If you’re not familiar with stock market investment tokenization, you might be surprised to learn how intuitive the concept is. The blockchain is a kind of backbone technology that can be developed, modified, and applied to a wide variety of different elements serving as “tokens”. Participants use blockchain as a public, distributed ledger to keep track of the distribution and exchange of those tokens.
The most commonly understood application of blockchain is with payment tokens. Cryptocurrencies like Bitcoin, Ethereum, and Litecoin all fall into this category. The intention is to enable consumers to provide payments in a secure, anonymized, and digital way. However, payment tokens aren’t the only type of tokens that can be used with blockchain. You could also provide asset-backed tokens that represent the fractional ownership of assets, including real-world assets: real estate, intellectual property, digital assets, and more.
Security tokens are one type of asset-backed tokens allowing companies to issue ownership fractions in their enterprise in lieu of the traditional option — company stock.
Investors interested in fractional ownership of a company can now buy shares of that company on the stock market - assuming it is a publicly traded corporation. So why would a company make the effort of changing?
Better funding opportunities. Fundraising is one of the biggest challenges for companies. Most startups don’t have the resources or history necessary to raise funds through publicly issued shares via an IPO. In recent years, new and existing businesses alike have turned to crowdfunding as a possible alternative. But crowdfunding campaigns can be overly restrictive, and without a proper marketing campaign, they could easily die. Issuing tokens of a company in exchange for cash could be an easy and smooth way to raise capital.
Automation via smart contracts. Blockchain can be developed to include smart contracts, or computer protocols designed to enforce specific actions or requirements. For corporations that must adhere to a wide variety of rules, regulations, and ongoing tasks like dividend distributions, this is a dream come true. It means they can fully automate (and guarantee the automation of) things like quarterly dividend distributions, the return of capital waterfalls, or clawback provisions.
Higher security for investors. Publicly traded stocks are already secure, but trading tokens on blockchain raises the bar for security. Fraudulent transactions are practically impossible to issue, given the public and distributed nature of the ledger, and every transaction is thoroughly encrypted.
Employee ownership possibilities. Security tokenization also gives companies more options for employee-owned ventures, which are hypothetically beneficial to corporations, employees, and the economy at large. The idea is to compensate employees fully or partially with fractional ownership in the employee in which they work; this incentivizes employees to work harder for what’s best for the business and can save the company money in the short-term. Security tokenization makes this much more feasible.
New ventures. The construct of security tokenization also opens the door to entirely new ventures, including fully autonomous organizations; the idea is to base organizations on a contribution model, allowing experts to contribute work freely and paying them in fractional ownership in the organization, with minimal, if any, oversight.
Liquidity and diversification. Security tokens make it easier to build liquidity for an otherwise illiquid asset, and because they’re infinitely divisible, it makes diversification easier for investors. One major advantage, thanks to these perks, is the simplification of mergers and acquisitions. It’s ordinarily very difficult to accurately value and cleanly divide organizations for these high-profile deals, but security tokenization could make the transaction much more feasible.
Cost savings. One of the biggest advantages of cryptocurrencies also applies to security tokens: reduced transaction costs. Over time, these costs should fall even lower, until it’s practically free to make exchanges.
These are just some of the unique benefits companies have, and some of the major problems security tokenization might solve. We also need to consider some of the other advantages of the blockchain in general, including the predictable supply of blockchain-based tokens, their fungibility, their divisibility, and the speed of processing transactions.
KYC has lately become the norm for crowdsale registration and exchange verification. Financial crime compliance and control is an important aspect for financial companies.
Сompliance and control for financial crime are at the core of importance for financial companies. Approx. 0,15% of transactions are fraudulent and regular KYC may not be enough to track them.
Therefore, the benefits of having information at the transaction level, where that data is centralized and easily referenced, are manifold. Moving to a model where banks know more is key to industry leadership. Know your transaction (KYT) is that model.
With the advent of the ISO 20022 standard and its MX messages, it has become possible to carry some remittance data in each interbank transaction (MX: XML, Extensible Markup Language, messages exchanged over SWIFTNet, whether they are ISO 20022 compliant or not).
