There is a lot of hype and hyperbole in the digital asset sector when it comes to securities or utility tokens. To date, the talk has far overshot the reality but that doesn’t mean that advocates aren’t on to something. Part of the discussion revolves around digital securities and the ability to remove intrinsic friction in the currently more analog process. Security issuance and management are ripe for a bit of digital innovation.
Then there is the other looming question. When is a digital asset no longer a security? And what about digital assets (or Crypto Assets as the Brits like to say) that have the characteristics of a security, commodity, and perhaps some other utility?
As the financial services industry is one of the most regulated sectors of business in the world, policymakers have not shot from the hip when it comes to updating rules. Some people believe this is a good thing for others, well, not so much.
Recently, Crowdfund Insider had a discussion with Derek Edward Schloss, Director of Strategy at the Security Token Academy, for a state of the Tokenization Economy in the United States. Schloss provided some excellent perspective on where we are now and where our digital path may be taking us in the coming years.
Our discussion is shared below.
Utility tokens have all but died out in the U.S. Issuers are compelled to utilize existing exemptions (Reg D, Reg A+, Reg CF) to issue these digital assets. What are some interesting offerings you have recently seen in the U.S.?
Derek Edward Schloss: As it relates to tokens — I think we’re still in the earliest stages of determining what value might look like at the network and protocol token levels in the future. At a minimum, for networks like Bitcoin or Ethereum to continue to grow, there needs to be some kind of token model to incentivize miners and stakers to participate on the network. If you believe in incentive models to collectively organize blockchain networks, then you probably believe network tokens will continue to exist across the blockchain space. In theory, if a new network is able to solve a problem not currently being solved elsewhere, and there is some token used to organize that network, it’s definitely possible that a project could carve out healthy adoption over time.
However, the major problem until this point has been the belief that network tokens could simply be issued outside of our U.S. securities framework. Today, it’s clear that most sales of pre-launched network tokens are also just investment contract securities — and fall squarely within U.S. securities laws. If you want to sell a token before a network has launched, you have to either register the offering or qualify for an exemption. We’ve seen the SEC affirm this stance a number of times over the last year, whether it’s through comments, settlements, speeches, or actions.
As a result, one major trend we’re continuing to see are more and more pre-launched networks looking to U.S. securities laws to compliantly kickstart their new networks.
Earlier this year, Blockstack sold $23 million worth of “investment contract” tokens under Reg A+ and Reg S. In addition, Althea is currently bootstrapping its decentralized internet network by marrying the concept of Reg CF with the concept of “token airdrops” on the Republic equity crowdfunding platform. CoinList is helping projects like Kadena and NuCypher launch regulated Reg D offerings on top of the CoinList platform.
Expect for more pre-launched networks to follow this theme. Over time, the aim for many of these networks will be to reach a state where the network tokens originally sold as investment contracts can transition from security to non-security as the investment contract factors erode, and the underlying network becomes more decentralized.
Some issuers are offering digital securities. Some are issuing digital assets that also have utility. Which path will dominate in the end?
Derek Edward Schloss: I think both models will continue to exist, as they both solve different problems.
For securities, a digitized wrapper around a legacy asset will empower that asset to interact with the world in new and uniquely programmable ways. In addition, the concept of trustless ledgers will provide owners of that asset with more transparency, less friction, and more self-sovereignty over their asset than any of our public and private markets enable. There are billions of dollars in assets already opting in to this new tokenized structure — with trillions of dollars in asset value that could benefit over the next few decades.
Alternatively, networks that issue native digital assets are distinct from real-world asset tokenization, but can presumably bring enormous value to the world. Maybe a network’s digital asset can incentivize and empower the formation of previously impossible mesh networks — like a decentralized internet community, or a real-time crowdsourced map of the world. We’re just starting to see how digital assets can uniquely empower these new types of business models.
The important point I want to drive home is that regardless of the type of digital asset, laws and regulations must be followed. Eventually, the hope is that the rules become much more tailored to all categories of digital assets, which would allow blockchain projects of all types to thrive.
Security tokens have struggled to gain traction — granted the entire industry is quite young. What will it take to make digital securities mainstream?
Derek Edward Schloss: My colleague Stephen McKeon, a Partner at Collaborative Fund, has this great line he told me over coffee the other day, “It turns out rewiring the global financial system does take some time.” I think that’s likely the best way to look at this space, and there are three areas in particular I consistently focus on when it comes to taking security tokens mainstream — regulatory, infrastructure, and deal flow.
