This post was last updated on July 26th, 2018 at 06:33 pm
Part 1 Audio: The Definitive Intro To Tokenized Securities
Part 2 Audio: How Security Token Platforms Actually Work
Part 3 Audio: 7 Predictions About Our (Wild) Tokenized Future
Table of Contents
- Intro: “Tokenize The World”
- Thanks to Our Sponsors
- TTW Part 1: The Definitive Intro To Tokenized Securities
- Part 2: How Security Token Platforms Actually Work
- Part 3: Seven Predictions About Our (Wild) Tokenized Future
Introduction to This Documentary
I decided to create this documentary about security tokenization after learning that many of my preconceived notions about security tokens were just flat wrong. During my journey, I also discovered that several individuals I respected (and who were otherwise well versed on cryptoassets) also had misconceptions about security tokenization, how and where security tokens attempted to add value, why they might be needed, and the mechanisms of how they worked.
As my friend, Taylor Pearson pointed out in a really long Tweet storm: understanding how cryptocurrencies work means understanding cryptography, distributed systems, economics, and politics.
Security tokens add to this list . . .
- SEC regulations & securities laws
- Equity mechanics
- Private and public issuance of stock
- Secondary trading
- Guidelines from over 100+ legal jurisdictions
My purpose here is not to convince you that security tokens and asset back tokens are valuable or needed, but instead to simply the complex and tell the story of projects makers, issuers, investors, and influencers driving adoption of security tokens.
To create this content, I had conversations with leading thinkers and creators in the field. What I found is that, at every step of the way, the tokenization of securities, real estate, art, and other real-world assets is forcing us to reexamine old habits and ways of operating.
This documentary started off as a passion project, quickly turned into a huge, time-consuming pain, and is now back to being a passion project as we hit publish.
Thanks To Our Sponsors
We’d like to take this opportunity to thank our two sponsors, Blocktrade.com and the Nomics API.
Blocktrade.com will be the first fully licensed security token exchange in Europe, focused on listing crypto assets, security tokens, and other tokenized financial instruments. By being fully MiFID II compliant they will enable crypto trading to institutional traders while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few things to announce in the next couple of weeks, including their public beta launch. Be sure to go to Blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.
The Nomics API offers squeaky clean and normalized primary source trade data offered through fast and modern endpoints. Instead of having to integrate with several exchange APIs of varying quality, you can get everything through one screaming fast fire hose. If you found that you or your developer have to spend too much time cleaning up and maintaining datasets, instead of identifying opportunities, or if you’re tired of interpolated data and want raw primary source trades delivered simply and consistently with top-notch support in SLAs, then check us out here.
Tokenize The World, Part 1: The Definitive Intro To Tokenized Securities
This documentary is brought to you by Nomics’ Cryptocurrency & Bitcoin API. The Nomics Market Data API offers squeaky clean and normalized primary source trade data offered through fast and modern endpoints. Instead of having to integrate with a bunch of exchange APIs of varying quality, you can get everything through one screaming fast firehose. If you found that you or your developer have to spend too much time cleaning up and maintaining datasets, instead of identifying opportunities, or if you’re tired of interpolated data and want raw primary source trades delivered simply and consistently with top-notch support in SLAs, then check us out the Nomics Market Data API.
In this first installment, we discuss:
- The origins of securities and how we determine what qualifies as a security.
- Why Beanie Babies, art, and other collectibles are not securities.
- The purpose behind securities laws.
- The benefits of tokenizing a security and fractionalizing property ownership.
- Why private securities often trade at a huge discount.
- How blockchain technology has changed trade execution.
- How tokenization unlocks liquidity.
- How security tokenization provides different kinds of value to public vs. private companies.
- Why cap table management largely not an electronic process right now.
- Ideal vs. non-ideal security token use cases.
- Why centralization within security token platforms is unavoidable and doesn’t erode the value proposition of these systems.
- The kinds of problems are being solved through security tokens.
- Which average American businesses could benefit the most from tokenization.
- How blockchain technology has changed trade execution.
- How tokenization unlocks liquidity.
- How security tokenization provides different kinds of value to public vs. private companies.
- Ideal vs. non-ideal security token use cases.
- Which average American businesses could benefit the most from tokenization.
