Tokenized Securities

Tokenized Securities, a new era has begun.

The tokenization of securities,  debts and assets opens up a 76 trillion US-Dollar market. The tokenization brings financial instruments to a global audience, right into private households. What before was accessible only to large institutional investors,  now is available to any private individual – by the means of any easy and quick transaction.

The tokenization of assets refers to the process of issuing a blockchain token (specifically, a security token) that digitally represents a real tradable asset—in many ways similar to the traditional process of securitization on a stock exchange, with a modern twist.”  Read the full article from DELOITTE here.

Tokenization of securities in full swing. Read full article in Forbes magazine, click here.

MIT Management School, the future of securities and real estate. Read the full article from MIT Management School here.

Learn how An Aurum Dynamics Corp offers its securities in a new era.  If you are an accredited or qualified investor you may participate in the private offerings of Convertible Bonds Aurum A2 and Common Shares.

If you are interested in tokenizing your own securities or assets. or if you would like to offer tokenized assets and securities for sale, do not hesitate to talk to us.  We always are looking for new venture capital opportunities, acquisitions and investments.

Tokenized securities on blockchain are here.

With the entire year in crypto defined by a maelstrom of projects embarking on decentralized finance (DeFi) aspects to their products, it can be easy to forget that previous advancements in blockchain-based technologies have continued to make great headway in terms of adoption and application.

UNDERSTANDING TOKENIZED SECURITIES

What is a Security?

To start with the basics, a security is a fungible and negotiable financial instrument that holds some type of monetary value. It can represent ownership in a company’s stock, a creditor relationship with an entity through a bond, or rights to ownership as represented by an option. To keep it simple, a security can be broken down into three overarching categories; equities, funds and debts. Equity is an investment in stock issued by another company. The stock can be either private or public, and represents ownership of an entity. The entity could either be a corporation or a trust. Equity securities entitle the holder to some control of the entity on a pro-rata basis, via voting rights. Debt represents money that is borrowed and has to be repaid. The issuer of the bond (or debt) owes the holders debt and is therefore generally obliged to pay them interest, and to pay the principal on the maturity date as stipulated in the offering documentation of the security. Typically, interest is paid as fixed intervals (monthly, quarterly, annually, etc). An investment fund is a supply of capital belonging to numerous investors used to collectively purchase securities. Each investor retains ownership and control of their own shares. The same principle can be tokenized, and the tokens can represent shares in the fund.

What is Tokenization?

Security tokenization is the process of materializing the ownership in a security through the issuance of a “token” registered on a distributed ledger technology (DLT) infrastructure. Therefore, a tokenized security can be equity, a bond, or an investment fund. It could also represent a securitized fraction of a real asset (e.g. a piece of art). The DLT infrastructure used to issue the tokens can, depending on the legislation and the choice of the issuer, either be the “primary register” for the security or a representation in the form of tokens primarily issued on a different infrastructure outside of the blockchain. For the purpose of this Ebook, we will refer to these tokens as ‘security tokens’ and we will detail how they work in the following section. Most players in this emerging industry refrain from calling these ‘digital securities’, as the term is too vague, and in fact, securities have been traded digitally for years. Our world is full of these securities, but many are currently difficult to physically transfer or subdivide, so buyers and sellers instead trade paper or unsecured digital files that represent some or all of the asset. These systems are cumbersome, difficult to transfer and can be hard to track. The underlying assets can also lack transferability: For example, if the underlying asset is a piece of property, transferring the ownership of that asset requires for it to be sold. Through tokenization, the rights of these assets can be shared almost instantaneously thanks to peer-to-peer trading. This is one advancement of many when applying blockchain technology in financial markets. There are of course many other use cases.

What Exactly is a Security Token?

2018 has been the inaugural year of Security Token Offerings (STOs) and many think that by 2030 tokenized securities will be the primary method of issuance. To understand security tokens, it’s fundamental to understand securities. With securities, it’s mandatory to respect the relevant laws and regulation for every jurisdiction the assets are issued in, and in every jurisdiction the securities will be distributed. As you might expect, the exact same process is needed when issuing security tokens on a blockchain.

Utility Tokens versus Security Tokens

To precisely define security tokens, let’s define something they are not, utility tokens. An ICO is a way to raise funds for a distributed network. A company, or a foundation, issues tokens that can be used by contributors to redeem a service the entity is offering. For example, if the issuer of the token is a company launching a decentralized car sharing platform, each kilometer of travel could be represented with a token. The tokens are a way to exchange value between participants of the network by representing a unit of service. As such, they are called utility tokens. However, if the main purpose of the token is to generate an increase of monetary value for its holder, it is an investment and therefore will be considered a security in most jurisdictions. Obviously, if the issuer needs to collect funds in order to finance a company in the form of debt or equity, or if an asset manager wants to issue an investment fund, the token representing these financial instruments won’t be utility tokens, they are representations of securities and are therefore called security tokens. The key difference here is that utility tokens represent a right to use a predefined good or service. Security tokens represent a right to future financial flows resulting from the main activity of the issuer of the token.

