Security Tokens Coming Of Age

Introduction

Understand when the security token industry will gain mainstream traction given the current state of progress, and the external challenges that key players in the ecosystem still face.

Expectations

It is expected that a completed end-to-end security token infrastructure, increasing investor demand, and a growing awareness of STO as a valid fundraising mechanism will drive a ramp up in the number of STO in 2019.

The Technology Adoption Curve

2018 could very well be an inflection point in the adoption of blockchain technology, at least from the perspective of buy-in and acceptance from traditional industry. In fact, a Deloitte 2018 Blockchain survey of companies earning over USD $500 million reveals that over 70% of executives consider themselves blockchain proficient. Clearly blockchain as a technology is gaining wider adoption rapidly, but how does this translate to security tokens?


As a simple model, the security token industry is comprised of two sides,
token issuers and investors. We break down the technology adoption curve for token issuers below (token issuers being companies that are running an STO).

Token Issuers (Companies Doing an STO) Adoption Currve

Similarly an adoption curve for STO investors is show below.

STO Investors Adoption Curve

Innovators

Current participants in the STO industry are risk takers that are building out the basic infrastructure. They are companies that have raised significant funding or funds that have access to sizable capital. Innovators tend to be less risk averse as they have greater resources with which to experiment. These are the adopters that build out the early traction within an industry.

Token Issuers 

Ecosystem key players contributing critical pieces of the security token infrastructure, many of whom have executed an STO themselves to fund development.

Investors 

Large venture capital funds with deep capital and influence that can convince their limited partners to allocate money specifically for a designated crypto fund. These players seek to get the best deals from security token issuers since they are the first risk-takers in the market.

  • Funds specifically targeting STO.
  • Funds that previously invested in ICO utilities.

Early Adopters

Tend to await early signs of traction in an industry before participating. Slightly more rational and less visionary than innovators. However, early adopters are highly knowledgeable, see opportunities early, and have the resources to be follow innovators closely. They are typically also key opinion leaders that can influence the early majority to participate.

Token Issuers 

  • Early-stage pre-A startups that understand STO as a way to more efficiently raise capital at a higher valuation than traditional equity financing models which offer almost no liquidity for shares in private companies.

 

  • Exceptional multinational corporations (MNCs) that have smaller business units requiring capital injections to take advantage of well-calculated opportunities.
 

Investors 

  • Retail crypto investors who believe in the market long term, but are highly dismayed with the rampant corruption of the ICO industry.

 

  • Retail investors who missed the ICO surge, who see the opportunity created by tokenization, or who seek a way for tokens to be linked with real value rather than with speculative hype and pure market manipulation.

Early Majority

Very rational decision makers. The early majority need to see very tangible benefits in order for them to adopt new technologies or methods. This adopter class is already achieving significant levels of success with existing solutions.

Switching over to another alternative for this could therefore be accompanied by a large opportunity cost and a long ramp-up time. They need to be convinced that the new solution can quickly yield better results.

Token Issuers 

Later-stage series A+ startups that are ready to scale with capital. They want to use the community-building capabilities of security tokens to kill two birds with one stone: raise money and establish a group of early adopter evangelists for their own product in different geographies.

Investors 

  • The first wave of traditional VC funds, PE funds that begin to see more of their portfolio companies (startups, SMEs) benefiting from launching STO and achieving higher than expected valuations based on liquidity premiums. Most likely, partners or employees or these funds have already begun personally investing in security tokens as early adopters.

 

  • Hedge funds that recognize there is growing demand for their activity in the market place as participants demand more liquidity.

Late Majority

Highly practical. Late adopters in this industry may be bound by externally imposed mandates that preclude them from being early pioneers. They may not have full autonomy to make certain strategic decisions by themselves, requiring buy-in from other stakeholders.

Token Issuers 

  • Family owned SMEs facing increased competition from consolidation in their industries. Faced with the option of adapting to rapid technological change such as automation or falling by the wayside, SMEs with solid business fundamentals may launch STOs to obtain the funds necessary for expansion and efficiency upgrades: factories, supply-chains, R&D.

 

  • MNC’s whose innovation leaders have witnessed other MNCs launch successful STO for business units. These laggard MNCs may feel a need to create similar results for their business units through a mix of internal demand and external media coverage of MNC STO.

Investors 

  • Family office heads that have heard of the returns achieved by sophisticated funds in the STO space. These family offices may even represent families that own an enterprise seeking to launch an STO.

 

  • Investment banks that begin to see M&A deal flow where one or both of the companies involved have undergone an STO.

Laggards

Participate when costs decrease or barriers to entry are lowered through competition in the market. These tend to be smaller players who want to capitalize on a lucrative trend that they believe will hold steady.

Token Issuers 

New startups and other businesses that could not raise money without an already established STO ecosystem. These companies are dependent on having a large investment public to communicate to, which implies they will not have the resources to be early adopters, but will still be able to benefit from STO.

Investors 

Large scale asset-management funds with billions of dollars who correctly identify security tokens as a unique and high performing asset class.

Overcoming Challenges: Bridging the Chasm

Bridging the Chasm

Regulation

Complying with existing securities regulatory requirements is a challenge born mostly by the security token platforms. Nevertheless, difficulties in implementing compliance measures into token smart contracts will delay downstream developments in the industry: exchanges, investors, and security token issuers all depend on the issuance platforms to achieve the first step in the life of a security token.

 

While security tokens intend to be complaint to SEC regulations, this does not guarantee that the specific compliance methods they first employ will function as intended or be accepted by securities regulators.

Infrastructure Development

Another major bottleneck in wider adoption of security tokens is a dependency on the entire infrastructure stack to be fully functioning before tokens can be issued and traded on a secondary exchange.

Delays in deployment from any of the ecosystem players could provide a hurdle that offsets adoption of security tokens as an alternate asset class for institutional investors.

Resolving Custody 

Especially for asset-backed security tokens, an open-ended question remains around standardization: specifically, who will take custody of the underlying asset? Who will take responsibility if the underlying asset is damaged? Whereas some physical assets are highly durable (such as gold), others are exceedingly delicate (ancient fine art).

 

Who will be able to build the necessary facilities to custody of a whole range of different physical assets? Will there need to be a new insurance industry specifically around asset-backed security tokens?

Limited Early Liquidy

The STO industry cannot be expected to appreciate as aggressively as the ICO industry did in 2017. Indeed, this is part of what makes security tokens attractive: growth is more organic and tied to growth in business fundamentals.

 

This makes security tokens attractive to value investors, but limits the volatility that pure short term speculators appreciate. It is important to keep in mind, however, that value investors are speculators as well: they intend to hold securities on a longer timeline, however.

Perception 

As discussed in our analysis piece on the movement from ICO toward STO, it is widely understood that the ICO industry is highly corrupt. A lack of business fundamentals coupled with lax disclosure requirements means that little more than speculative hype and market manipulation controls the price of utility tokens that make it onto a trading venue.

 

This makes it difficult for institutional investors to participate in ICO; it would be very difficult to justify any decision based on accepted business principles.

Education 

It is quite possible that institutional investor appetites for crypto have waned as a response to the alt-coin crash in the summer of 2018. Educating investors on the opportunity in security tokens will be complicated by this ICO market correction. It will become imperative for security token issuers to effectively communicate the difference between ICO and STO.

 

It will also be critical that the media plays a balanced role in building the foundation for STO acceptance. Attempting to hype the STO with the same aggressive tactics applied to ICO could be a fatal mistake that sets the industry back months if not years.

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