We also discuss three misconceptions about security tokens:
- The first misconception is that security tokens are not valuable, because they are centralized around the issuer and in many cases are not censorship resistant.
- The second misconception is that securities should not be represented with a blockchain because securities are not, at their core, digital assets.
- And the third is that security tokens are overkill and that all that is needed is a highly efficient database, rather than a blockchain, to address the needs of issuers and traders.
Special thanks to all of our guests including Professor Stephen McKeon, securities attorney Zach Robins, Harbor CEO Joshua Stein, and Bruce Fenton (CEO Chainstone Labs/Atlantic Financial and Board Member at Medici Ventures, tZero & the Bitcoin Foundation). Thanks also to Polymath’s CEO Trevor Koverko & COO Chris Housser, who appear prominently in part 2 of this audio documentary.
Links Relevant To This Episode:
- [Podcast] The Economics of Cryptoasset Markets w/ Professor Stephen McKeon
- Taylor Pearson
- Stephen McKeon
- Stephen McKeon on Medium
- Stephen McKeon on LinkedIn
- Stephen McKeon on Twitter
- Zach Robins
- Josh Stein
- Bruce Fenton
- Chris Burniske
Terms Mentioned in the Episode:
Part 1 Transcript:
Clay Collins: [00:00:03] Welcome to Flippening, the first and original podcast for full-time, professional and institutional crypto investors. I’m your host, Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the front lines of financial disruption. Go to Flippening.com to join our newsletter for cryptocurrency investors and find out just why this podcast is called Flippening.
Announcer: [00:00:25] Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion and do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.
Clay Collins: [00:00:40] Welcome to part one of Tokenize the World, a security token documentary. If you don’t know what a security is, let alone what a security token is, we’ve got you covered because right after this intro, we’re starting from the top.
Clay Collins: [00:00:51] I decided to create this series after learning that many of my preconceived notions about security tokens were just flat wrong and that several individuals I respected and who, otherwise, were well versed on crypto assets had misconceptions about security tokens, how and where they attempted to add value, why they might be needed, and the mechanisms of how they worked, and who could blame them really?
Clay Collins: [00:01:11] As my friend, Taylor [Pearson [00:01:12], pointed out in a really long Tweet storm, just understanding how cryptocurrencies work means understanding cryptography, distributed systems, economics, and politics. Security tokens add to this list, SEC regulations, securities laws, equity mechanics, private and public issuance of stock, and guidelines from over 100 legal jurisdictions. With this in mind, my purpose here is not to convince you that security tokens and asset back tokens are valuable or needed, but instead to simply the complex and tell the story of projects makers, issuers, investors, and influencers driving adoption of security tokens.
Clay Collins: [00:01:45] To create this content, I had conversations with leading thinkers and creators in the field. What I found is that, at every step of the way, the tokenization of securities, real estate, art, and other real-world assets is forcing us to reexamine old habits and ways of operating. This documentary started off as a passion project, quickly turned into a huge, time-consuming pain in the [beep [00:02:06], and is now back to being a passion project just as it’s about to be released.
Clay Collins: [00:02:10] I should mention two things before we end this intro. The first is that I am not an attorney or financial advisor and absolutely none of this should be taken as legal or investment advice. The second thing worth mentioning is that this documentary is brought to you by the Nomics API. Nomics employs me and is making this content possible, so here’s a bit about the API. The Nomics API offers squeaky clean and normalized primary source trade data offered through fast and modern endpoints. Instead of having to integrate with a bunch of exchange APIs of varying quality, you can get everything through one screaming fast fire hose. If you found that you or your developer have to spend too much time cleaning up and maintaining datasets, instead of identifying opportunities, or if you’re tired of interpolated data and want raw primary source trades delivered simply and consistently with top-notch support in SLAs, then check us out at Nomics.com.
Clay Collins: [00:02:58] Let’s get back to the documentary, which starts out by addressing two questions. The first is how we traditionally interact with securities in the past, and what needs improvement? The second is, what’s a security in the first place? Here to address that topic is securities attorney, Zach Robins.
Clay Collins: [00:03:19] At it’s most basic level, what is a security?