Compliance

As we are talking about securities, we need to ensure the transfer of these security tokens are performed in a compliant manner. Typically, when a security token transfer occurs on a blockchain, the source address calls the smart contract transfer function. In its most basic form, this function has a destination address and an amount to transfer. However, for a STO to be issued in a legal manner, transfer instructions need to be programmed into the token to ensure compliance in every jurisdiction the offering is issued in:

Permissioned tokens

Permissioned tokens work with a validator or regulation service which will validate whether or not a trade should have the permission to be executed. In permissioned tokens the securities rules are coded into the token and the validator which can be centralized or decentralized. There are several open source smart contract templates (so called “protocols”) for permissioned tokens, the main ones are overwriting the “transferfrom” functions of the ERC20 token standard, and ask permission from a validator/regulator service, which may or may not be included in the protocol.

Identities management

To enforce the compliant trading of tokens it is of course important to execute the transfer between one wallet and another. However, as issuing securities implies respect to strict offering and secondary market rules, and as AML and KYC regulations apply, it is also fundamental to allow for the creation and management of identities for every stakeholder. Using protocols like the ERC-725/735 allows for a unique identity for a person or group that can be published and managed via the blockchain and allow for the identity to hold keys and sign actions. It provides an easier way to operate the lifecycle management of a token by identifying more easily who can and cannot make transfers and allow for multiple people within an organization to sign off on transactions if they have the necessary identity keys.

T-REX (Token for Regulated EXchanges)

To ensure compliance from the issuance of security tokens to their lifecycle management (securities servicing and transfers), issuers can use the open source T-REX (Token for Regulated EXchanges) infrastructure. This set of on-chain solutions is used to create compliant-by-design security tokens by respecting market standards and well tested smart contract templates. The T-REX ensures continuity with regards to KYC and AML compliance checks, ensuring all participants are eligible for the investment. It ensures interoperability with the main liquidity providers and allows issuers to allocate tokens to their investors and shareholders. The T-REX can easily be completed by other smart contracts and dApps to manage taxes, and to conduct post-issuance corporate actions such as dividend payments, voting and announcements. Only the T-REX suite of blockchain tools assembles on-chain identities and permissioned tokens to guarantee transfers of ownership in a built-in validator service.

What are the benefits of Tokenization?

Why tokenization? Why replace an infrastructure that has existed for decades? There are a number of benefits when comparing security tokens and finance methods that operate today:

Automation

A number of service functions that are currently carried out by middlemen can be automated through the blockchain. Currently, these various levels of intermediation often complicate communication between the issuer of a security and his investors. Each intermediary maintains its own ledger of data, and while central intermediaries maintain aggregated records, the parties’ ledgers can differ quite substantially. Every level of holding needs to perform position reconciliations with the previous ones which represents an important and costly operational process (not to mention the cost of reconciliation breaks needing to be fixed). Through a STO, the processes can be simplified and automated via smart contracts, and also by sharing the same information. Issuers offer shares directly to investors, making the information accurate, transparent and immutable.

Shared information and Transparency

Security Tokens eliminate the asymmetry of information that is present during the actual transfer of ownership of a specific security. Using the blockchain as a central source of truth, is shared by every player on the value chain. The tokenization of securities on a blockchain will also make governance and ownership more transparent and reliable than a traditional private security offering.

Cost-effective

In the traditional securities markets, middlemen charge significant fees for their services. These fees charged by those intermediaries pile-up to be paid by the end-investor, adding another barrier to entry. By using blockchain technology and smart contracts, issuers can cut out many of the typical, low-value added, expensive, intermediaries that are needed for offerings. This in turn will re-create the links, allowing the issuers and their investors to have more direct relationship with one another.

Immutability

Financial institutions currently rely on private databases. In these internal systems there are different levels of access for the users that operate the database. In the lowest form, there will be users with read-only access, who will not be able to change any data. Usually there will be at least one user with a higher level of access, such as a systems administrator, and they may be able to make amendments to existing data. Investors and regulators need to trust organisations because there is no control mechanism making the data immutable in the first place. This is where blockchains can add substantial value. Once an investor buys tokens on a blockchain, nobody can erase the history of his ownership. Once data has been written to a blockchain, i.e. after a transaction has occurred, nobody, not even a system administrator, can change it. This is highly beneficial when it comes to auditing, as you can prove your data hasn’t been altered, reducing time and costs.

Inclusivity

Global reach and lower fees of the blockchain infrastructure allows for a new breed of investor and the potential for a worldwide investor base. The ability to divide the underlying assets into smaller units, making it more affordable for some investors and easier to transfer, allows for fractional ownership. Investing in an apartment, for example, could cost too much and might make it difficult to sell later, but owning a fractional share in the whole building could be cheaper to buy and easier to sell.