For regulation, it’s important to note that over the course of history, laws, and regulations have always lagged behind disruptive technological innovations. We’re seeing more and more jurisdictions layout regulatory frameworks that will carve a path for security token issuers to launch, manage, and trade security tokens over the course of their lifecycle. Every disruptive technology in the past has faced a similar adoption curve, and regulation plays an enormous role in bringing new technology to the mainstream.
“For investors to really get excited about security tokens, the underlying deals should be interesting and attractive”
For infrastructure, a fully compliant end-to-end ecosystem is required for mainstream security token adoption. This includes areas like legal, broker-dealing, issuance, trading, custody, and lifecycle compliance. In addition, this infrastructure should be optimized for a variety of use cases and end-users — from retail to institutional.
Improved deal flow is the final part. For investors to really get excited about security tokens, the underlying deals should be interesting and attractive. For the time being, the majority of issuers and investors will seek out well-oiled legacy systems and avoid investing additional resources until infrastructure and regulation is proven. We’ve been excited to witness that over the last twelve months, security token infrastructure and regulation has started to increase significantly in key jurisdictions around the world.
We have seen other jurisdictions outside the U.S. make some progress. Which countries do you think have the most potential? What about France and its ICO path?
Derek Edward Schloss: As it relates to the regulatory side of this technology, I’m a firm believer that the industry will benefit from clarity that first delineates between non-security cryptoassets and assets like security tokens. Generally, digital assets can serve a number of unique purposes, and regulations should be tailored to specific asset categories instead of batched and regulated together just because they take the same digital form.
Second, for the applications around security tokens to thrive, it will require jurisdictions to specify the exact technological rails by which security tokens can and cannot operate on today. For me, this is the regulatory “table stakes” to incentivize the largest institutions and service providers to build the foundational tools within a jurisdiction’s borders, and for projects and issuers to feel comfortable investing time and money into tokenization.
With that said, we’ve already started to see a number of jurisdictions outside the U.S. make progress in both of these areas – France has created an innovative ICO framework, in addition to providing some of its initial foundation for blockchain-based securities. Hong Kong’s SFC has started to publish guidance on STOs and the regulations around the trading platforms that offer security tokens.
Demand for digitized instruments continues to increase each month, and I expect to see efforts from legislators and regulators ramp up to create safe environments around the technology. Over time, to fully leverage the potential of blockchain-based securities, existing securities laws will continue to be tweaked and optimized to better facilitate, instead of work against, the killer new features of digitization and trustless ledgers.
There is some discussion about creating a Safe Harbor for utility tokens. What are your thoughts on that?
Derek Edward Schloss: To understand the Safe Harbor argument for network tokens, it’s important to understand why a Safe Harbor might be required in the first place.
Over time, we know one important goal for any new blockchain network is to transition into a more distributed state, where no centralized force or third-party can be deemed to be operating the network. This concept has been referred to as “sufficient decentralization” by the SEC’s Bill Hinman and others.
The problem is that tokens originally sold as securities – like Blockstack’s STX token sold earlier this year in a Reg A+ offering — will not be able to shed the token’s security status until the investment contract factors are no longer present, and the network is deemed to be sufficiently decentralized. Until that point occurs, all token transactions in a blockchain’s network – which might include things like mining, staking, selling – must be treated as a security transaction. The token’s “security” classification will limit the kinds and types of participants that can engage with a network, and also dulls some of the peer to peer benefits that occur within a well-oiled blockchain network. As a result, a token’s existing “security” classification makes it more difficult that a network might be able to “sufficiently decentralize” over time.
The Safe Harbor argument floated by the SEC’s Hester Peirce is compelling, as it could open the door for token issuers to create a functional network within a set period of time, without being limited by our legacy securities framework. If the token is used on the network as intended, and the network is up and running within the allocated time, then the token is deemed to not be a security. If a functional network is not produced by the time limit, then the token will need to be registered as a security, and potentially face other penalties depending on the circumstances. In this way, the Safe Harbor idea seems to better balance the securities framework against this new network token paradigm.
Is the U.S. falling behind when it comes to digital asset innovation?
Derek Edward Schloss: I think this is an interesting question and I can see it both ways – it does feel like the rest of the world is moving quickly and other jurisdictions are well into the process of creating thoughtful guidelines for a new digital asset economy. I had a conversation with law firm Fisher Broyles’ Marc Boiron about this recently, and he brought up an interesting point – while other jurisdictions are moving quickly on the regulatory front, as it relates to the efficient machine that is our securities markets, the U.S. does have a significant lead on the rest of the world. I think that’s the right way to think about this. With that said, in order to keep our established lead, the U.S. must ramp its efforts sooner rather than later — and create thoughtful guidance that our robust securities and asset markets can rely on.