Zach Robins: [00:03:27] The Securities Act of 1933 and then the Securities and Exchange Act of 1934 are the bedrock laws that oversee securities laws and were both responses to the Great Depression. Today, we judge a security by something known as the Howey Test. The Howey Test is a four-part test, which basically says, “Is an investor contributing capital? Is the capital being contributed to a common enterprise that relies upon the work of others,” and the fourth part, most important part, “is there an expectation of profits?” That Howey Test came from case law, and that, today, is still how we judge a security.
Zach Robins: [00:04:16] The vast majority of securities out there are privately held. Those are shares in private companies, those are interests in real estate, in many other assets out there.
Zach Robins: [00:04:28] When I’m trying to explain a security to someone, and it’s obviously helpful to describe it in as layman’s terms as possible, I love to use the example of Kickstarter because, in 2018, everyone knows what Kickstarter is, and Kickstarter is where you back a campaign, you give money to that campaign, and you never have an expectation though of making money off that campaign. Your expectation is that you’re going to receive access to a service or perhaps a physical good will be coming back to you, and so that is not a security, whereas if I were to invest in an investment crowd funding campaign, there is a clear expectation of profits.
Clay Collins: [00:05:17] There’s some interesting nuance in Zach’s comments, but the most essential part of what Zach said is the Howey Test as a set of conditions used by the FCC to determine what is and is not a security. I think it’s important that we restate this four-part test. Something qualifies as a security if it involves:
Clay Collins: [00:05:33] 1. An investment of money.
Clay Collins: [00:05:35] 2. A common enterprise.
Clay Collins: [00:05:36] 3. With the expectation of profits.
Clay Collins: [00:05:39] 4. Predominantly from the efforts of others.
Clay Collins: [00:05:42] This last part is arguably the most important component. It is key that profits are derived from the efforts of others. That’s why a direct fractional ownership stake in real estate generally doesn’t constitute a security, and that’s why Beanie Babies, lottery tickets, pieces of art, and collectibles are not securities.
Clay Collins: [00:05:59] For more on this, here’s a piece of my conversation with Bruce Fenton. Bruce is the owner of Chainstone Labs, hosted the Satoshi Roundtable, and one of the leaders of the Ravencoin Project.
Clay Collins: [00:06:10] You mentioned that you could have a token that represents a Beanie Baby, and that wouldn’t necessarily be a security. The somewhat absurd example of a Beanie Baby might help us get to the core of this discussion about securities. If you had a token that represented a Beanie Baby, that would not be a security, but if you could have fractional ownership in a Beanie Baby that you believed would appreciate in value and these tokens that represented fractional ownership or being traded, would that be a security?
Bruce Fenton: [00:06:44] No. That’s a great question. I’m glad you asked that because that’s a common misconception. A lot of people are really misunderstanding what tokens are and how they work and what securities are and how they work. The fact that something is a token doesn’t change it at all, whether it’s a security or not. That’s completely based on just the Howey Test.
Bruce Fenton: [00:07:02] A Beanie Baby, nobody argues that a Beanie Baby is a security. If you tokenize it, basically, something being a security doesn’t change its properties. What really matters is what the agreement is, going back to when we talked about what a stock is. What is the agreement between people? What is the agreement between human beings? In the example with a Beanie Baby, if you have a fractional Beanie Baby and you believe it goes up, that alone doesn’t make it a security, and that would not be subject to the Howey Test. That wouldn’t be considered a security under the Howey Test. Collectibles are allowed. They are not considered securities. You can trade them freely. You could certainly tokenize them and trade them. There’s no reason you couldn’t. Just because something’s anticipated to go up in value doesn’t make it a security.
Bruce Fenton: [00:07:49] That’s one part of the Howey Test, whether somebody anticipates that it’s going to go up, but that alone doesn’t make it … People think that things are going to go up all the time. People were buying ringtones for a while. People buy magic cards. They buy comic books. They buy art. They buy rare cars. None of those things are securities, and the tokenization of something and splitting it into fractions doesn’t make it a security. What makes it a security is the agreement between people. If you’re raising money from people where they think that the person’s work … That was a key component of the Howey Test, a person’s work, as in CEOs and CFOs and COOs, are going to do something that will make someone else the shareholder or the instrument holder money. That’s a very different thing.
Bruce Fenton: [00:08:36] If you invested in a company that sells Beanie Babies or comic books and says, “We’re giving you a token and we’re gonna buy X number of Beanie Babies and you’re gonna get a percentage of what we sell,” or something, those are the kind of things when you’re getting into being a security.
