The Security Token Ecosystem

The Ecosystem

This articles deep, holistic understanding of who the key players are in the security token industry, what each of them will provide the ecosystem, and what progress they are making in the nascent development of the industry as a whole.

Token Issuance Platforms

Services Provided

Token issuance, Standardization

The first step in the life cycle of any security token is its issuance to the investing public. There are various issuance platforms racing to render token issuance services. Each platform has a different focus: some focus specifically on security tokens while others intend to focus on launching asset-backed tokens.

Nevertheless, each platform ultimately seeks to be the one-stop solution for any company or asset that seeks to tokenize and access deeper liquidity. To achieve this, many issuance platforms are partnering closely with exchanges.

Polymath

Polymath allows companies to raise STO funding either through its native POLY token or through ETH. The company is defining a security token protocol known as ST-20, which is designed to be open-source and feature built-in KYC. Polymath also showcases an intuitive user interface that indicates its ambitions to build a service that is accessible to a mass market.

 

As the entire security token industry is in early development, partnerships provide a glimpse into how the industry will evolve in the near term future. On the exchange side, Polymath has partnered with OpenFinance Network to provide access to secondary liquidity for the security tokens issued through its platform. Ultimately, such a partnership could afford a full-stack service for clients to issue tokens and list them on an exchange, all in a single package.

 

On the other hand, in order for the security token industry to mature, there needs to be a step-up in the number of companies that are aware of STO as a fundraising mechanism. To promote STO on the client side, Polymath has entered into a high-profile partnership with 7pass, a “hybrid investment company focused on the emerging global legal cannabis market.” This represents the first security token created on Polymath’s platform.

 

Given the somewhat controversial nature of cannabis legalization in the US and the recent developments towards decriminalization, this partnership represents a prime PR and market education opportunity for Polymath.

Indiegogo

Indiegogo, a household brand, is a making a swift foray into the security token space. As one of the original pioneers of the crowdfunding model, security token issuance appears to be a natural evolution of its already revenue-generating business lines. In fact, as of April 2018, projects on Indiegogo have raised an estimated USD $1.5 billion dollars. Some of its top projects thus far include Mate-X (affordable folding electric bike), Bristly (toothbrush for dogs), and Tropic (travel shoe).

 

The first security token to appear on Indiegogo’s ico.indiegogo.com URL is the Aspen Digital Security Token. The token presents purchasers an “opportunity to gain an indirect fragmented equity ownership stake in the St. Regis Aspen Resort.” As a major crowdfunding portal, Indiegogo is in prime position to educate its audience on the growing relevance of security tokens. For an audience that is already familiar participating in the crowdfunding model, STO may be an attractive alternative, especially since contributors to a successful Indiegogo project are currently unable to participate in the benefits of that success.

 

To answer the liquidity demands of security token investors, Indiegogo is partnering with Templum, an “operator of an Alternative Trading System (ATS) for the secondary trading of digital assets that are securities.” According to the Templum St. Regis STO website, the parameters of the raise are as follows:

$
1
m
Raise Amount
$
1
k
Minimum Investment

Securrency

Securrency has several features engineered to service a wide range of clients and differentiate itself from other issuance platforms. Their drag-and-drop workflow is designed to streamline and simplify the tokenization process for non-crypto clients. In addition, their ledger-agnostic implementation also supports STO launch “across a range of blockchain technologies.”

By analyzing press releases around partnerships, however, it is apparent that Securrency’s regulatory compliance technology is one of the most often cited advantages of the platform. Its partnerships with SharesPost, seriesOne and GoChain highlight that “maintaining compliance in this new market of tokenized securities can be challenging,” especially given the cross-border nature and novelty of the industry. 

As security tokens move toward the standards demanded by traditional equities markets, the issuance platform’s ability to ensure regulatory compliance to its clients will come to the fore. Indeed, running afoul of securities laws in the United States can result in felony penalties which are levied on a per violation basis.

