The Tokenized Truth – Pros & Cons of Security Tokens

  • Olga Feldmeier
  • February 26, 2019

If the token space were a galaxy and we approached it on an imaginary rocket ship and observed it, we would see a lot of stars. And we would know it is a big galaxy. But we have not seen the supernova yet.

Tokens are a galaxy, but their supernova is yet to come
Several years from now, we will look back at the 20 billion raised in ICOs and 800b crypto market cap and see it as a little ripple in the ocean of tokenized assets. The numbers are huge, no matter where you look. Take $250 trillion worth of private companies or $220 trillion of real estate. The World Economic Forum (WEF) predicts that by 2025 about 10% of GDP will be tokenized, some $12-14 trillion. Or look at the smaller pie: alternative investments such as Private Equity and Venture Capital, infrastructure projects, real estate development projects - a $7 trillion industry. But it is this asset class where tokenization will be a game changer. Why? Because they are illiquid, huge sums game accessible only to very rich people and institutions. It is a huge business opportunity, the one we at SMART VALOR have decided to focus on.

It is in this space where today we can say the initial market validation is in place. VCs, real estate properties, music and companies have been sold over the blockchain. It is a fact.

If the tokens are a new galaxy, with all the new stars in the process of being born in a supernova, why are we having this strange discussion about security tokens OR utility tokens. Asking a company whose business model is suitable for the utility token (such as a marketplace or protocol) to make a difficult decision between issuing a security token OR a utility token is similar to asking it to commit to only one funding structure: debt or equity. The reality is most companies have both, and some even add mezzanine capital. So why, in the tech space, should we not also have both security and utility tokens?

After all, utility tokens to have their fair share of advantages which seem to cancel out the negatives of security tokens:

Comparative Analysis: Utility vs Security Token

However, utility tokens aren’t extremely popular these days. Too many frauds. Too many regulatory problems in the U.S. On top of that, cryptocurrencies are still in the bear market. But does all of that indicate the end times of one of the most interesting innovations in business model design - tokenomics?

The right token is the token that helps you to scale your business
You can get your answer by looking at the success factors behind the stratospheric launch of Binance. Many people rightly pointed out that Binance hit the flywheel of community based platform by issuing their own cryptocurrency BNB. Before the ICO age, issuing your own money was the privilege of governments and huge powerful organizations (in the form of bonds). Now anybody can do it. And some very smart people did, with amazing results.

Today we see our platform’s own cryptocurrency VALOR as one of the crucial elements of the business model design and the key to scaling the platform. We are firm believers that the platform will be much more successful if a wider community of users can participate and benefit from its success. Not only accredited investors. Not only people with lots of money or from specific countries. But everybody. Anybody who is interested in using the platform for purchasing cryptocurrencies and tokenized real assets. This is a true democratization of access to wealth. Without security tokens, this kind of access would not be possible.

Legal ambiguity of the token world
And then there is this legal ambiguity which feels like the dark matter of the token space.

In the traditional financial markets, there are three ways of raising funds: Equity, Debt and Mezzanine Capital. The latter is a hybrid of debt and equity financing that gives the lender the right to convert to an equity investment, in case of default, generally, after venture capital companies and other senior lenders are paid.

The great thing about tokenization is that it enables us to structure and ‘code’ any type of funding instrument. Replicated in a smart contract, the payout can be connected to any metrix: cash flow, profit, number of users. The latter is actually a specific form of a utility token. Again, think about Binance. The more people use the platform, the more demand for token they generate and the more the price of BNB rises.

Now, would you consider the example above to be security or utility? This is largely down to the country in which your business operates and where the tokens are distributed. We learnt this lesson whilst deciding on the function of the VALOR, SMART VALOR’s native cryptocurrency. The VALOR is very similar to Binance’s BNB token. It will be used for payment, staking and rewards. In Switzerland, it is considered as a hybrid form of utility and payment token. Yet in the United States it will most likely be regarded as a security token since basically anything is considered security there. Therefore to save us from future questions we have filed with the SEC for Regulation D exemption for private security offering.