Clay Collins: [00:08:52] What if we take the example beyond Beanie Babies and we say, “Fractional ownership in a piece of Vincent Van Gogh artwork or fractional ownership in a piece of property that isn’t being put to productive use.” Is it the same thing apply or not?
Bruce Fenton: [00:09:08] It depends. The law is complex. In the example of a Van Gogh painting, sure, I don’t believe that would be a security, also. Real estate, it depends how it’s sold. If it’s just real estate in itself, that wouldn’t be a security. Real estate is not a security. However, real estate investments can be securitized depending how they’re sold. If I go out and say I want to be a developer and I’m going to raise 100,000 each from 20 people or something, those are the areas where you’re likely getting into something that’s going to be a security. It depends exactly how it’s done. There are ways to structure real estate transactions, which is not a security. We have joint owners and they all own part of the real estate, but Howey and the FCC and the law is mainly concerned about is when someone is asking someone else for money for something that they are claiming or presenting or the people believe will yield them an investment return based on the efforts of another person. That’s where it really comes down to it.
Bruce Fenton: [00:10:06] You could buy a Van Gogh, and that’s just going to do what it … It’s going to go up or down in value based on supply and demand. Same with Beanie Babies, comic books, Van Goghs, ’67 Mustangs. All of those things will be based on supply and demand, whereas if you have interest in Bob’s Car Repair or Jane’s Art Stor or something like that and you own a 1/1,000th of the company, then that is a security because your efforts don’t depend on supply and demand. They depend on Jane’s efforts as a art dealer or Bob’s efforts as a car dealer or whatever. That’s one way that it becomes a security.
Bruce Fenton: [00:10:44] There’s other ways, too. You could have something where you don’t depend on anybody’s effort, but because of what the instrument is invested in, then that becomes a security. For example, if you buy other securities, you’re automatically a security. That’s one thing that we ran into with my company. I want to issue an asset management product that would invest in securities, and I spent probably a year looking at the law, and I’m very clever and creative with these things. I love to think outside the box. It’s probably my biggest strength, and I have a decent understanding of both the securities industry and blockchain, and I looked and looked and looked and tried to figure out a way around it. They’re just isn’t any way around it, at least for my particular product. If you have an investment that buys securities or if you are having something that is basically shares of your business or something like that, it’s definitely a security, so for, at least in my case, there was no way to try and claim it was a utility token or something like that. That’s important to know exactly how the Howey Test decision works and what they’re most likely to look at when they’re looking at these things.
Clay Collins: [00:11:48] What I noticed during my discussion of securities is that there seems to be a definitional tautology. Something is a security because it’s regulated by the FCC, and it’s regulated by the FCC because it’s a security.
Clay Collins: [00:11:59] Here to help us gain clarity on this is Joshua Stein. Joshua is an attorney and the CEO of Harbor, one of the leading platforms for issuing blockchain-based security tokens.
Joshua Stein: [00:12:09] There’s the tautology of a security is that which is defined as a security under the law. That’s the legal answer of, when do the security rules apply, but underneath that, there’s a underlying public policy concern. Why do we define certain things as a security? What is it that drives the categorization? The answer is it’s a classic principal agent problem. When you have fractional ownership and you give over your money to someone else to then invest and manage that, there is a principal agent problem where the interests aren’t aligned exactly. That’s where the regulation springs up so that investors can be protected and that the capital can be formed, and the securities laws are designed to do that. They’re designed to protect investors, facilitate capital formation, ensure orderly secondary markets, and it drives out of this principal agent issue where you have to have some level of disclosure and trust of the third party that you’re entrusting your money to.
Clay Collins: [00:13:06] Securities laws were created to prevent fraud and to prevent bad actors from making decisions that negatively affect others. I think Josh’s answer gets at the root of this issue, which is that they were created to solve the principal agent problem. The principal agent problem in political science and economics occurs when one person or entity, i.e., the agent, is able to make decisions or take actions on behalf of another person or entity.
Clay Collins: [00:13:27] Professor Stephen McKeon from the University of Oregon has some further insight into the purpose behind these laws.