Exchanges

Services Provided

Liquidity, Trading

Key Players 

Security Token Exchanges, National Stock Exchanges, Crypto Exchanges

Exchanges help to ensure that this part of the ecosystem functions properly. They are the liquidity providers. After a token has been issued, it is important that the investing public has the ability to easily trade that token with others in exchange for fiat currency, cryptocurrency, or even other securities. Here, “easily” would mean that:

  • Investors can find buyers/sellers very quickly at some desired price
  • The trades between buyer and seller happen almost instantaneously
  • Settlement of the trades happens almost instantaneously

Security Token Exchanges

In a bid to position themselves competitively, security token exchanges resort to acquiring “Non-blockchain services” companies that already possess the licenses required to operate exchanges and customary add-on services. For example, Overstock’s tZero exchange inherited:

 


Purely through acquisitions of “Non-blockchain services” companies, according to its
10-K SEC filing
While these impressive shortcuts are made possible by massive fundraising, the timelines for the full launch of these exchanges remain ambiguous.

 

Key partnerships with various service providers are intended to accelerate adoption of these exchanges by supporting well-defined equity industry standards. For example, the partnership between Templum and CUSIP Global Holdings (June 28, 2018) will create efficiencies through the marriage of Templum’s exchange infrastructure and CUSIP’s industry-standard unique security identifiers. As the first security token exchange to offer CUSIP identifiers, Templum seeks to advance by adhering to already established practices rather than reinventing the wheel.

 

As early pioneers who recognized the opportunity in security tokens, these pure security token exchanges will remain the drivers of innovation in this industry though their execution is yet to be proven.

National Stock Exchanges

The incumbent stock exchanges have a sizeable advantage over the two other types of security token exchange: they already have a working product that is compliant with securities regulations and a large user base.

 

These incumbents see that traditional equity ownership will migrate from static paper documents towards dynamic security tokens, massively cutting cost and operational complexity while simultaneously increasing liquidity. The key for these incumbents is leveraging their industry resources, adapting their existing infrastructure to support security tokens, and taking advantage of their jurisdiction’s support for blockchain technology.

 

They are making rapid progress on these fronts. The Gibraltar Stock Exchange (GSX) in particular has unique advantages. According to the Gibraltar Financial Services Commission (GSFC), Gibraltar as a jurisdiction wishes to facilitate innovation by ensuring “robust and speedy interaction with regulators…” The GSFC’s lean “Distributed Ledger Technology (DLT) Framework” designates DLT Providers which are permitted to conduct business that “use distributed ledger technology (DLT) for storing or transmitting value belonging to others.”

 

Furthermore, GSX also owns the Gibraltar Blockchain Exchange (GBX) which is already trading the standard cryptocurrency pairs such as BTC/USD and ETH/USD. It is therefore arguably the most prepared exchange to explore the opportunities present in the new STO then ICO paradigm that we suggest in our analysis piece of ICO conflicts of interest.

 

Other national exchanges such as the SIX Swiss boast daily turnovers of more than CHF 2,000,000,000 (USD $2,054,178,000). The majority of participants on these exchanges are equity traders. However, if they are given the proper infrastructure, it is quite likely that they can become some of the early adopters of STO.

Crypto Exchanges

Crypto exchanges, boast high daily turnover. Binance, the top crypto exchange by volume, regularly reports over USD $1,000,000,000 in turnover per day.

 

Crypto exchanges do have a unique value proposition for attracting early security token issuers. They have an captive user base of traders and investors who are already familiar with trading crypto. These investors will need very little education on the value of security tokenization and in all likelihood will be the foremost early adopters of security token secondary trading.

 

Binance, in partnership with Neufund and the Malta Stock Exchange, is seeking to build out the infrastructure to support security tokens for this reason. In the arms race to accommodate the expected deluge of security tokens over the next few years, it seeks to leverage its position as the largest crypto exchange to attract security token holders who seek liquidity on the secondary markets.

Funds

Services Provided

Token issuance, Standardization

With USD$84.2 billion invested in venture capital for 2017 alone, it is apparent that institutional investors (funds) have the potential to contribute substantially to liquidity in the early security token industry.

 

The promise of security tokens is ultimately to allow investment opportunities to the general public in asset classes that are lucrative, but also illiquid and expensive if there is no option to purchase fractionally. However, it is likely that early investment demand will not come from the general public, but from large funds that have deep capital and the ability to influence others to follow their investments.

 

As with exchanges, we identify three different types of funds that together are set to deliver a substantial portion of early investor-side demand for security tokens:

Crypto Funds

2015 and onwards saw the emergence of “venture capital” funds that focused specifically on blockchain related projects. These eventually took on the moniker of “crypto funds” because of “investments” made into blockchain projects are typically transacted in cryptocurrency rather than fiat currency.