But if a corporation is making payments to another corporation, for example, there may be additional documents required. These may include bills of lading, tax withholding documents, regulatory documents, proof of identity, or even proof of residency.
Sometimes even more granular detail is necessary, such as who reviewed which document in what step of the process. The automated enrichment of messages with accurate and relevant information coming directly from original sources of the data, rather than manually, is the ideal scenario.
It seems hypocritical to expect cryptocurrency users to account for where their coins came from. Surely it’s no one’s business what your bitcoin was spent on before it was passed onto the next person, and besides, doesn’t discriminating against specific coins go against the very concept of fungibility? Like it or not, KYT is on the rise, and if left unchecked, could create a two-state bitcoin, with one highway for the verified and one for the unverified and their “dark money”.
Based on the results of the check, KYT determines bitcoin in one of two states: 1st state will indicate “clean bitcoin”, and the 2nd state will indicate “dark capital”. Transaction analysis is performed within the blockchain, using blockchain data for audit / investigation purposes to find any fraudulent transaction on the network. These generated reports can be used as proof/proof of the transaction obtained from the data model.
Machine learning helps to detect anomalies: either negative, like fraud, or positive like specific client needs.
Currently, banks are using rule-based systems to detect fraud consisting of «if» and «then» statements. These can block multiple cases, but a fraud, in its very definition, is constantly evolving. The KYT solutions can therefore be defined as semi-supervised, keeping the people in the loop and building on their expertise and judgment.
Security tokenization will also introduce some new problems for companies attempting to issue those tokens.
Developing blockchain infrastructure. All these advantages sound good in theory, but they require any interested organization to develop their own blockchain infrastructure. This can be exceedingly complicated if you’re worried about things like security and compliance, and on top of that, there’s a major shortage of blockchain developers—and the workarounds aren’t exactly ideal.
Complying with laws and regulations. Securities are a complex business, and distributing those securities with the blockchain may makes things more complicated. For example, know your customer (KYC) rules demand that investors be accredited before transactions are approved, and the SEC’s Rule 144 restricts the sale of any company stock before a specific holding period. Ensuring that your security tokens adhere to every conceivable law and regulation makes the already-complex art of blockchain development even more challenging.
Managing complexities of intangible assets. Security tokenization is relatively easy to understand when it refers to a tangible things. But when asset tokenization apply to less tangible goods, like intellectual property or digital assets, it can get more complicated. How can you prove the value of an intangible asset? How can you provide backing for the tokens that your investors will be exchanging?
Dealing with volume issues and accurate estimates. Small companies attempting to tokenize their business may be forced to deal with volume and valuation issues. In the world of cryptocurrency, there are thousands of people intentionally trying to manipulate the markets, buying coins then artificially inflating the prices so they can sell them for a quick profit. Finding a way to compensate for these issues can be challenging, and in some cases, limiting. Anyone capable of securing majority control over the public ledger could also gain the power to manipulate transactions.
Overcoming barriers to investor entry. Buying cryptocurrency is straightforward to someone already familiar with the process, but to the unacquainted, the barrier to entry is high. Managing token transactions with a wallet may be confusing to some new investors, and may discourage people from taking part.
Navigating inconsistencies in policies and practices. There’s no one standard for how to tokenize a business since it’s a very new concept, but as multiple companies emerge with their own standards and development infrastructure, it’s likely that investors and developers alike will be confused. This will likely decrease as security tokenization becomes more common.
So should you start preparing for a world where everything is tokenized through the blockchain? Not yet. Corporate leaders are investing in the possibility, and to be sure, the blockchain will continue to grow in terms of both potential applications and total reach. But adopting security tokens is challenging, and only the most dedicated corporate leaders are prepared to handle those challenges—at least in the short-term.
In a few years we’ll likely see the emergence of systems that take advantage of the enormous benefits of security tokenization while minimizing the downsides.
// By Alexey Pogorely, Director of Lybrion