Stephen McKeon: [00:13:34] One thing that’s not talked about often enough is that there’s a difference between a scam and a bad idea. Regulations should attempt to curb the first, but not the latter. It’s hard to tell [inaudible [00:13:47] what are the bad ideas and what are the things that are going to be world-changing. Sometimes, it’s actually not obvious right away. What regulations should do is try to curb market manipulation, try to curb outright scams, but not actually try and protect the investor from taking a chance on a particular idea. The government authorizes many ways for the general public to lose money. They sell lottery tickets. They regulate casinos and so on.
Stephen McKeon: [00:14:18] I think it’s up to the investor to decide whether the investment is good or not or whether it’s something they want to put their money behind, but what regulations should do is try to prevent the purely bad actors.
Clay Collins: [00:14:31] There we have it. The spirit of this regulation is to prevent fraud and principal actor situations, and the letter of the law is the Howey Test.
Clay Collins: [00:14:38] It’s probably obvious to everyone listening, but still worth noting that stocks, bonds, ownership interest in mutual funds, hedge funds, etc., these things are all securities. With this established, let’s move to security tokens.
Clay Collins: [00:14:49] To kick of this exploration, we’ll feature a little audio from my conversation with Josh Stein from Harbor.
Clay Collins: [00:14:56] I think what’s interesting about this space or perhaps what people find confusing is you’re taking something that’s already complex and not well understood, which is tokens and blockchain technology, and then you’re adding to that something else that’s pretty complex and not well understood, which is securities laws and then everything else that goes around that, including trading and settlement and all of those things. When you explain, I guess, at dinner parties what security tokens are at their core, how do you explain it?
Joshua Stein: [00:15:31] They’re the same security interests you have today, only with electronic wrapper. I think a great analogy is email to snail mail and what happened with written communications. I can type out the same exact written communication, and 25 years ago, I would click Print, put it in an envelope, put a stamp on it, wait two to three days and have it delivered. Now, I click Send on an email. It happens instantaneously at almost no cost. The content of the written communication is exactly the same, whether it’s in electronic medium or paper medium, but the difference is once something’s electronic and digital, I can send it faster, cheaper, and easier by orders of magnitude.
Joshua Stein: [00:16:10] Similarly, with photography, whether I use film or whether I use digital sensor, the photo of the object looks the same. What’s different is, again, digital photography is orders of magnitude, faster, cheaper, and easier to develop or use the images, and once in this electronic format, you can do a lot of transformative things.
Joshua Stein: [00:16:31] Similarly, when we tokenize or digitize securities, we can issue, but especially trade them, orders of magnitude, faster, cheaper, and easier, and that leads to transformative uses that we didn’t do before.
Clay Collins: [00:16:44] There’s definitely a group of people who I think misunderstand fundamentally what’s going on, and they say things like, “It’s not centralized. The issuer has a lot of control if theft happened or if shares need to be reissued.” That could absolutely happen. I don’t think anyone is trying to necessarily decentralize company ownership. Though, with that said, what do you see as the primary benefits of tokenizing a security versus what is arguably an electronic process already?
Joshua Stein: [00:17:21] It’s not an electronic process today. In the public markets, it is, and the public markets function very well. In fact, tokenization does not offer huge benefits to the public markets. There are some administrative efficiencies using blockchain technology. Settlement becomes faster and easier, and cap table management is more accurate, but for public securities today, shares in a public company, tokenization doesn’t offer transformative value. Where it does is the tokenization of private security interests, which, today, exists only on paper and have zero liquidity. The purpose of Harbor and the purpose of security tokens is to take some of that liquidity from the public markets, bring it to private securities through the technology, and then you unlock tremendous value.
Clay Collins: [00:18:07] Hey, it’s me cutting in here. This is absolutely key distinction that Josh just made. Security tokens provide enormous incremental value for publicly traded companies, but the real transformative value here is for private companies, which is what most of the world securities are. For private companies, security tokens are a huge lever. Let’s go back to my conversation with Josh.
Clay Collins: [00:18:29] Let’s then take an example, maybe a local coffee shop. Let’s say my neighborhood here doesn’t want Starbucks to move in, but the local beloved coffee shop is having problems, so the neighborhood decides that they’re going to chip in and help the coffee shop do a fundraise. The coffee shop is going to issue security tokens with Harbor. As an example, is that a use case for what you’re doing?