These funds recognized that the traditional methods of evaluating the worth or potential of a business did not apply to the early blockchain industry. Blockchain projects in general have a tendency to raise first build later, which makes typical investment analysis irrelevant in that there is no existing business model to assess.

 

Venture capital” here is used tenuously, as is the word “investment.” A central and unresolved issue is whether the method blockchain projects use to fundraise makes these projects unregulated securities issuers. For a more in depth analysis of the ramifications of various securities legislations, read our series on the relevant regulations.


Just as the early venture capitalists of Silicon Valley paved the road for generations of transformative companies, these crypto funds were a turn-key element of the entire crypto industry. They institutionalized the investment side and created opportunities for blockchain projects to kick off their Initial Coin Offerings with private sales, the proceeds of which could fund aggressive marketing campaigns and guarantee that exchange listing fees to top trading venues could be paid.

These early crypto funds are experienced players in the industry and recognize that STO is a next logical step in identifying viable use cases for blockchain technology.

Venture Capital Funds

Traditional VC funds with huge capital resources and substantial influence have not overlooked the opportunities present in the crypto industry. Importantly, traditional VC not only brings money and influence to the industry: they also bring method.

 

Due diligence best practices, fundamental business analysis, and large portfolio ecosystems are all essential tools in the VC toolkit. These are coincidentally the same tools that the crypto industry must import to survive in the long term on business fundamentals.

 

Funds such as a16z are decisively moving into the space. Following a USD$300M raise, a16z has appointed a high-caliber industry leader to head crypto investments.

 

The structural adjustments currently taking place in the crypto industry are also the same forces that are pushing awareness of the benefits of security tokens to the fore. To learn more about the evolution from ICO to STO, read our analysis piece here.

Security Token Funds

Very few funds have yet to develop a core competency in STO since the industry is still in its infancy. It is reasonable to assume that as the industry matures, we will observe a proliferation of funds that exclusively target STO as a means of returning to investors. This phenomenon would be consistent with the rise of crypto funds we witnessed during the 2016-2018 ramp-up and peak seasons for ICO.

 

At time of writing, one of the highest profile security token funds, SPiCE VC, has launched its own STO, whereby token purchasers are entitled to returns in the fund. Assets under management (AUM) is reported at $15,609,762 on August 8, 2018, though perishing crypto prices during the summer of 2018 likely prevented SPiCE VC from achieving a higher raise. The fund also claims that its SPICE token “is the 4th security token ever, the 1st tokenized closed-ended fund, and on track to become the first security token to be traded on a regulated trading platform.”

 

SPiCE VC’s tokenization strategy highlights the flexibility of security tokens. Not only can they provide liquidity for assets and company equity, but also they can provide a fundraising mechanism for funds (a special subset of companies).

Notable STO's So Far

Services Provided

Token issuance, Standardization

Companies and Funds

The prototypical application for security tokens is for companies and funds to implement their equity on the blockchain. Ultimately, the raison d’être for moving to this new model of company ownership is accessing deeper pools of liquidity on the secondary market, encouraging wider participation from the investor public, and benefiting from liquidity premiums (the concept that if there exist two identical assets, investors are willing to pay more for the one that is more liquid).

 

We discuss these phenomena in depth in our Security Tokens: Equity Revolution or Evolution analysis piece, where we place security tokens in the context of humanity’s financial innovations to date.

 

Traditional companies are starting to take notice of security token advantages. St. Regis, a brand of Marriott International hotels has launched an STO to fund its Aspen, Colorodo luxury ski resort. As a group, Marriott reports over $22 billion dollars in revenue for 2017.

 

Their awareness of this new fundraising paradigm signals that other large multi-national corporations (MNCs) are likely to explore STO, especially for their smaller business units that need capital injections. In their STO introduction, St. Regis cites high-spending clientele, prime location, world-class winter sporting events, and dominant market share as reasons to invest. This focus on existing business fundamentals is a clear deviation from the ICO model which heavily emphasizes hype marketing as a substitute for business metrics.

 


tZero and SPiCE VC have the honor of appearing twice in this analysis piece. Both represent critical elements of the security token ecosystem. tZero contributes token issuance while SPiCE VC contributes capital.