Liquidity

Privately issued securities are often difficult to trade and therefore have been highly illiquid. The use of blockchain allows value to circulate more easily by bringing online trust, as it prevents the “double spending” problem. The ability to fractionalize tangible assets through tokenization can also bring liquidity into these markets that have had little to no access to it. Traditionally, private securities could only be traded on secondary markets after using an extensive amount of middlemen and following strict, difficult to navigate regulations. By streamlining and automating these processes and by using a common distributed infrastructure, companies can remove the burdensome hurdles that previously restricted the liquidity of their securities. Secondary markets will also offer increased liquidity through a constant 24/7/365 trading market.

Speed

Fast digital transfer of ownership, T+0 settlement, 24/7/365.This results in increased liquidity and the opportunity for investors to transfer or sell their tokens after they’ve been issued. This is fairly commonplace for some traditional securities, in particular when they are largely distributed in the public. However, it’s far less common in other types of securities or financial instruments such as loans, real estate or private equity funds, which are generally far less liquid. Tokenizing those instruments through an STO can facilitate the transferral of these types of securities which aren’t always technically transferrable in their traditional form.

 

Token Economics – Value and Revenue Management

Value of the tokens

The tokens issued represent the value of the issuer’s assets on the blockchain. Therefore, simple mathematics allows you to calculate the value of each token during the issuance:

First, the issuer needs to determine the value of the underlying asset during the offering. After this the amount of the asset that will be tokenized will need to be defined (it could be the totality for a new investment fund, or 15-25% for an equity fund raising for example). Finally, they will need to determine the number of tokens issued.

The token economics can be calculated simply:

value of 1 token = (total value of the asset % tokenized) /number of issued tokens

Or

number of issued tokens = (total value of the asset ∗ % tokenized) / value of 1 token

For example, if the issuer plans to tokenize the totality of a 100 million euros real estate fund, and divide it into 100 million shares, each share is valued at 1 euro. To convince investors that the underlying asset is valued properly and that the investment is a good opportunity, the issuer will need to detail the anticipated revenues and rights associated to the tokens.

Revenues associated to the tokens

Investors will only invest if they think the underlying asset will gain value and/or generate revenue for them. The issuer needs to explain in his documentation how the benefits will be distributed:

Services

The goods or services of a business can be offered as a way to raise investment for that business and/or to launch a decentralized network. The tokens issued in these cases are called utility tokens and can only be used to access the network, or purchase the goods or services offered by the issuer of the token. Type of distribution: In which form will the revenue generated by the underlying assets be distributed? Issuers can choose to do buybacks, meaning buying their own shares to reduce the circulating supply available on the market. Buybacks are normally purchased at the market value per share plus a premium. Also, reducing the number of shares available is supposed to increase the demand and therefore the price of the circulating tokens. Dividends are also a common option to distribute revenues. Investors will receive dividend payments for owning shares. Dividends correspond to a cash distribution, in fiat, in stablecoin, or in crypto-currencies. For example, a company could decide to distribute 10% of its profits annually to token holders.

Frequency of distributions:

Once the form of revenue distribution is defined, the frequency of distributions is important as well. Standard companies pay dividends annually but some financial products share profits more regularly, such as on a quarterly or monthly basis. Thanks to the blockchain, cash distribution can be automated, at least partially. It represents an opportunity for issuers to offer additional incentives for investors by planning more frequent cash distributions. Whatever the form and frequency of distributions, the sharable revenues will be impacted by management costs from intermediaries.

Operational team and managers fees:

Founders are more than just shareholders and are usually active in the company as well. Therefore they will get salary and bonuses to reward their work. It will obviously impact the total amount to share with other investors. For funds, the managers will receive performance fees.

Agents fees

Agents that are mandatory in current financial transactions, including custodians and management companies in some cases, will need to be paid as well. As there are less intermediaries involved in tokenized securities than in typical security issuances, there are less middlemen taking fees. Through the use of programmable smart contracts, there are automation opportunities, thus reducing cost and adding, transparency, accuracy and immutability. Having said that, these fees are not completely removed, as there is still a need for some middlemen, such as distributors for example.

Rights associated to the tokens

If tokens represent the shares, any rights associated to the shares are associated to the tokens. Therefore, companies regulations and/or financial regulations apply. Also, standard shareholders agreements can provide additional rights to token holders such as information rights, drag along, tag along, etc. All of these rights should be detailed in the legal documentation of the offering. Some of them can be expressed directly on the blockchain during the lifecycle of the security, via votings. For example, if the issuer is using a proper identification system for investors, voting can be performed on-chain. It is now legally recognized by some regulations, as in France, for example. Token holders, from all around the world, can now easily participate in general meetings. Depending on the type of financial instrument issued, investors will expect different type of rights. However for debts, they will be less demanding than for equity.

 

Last but not least, ensure the legal compliance and the right jurisdiction for your token offering. 

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