The fact is that in essence, this token is neither equity, bond, nor mezzanine. It is a new financial instrument, not comparable to anything else we have in traditional finance. Why does it make sense to treat it differently to a security, in terms of regulations? Is it safer than security or equity participation? Well yes, since once you buy it to use services of the platform, you will most likely to be able to do so. Even if the value of the token will not skyrocket in value, like Binance’s token, BNB did by 24’434% or not according to your expectations, you will still be able to use it by paying for the services you would buy anyways. This is the logic of BNB: if you know that you are going to invest and trade in cryptocurrencies and digital assets and you use Binance, you are better off buying their token, because you can pay transaction fees with it at a significant discount. This is a very simple strategy for scaling that won me over in a conversation with Binance CEO Changpeng Zhao.

Forbes - Decrypting Blockchain: Changpeng Zhao, Founder and CEO of Binance with Olga Feldmeier

In many cases of token design, there is a straightforward correlation between the price of the token and demand for it. This is achieved through the limitation of the amount of the token in circulation on one side, and the connection between usage of the platform and purchase of the token on the other side, e.g. every user that wants to use certain (exclusive) features or services will need to buy/hold the platform’s native currency. After certain time period it can be sold on the exchange again. This is called staking.

The result is one many companies seek. As the business starts to scale, the first beneficiaries become the utility token holders, those that funded the business at the very beginning. Note that in this phase the platform itself can be — in accounting terms — still not profitable. Yet the early contributors are already financially benefiting from growing popularity of that business. At a later stage, possibly even 10 years later, as was the case with Amazon, the company becomes profitable and starts to pay out dividends. This is the part that does not benefit token holders directly, but mainly benefits shareholders. We can assume from these differences that investors will decide between security and utility token based on their short- or long-term orientation.

The best place to do security token business
Of course, creating a security token significantly adds up on your issuance bill. However, it is the same on the exchange side. The exchange or the distribution venue for the token needs to apply with rules applicable in its own country and in the country it distributes the tokens. If you want to distribute and make markets in securities, you need to be either an exchange or a bank. But wait, wasn't tokenization itself the invention to disintermediate these players? Now you have to become one of them and replicate their costly licenses? Does it make any sense for anybody, apart from lawyers? And the answer is - no.

Luckily there are some progressive regulators who understand the power of this technology. They want to make it happen and fast. For example, in Switzerland they are working on a new type of exchange license, which enables you to be exchange, custodian and clearing house all in one. The roles that were always strictly separated in the past century of centralized infrastructure. It even goes as far as enabling you to distribute security AND non-security tokens, to institutions AND individuals, discretionary AND non-discretionary. In the neighbouring country Liechtenstein, they introduced the draft of the blockchain act, enabling the new concept of ownership through token while cementing a comprehensive legal framework for tokenized assets.

SMART VALOR licensing approach

It’s not black or white
It’s clear that token owners do not profit from the dividends, just like the debt or mezzanine capital givers. Does this mean that this form of participation — utility token — has no purpose? I would like to argue that it is not black or white. Just as it is not equity or debt — It is not ICO or STO. After all, the utility token is much easier to distribute due to less restricting regulations. Since it is not a security, you can sell it to any investor around the globe without registering it in your home country. Even if you go through that trouble, in most countries it would only be available for accredited investors, which is understandable given the high risk. So compare a token that anyone can use anywhere to risky security that only some investors in some countries can buy. Thus we come to the topic of liquidity - the large promise of tokenized investments. This is how things are put into perspective in the end.

So does this all mean that utility tokens are gone forever? I don’t think so. I’m sure that they will return once more. Possibly under a different name to escape the negative reputation they have earned. That is immaterial. The key prerequisite is — the business model or technology you develop will be more successful with the addition of utility token than without it. At the end of the day, if the utility token is the thing that allows you to attract more users and grow the business faster, it would be a very bad idea not to use it - in combination with a security token.

If you want to learn more, you can join our Early Access Program or participate in VALOR token sale 22-28 February here.

About SMART VALOR
SMART VALOR SV is a security token exchange for alternative investments. We tokenize, list and trade real assets such as private companies, venture capital funds, real estate projects, etc. The company is headquartered in Switzerland with offices in Munich (Germany) and Vaduz (Liechtenstein). It was selected out of hundreds of applicants to join Thomson Reuters Incubator in Baar.