 

True to spirit, they have launched their products using the proceeds from STO. This highlights that it is not only traditional companies who stand to benefit from tokenization. New industry players championing new equity ownership paradigms from their inception are able to take advantage of the very infrastructure that they are contributing to.

Asset Backed Token Issuers

Two oft-cited use cases for asset-backed security tokens are real estate and fine art.

However, unique challenges remain in the proposed tokenization of physical assets. Many of these challenges involve standardizing responses to contingencies. Clearly, situations may arise where the physical asset underlying a token’s value is damaged or stolen. If a physical asset is damaged, how does that affect its value? For a bar of gold, a scratch or dent may decrease its value negligibly. For a Picasso or Rembrandt, any superficial damage could plummet its value irrevocably.

Furthermore, if a physical good is stolen, what happens to the value of the token? There is a chance that the physical good will be wholly/partially recovered again or a chance that it may never be recovered. In the meantime, how should the value of the token be reflected?

Not to mention, what will be the oracle (sensor) that reports damage or theft to the blockchain? Is it secure? Who will know this information first? Should it be illegal if someone makes a trade based on receiving this kind of information before it is available to the public? Though asset-backed tokens have tremendous potential in the security token space, they also face levels of complexity not encountered by equity tokens.

Wallets

Services Provided

Token Storage

Key Players 

Online Wallets, Hardware Wallets, Paper Wallets

Wallets are where users can either store or transfer their funds from one to another. The wallets form the custody later of this ecosystem and are also the foundation of the token economy. Without safe ways to store and transfer funds, it is not possible to support the blockchain ecosystem.

The discussion of wallets therefore is essentially a discussion of the trade-offs between accessibility and security. In general, the more easily a user can access his/her stored cryptofunds, the more easily hackers can access them as well. However, the most secure methods also pose risks if a user accidentally loses or damages their wallet.

Online Wallets – Online Private Keys

Examples: Coinbase, Blockchain

Online wallets are accessed directly through the browser, most notably with exchanges. They maintain a constant connection to the internet and thus are convenient for the end user. Online wallets are ideal for storing a limited amount of cryptofunds that are expected to be transacted with high frequency as the keys are hosted by the wallet hosting company.

 

They are not an optimal solution for longer term storage because their connectivity to the internet opens multiple avenues for hackers to access funds provided they are able to obtain key information (such as a user’s private key).

 

They do have the added advantage that users are not responsible for storing the keys, as lost keys can mean big losses.

Online Wallets – Offline Private Keys

Examples: MetaMask, MyEtherWallet

These wallets are accessed directly through the browser, however the keys are generated locally in the web browser and the user must secure the keys themselves. If the keys are lost the crypto is lost.

 

Whilst they are more secure, they are not without risk. For example, MyEtherWallet was hacked by rerouting traffic to malicious servers.

Hardware Wallets

Examples: Trezor, keepkey, Ledger

Hardware wallets are also known as cold wallets as they are stand-alone and do not connect to the internet. They store a user’s private key and have additional security features that are designed to prevent users from approving an unintended transaction.

 

Whereas there is a risk of hardware failure, loss or theft, multi-factor authentication and even biometrics can be implemented to ensure that funds cannot be accessed except by the intended user. Hardware wallets are thus a better a solution for long term storage of cryptofunds.

Paper Wallets

Examples: MyEtherWallet

Paper wallets in its most basic form is a user’s public key and private key printed on a slip of paper. Typically, the keys are printed as a QR code. Paper wallets do not require power to run, nor do they run the risk of hardware failure. It is possible to generate a wallet offline with a computer that has never been connected to the internet.

 

However, they are relatively non-durable in their own right and can be used to steal funds if a hacker manages to take a picture of the wallet. Paper wallets should always be folded and bound with the critical information facing inwards.

Media

Services Provided

Publicity, Community, Marketing

For security tokens, the role of the media is to highlight key events that are material to the development of the industry. This information should be valuable for investors, companies exploring STO, ecosystem players who want to understand changes in the market, and the general public.

At Security Token Network, we provide in-depth analysis in one place on the security token industry that cannot be found elsewhere on the internet. If you seek opportunities in this industry, subscribe to our newsletter and follow us on social media.

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