and broke a rule on every single page…”
We love telling people that, draws a smile every time.
Remember, these assets are securities, which means that just because there’s new technology involved does not mean you get to negate 88 years of established case law and precedent. This is a sentiment that is continually shared by the SEC and other regulatory bodies, especially as they continue to let the industry question their stance on the creation and issuance of crypto assets.
Raising capital from foreign investors for domestic operators is perfectly possible today…as long as you file the exemption for Regulation S and follow the required provisions for raising capital from non-US citizen non-US residents. We’ve assisted in a number of Reg D/Reg S offerings, and are perfectly capable in doing so.
Fact: All securities laws still need to be followed, blockchain does not magically unlock a new class of investors unless you file the proper registration exemptions and follow all existing securities laws.
Myth: Blockchain holds the promise of decentralized trading.
Unfortunately false. It is illegal to trade and settle securities outside of regulatory processes*. We named this case in a previous article, but in 1999 the SEC famously sued three individuals for trying to trade securities on eBay. Further, there is a class action lawsuit currently underway against Uniswap for offering unregistered securities.
*the only jurisdiction we know of that allows the decentralized trading of securities is Luxembourg, although we’ve heard rumors that certain countries in Indonesia or Asia are considering frameworks for how to allow this
Additionally, Kim Kardashian’s $1 Million Fine Could Impact Uniswap, SushiSwap And Other Decentralized Exchanges. And finally, SEC’s Gensler Wants to Divide Crypto Exchange Functions.
The custody, trading, settlement, and shareholder ledger management of securities is a highly regulated activity within nearly all jurisdictions worldwide. There are important differences between jurisdictions with regards to the information that needs to be gathered and which parties handle these core functions, but broadly, these interests are divided to prevent any singular party from causing a crash. We hardly need to mention the dozens of crypto exchanges like Mt. Gox or Quadriga CX, who’s poor handling of cash, assets, security, or internal ledger management has led to losses counted in the tens of billions of dollars. And those are just the centralized exchanges - the losses from decentralized trading via exploit or sloppy operational standards count in the billions as well.
Fact: Digital asset securities cannot trade on decentralized exchanges in nearly all jurisdictions worldwide. Instead, digital asset securities are subject to regulations where the issuance, trading, settlement, and clearing are concerned.
Conclusion
Let’s be clear about the facts behind digital asset securities. There are clear regulations that have been outlined for securities that don’t change because we simply change the underlying nature of how they are reflected. Should you encounter these myths in the real-world we’d ask that you respectfully correct and instruct those sharing that which is incorrect. This industry will grow and flourish when we have a shared, and accurate understanding, of the facts.
Till next time.
Figure’s ATS does settle via Provenance blockchain and we believe is the only ATS that can facilitate direct bilateral settlement between two wallets.