The addition of security tokens to the financial instrument toolbox is helping new, dynamic and lean financial services businesses to emerge and flourish. Blockchain-based technologies help these new entities grow rapidly, offering innovative business initiatives with minimal resources. Many of the required systems and support processes including software, security, operational infrastructure and administration – can be easily accessed as tools built on a distributed blockchain application with comparatively minimal expense and all of this is breaking down barriers to entry in both the securities offering and fundraising, and the securities trading space.

On the fundraising side, with a tokenized issuance, businesses can benefit from disintermediation, direct access to investors, efficient transaction management, and increasingly automated legal and regulatory compliance functions and on-going administration. Where required, flexible hybrid (traditional and tokenized) issuances can also be made to accommodate particular investor requirements, for example. FinTech businesses which support security token issuances tend to offer a plug and play platform solution, having partnered in advance with like-minded lean, tech driven support services, not encumbered by the more historical methods of fundraising which are monopolized by the larger, traditional financial institutions. On the inter-institutional side, the prospect of real-time, open ledger transaction recording and settlement processing is highly appealing (albeit currently challenging from a regulatory perspective). On the trading side, availability of on-chain security tokens provides traders with increasing opportunities to develop more structured products with multi-asset baskets, layered reference tokens and tokenized derivatives products amongst the potentially interesting applications.

Security tokens in the financial toolbox

The ramifications of using security tokens as financial tools are far-reaching. At the inter-institutional level, adoption carries the promise of enhanced liquidity, improved capital positions and decreased settlement risk. However, there are also likely to be drawbacks on the institutional side as transaction fees and distribution network monopolies are eroded.  Direct distribution of securities by way of tokenized issuance between issuer and investor has the effect of disintermediation, bypassing centralized financial institutions, reducing their role and offering an alternative route to finance. The opportunities in this space are being grasped by lean “fail fast” financial entities, which are becoming increasingly commonplace, hosting platforms which facilitate direct to market fundraising. Security token offerings have commonly been limited to sophisticated and professional investor groups to date, however in the US, cryptoassets and security token exchange INX is seeking permission to host the first security token sale to be registered with the Securities and Exchange Commission (SEC). It it hopes to raise up to US$130 million through an initial public offering, which is expected to be open to both professional and retail investors.

In an open-source world, the widespread availability of outstanding technology on which real world financial products can be built and operated, without (necessarily) having any significant bricks and mortar institution in place, is rapidly transforming multiple aspects of financial services. The impact on investing, trading, fundraising and payments is already becoming clear. Through organisations like the global consortium R3CEV, bankrolled by several of the world’s major financial institutions, the big players are working to identify ways in which blockchain may affect finance in the future and how to stay in the game.

As mentioned, security tokens show additional promise in their use as derivative tools, thanks in part to the flexibility that tokenization offers. Tokenized derivatives have seen recent specific attention from the UK Financial Conduct Authority, which has noted that tighter controls are required in the retail market for these products. Nonetheless, tokenized derivatives are an exceptionally useful tool on a professional level. They represent a new asset class, providing a bridge between historical asset classes, real world assets and crypto, flexibly gathering together various asset categories into a single user-friendly basket with optionality that doesn’t need to be shadowed by an unmanageable (often lacking) paper trail.

Additionally, blockchain ledgers are showing signs of closing the well-known gap in the traditional reporting model. Decentralized and distributed ledgers offer accurate and immutable information to all users, consistently and in real-time. They present a real opportunity to eliminate the lag between trades and recordkeeping. This could minimize legal risk while solving such issues as erroneous documentation and missing paper trails. The likelihood of repeat events such as the lengthy record unpicking and litigation surrounding the Lehman Brothers collapse would be greatly reduced, due to the architecture of the system.

Regulatory oversight

A tug of war has emerged between centralized regulatory practices and the decentralized ethos inherent in blockchain architecture and favored by its supporters. This tension manifests itself in specific friction points; its mere existence hints at the potential that security tokens and other types of tokens harbour for industry-wide disruption. The broader implication of these tensions involves a deep-seated concern over the mass adoption of decentralized ledger systems and the falling away of the traditional systems of oversight and control. That said, tokenization does require careful governance, especially during its programming and execution, to protect all parties and ensure strict privacy policies are followed.

A focal point of the inherent centralized-decentralized tension is regional and national regulatory oversight. Cryptoassets regulation varies from country to country. Several major cryptoassets institutions are based in crypto-friendly Malta, among them Binance, which recently launched its new platform Binance Lending.

In the US, the SEC has stringently applied the basic principles of securities law to cryptoassets. Many organizations and individuals hope that this approach to regulation will be eased or modified in future – such as to reduce the cost of international payments – to allow for further innovation. However, as recently as August this year, SEC Chairman Jay Clayton reiterated that exceptions or changes in securities law to accommodate cryptoassets are not going to happen.

Russia strictly prohibits the trading of cryptoassets, and in August 2019, authorities seized over 2,000 illegally imported Bitmain ASIC cryptocurrency miners from the mining firm Intelion Mining, after the firm failed to provide valid documentation and avoided USD1.2 million in import fees. The regulatory issue is compounded because those who tokenize assets often lack licensing and regulatory preapproval. As a result, tokenized offerings are often viewed critically by prospective investors and seen as not up to standard by regulators.

Tokenization cooperation

Institutions are working hard to keep up and keep on top of the revolutionizing potential that tokenization represents. Whilst tokenisation of securities and issuance through non-traditional direct to market platforms may reduce the role of traditional investment banks, there are opportunities too. There is significant investment among the large established financial institutions to understand blockchain’s potential in financial services and to support the development of applications. Payments is one area where institutions see clear potential use cases and opportunities for improvement on the existing systems – JP Morgan is set to begin customer testing of its cryptoasset JPM Coin, Wells Fargo has recently announced it is testing “Digital cash” and global German insurer Allianz intends to launch a blockchain-based payments token in the near future. In addition, in August 2019, 14 financial firms, among them UBS, Barclays, Nasdaq and Credit Suisse Group, established the new company Fnality International. Fnality is working on a utility settlement coin, intended to be a token for cross-border settlements to enable banks to communicate directly without intermediaries.

It is possible that a critical economic point may expose latent risk in the traditional financial space, and the usefulness of tokenization as a sector-wide financial tool may gain further traction. This may take the shape of digitised payments and trading sector platforms that exchange value and communication using truthful, real-time reporting. Using Hyperledger, the blockchain trade platform, manages, tracks and secures open-account trade transactions between organizations in Europe and it is backed by such major European banks as Deutsche Bank, Santander and Société Générale. Direct delivery of realtime trading information, powered by a cryptoasset-based trading toolset, has clear potential on the risk management front, with basic, multiport, instant information sharing, powerfully mitigating such risks as over- and under-valuation, portfolio inaccuracies, erroneous accounts, and fraudulent auditing.

Explore the frontier of technology and its place in the future of enterprise at the fourth DLA Piper European Technology Summit on October 15, 2019, which includes a panel discussion on FinTech. This panel, moderated by Martin Bartlam, will explore how new and traditional financial services models are both competing as well as collaborating as they strive for market share locally, regionally or globally.

Visit the European Technology Summit 2019 website for more information and to register your interest.

More on Security Tokens from DLA Piper:

TechLaw Podcast: The Future of Cryptoassets

Technology’s Legal Edge blog: Legal Issues of blockchain and how to deal with them

FINBRIEF: FCA Guidance on Cryptoassets