Joshua Stein: [00:18:57] Yes. It is a use case. You can tokenize stock holdings in a private company. When you tokenize ownership of a private company, you get the administrative advantages you talked about, better cap table management, and you don’t have those double-counting shares and other issues that often happens in private companies. The real transformative use is unlocking liquidity, which investors value.
Joshua Stein: [00:19:20] I actually think private companies are a mixed use case. For some private companies, tokenization of shares makes sense. For others, they don’t, and I want to explain why.
Joshua Stein: [00:19:31] What tokenization does is it brings liquidity, so where you want to lock up the capital, but not the investor, it’s a great solution.
Clay Collins: [00:19:41] Hey, it’s me, again, cutting here from the editor’s booth to emphasize what Josh said. Most private companies lock up both capital and investors. That is they make it impossible for investors to resell their interest in a business. Tokenized securities allow businesses to retain invested capital while making it easier for investors to enter and exit their positions and companies by selling their shares to others. Back to Josh.
Joshua Stein: [00:20:03] Where you’re sensitive to the cost of capital, where you want to gather in or you have the ability to gather in investors, a broader investor base, particularly globally, tokenization is a great solution. Where you really care about the identity of the ownership, where you are not interested in a lot of liquidity in the security, tokenization provides some of the incremental administrative advantages we discussed, but it doesn’t bring transformative value because the transformative value comes from liquidity.
Joshua Stein: [00:20:33] I think a great example of where this locking up the capital, but not the investor becomes really transformative is think about investments that are long-term, plays that are very capital-intensive, and where they’re very sensitive to the cost of capital. Real estate is a great example. If you think about a private REIT today, REIT is a real estate investment trust, it’s simply a C corporation that has special tax treatment, depending on how it pays out dividends and it limits its investments to real estate, a REIT is a common investing vehicle in real-
Joshua Stein: [00:21:00] It’s its investments to real estate. A REIT is a common investing vehicle in real estate. Real estate is very capital intensive. It’s very sensitive to the cost of capital. There’s real desire for investors to get into U.S. real estate worldwide. Today they could get into public REITS, but those own huge baskets of property. There’s a lot of opportunities on the private side, but it’s difficult to get into. Private REITS, like private securities today, there is no liquidity. The reason there’s no liquidity is because buyer and seller can’t find each other, you have to repaper every transaction, and most importantly, there’s fundamental transfer restrictions on those shares or interests. You can’t just go sell them, even if you do find a buyer. You have to go to the fund manager to get their say-so. The reason is because there are very complex requirements, both regulatory and contractual. That the issuer has to manage.
Joshua Stein: [00:21:57] The example of a private REIT is they have to have a minimum of 100 investors for tax purposes, not more than 2,000 or they have to go public. They have to have non-U.S. persons own less than 50% and the top 5 shareholders have to own less than 50%. What happens when you tokenize and what happens when you can apply those restrictions at the token level is that now buyer/seller can find each other and they can transact directly without having to go through the fund manager for prior approval.
Clay Collins: [00:22:24] This is a really interesting aspect of security tokens. I’d love to dig into what the law says here a little bit. As a founder, I’m familiar RAG-A, RAG-D, RAG-CF. I’m familiar with the obligations that I have when selling private company stock. I am not as familiar with what the law says about what a purchaser of that stock can do with regards to selling it to other people. Under the laws the issuer held responsible for what a stock purchaser does in terms of buying and selling stock once it’s been purchased.
Joshua Stein: [00:23:08] There’s certain aspects of it that rebound onto the issuer. For instance, if you don’t have these type transfer restrictions on the private shares in a company and you end up with more than 2,000 shareholders that company must go public.
Clay Collins: [00:23:22] Wow. So the SEC holds the issuer responsible for the action taken, or for at least regulating what happens with its own stock.
Joshua Stein: [00:23:33] In some aspects, yes. If you’re a REIT and you end up with less than 100 investors you blow your favorable tax treatment. If you’re an investment fund those generally have a limit of 99 investors, if you have more than that you have to go public. There are sometimes liquidity restrictions, there’s things call publicly traded partnership rules where if you’re LP interests in a fund are too liquid in certain ways you can blow the payroll tax treatment for that investment fund.
Clay Collins: [00:24:02] Me again, so what Josh just said is a big deal. If you’re a REIT or a company, having too many or too few investors can be a big problem. Going over or under the required number of investors can result in you being forced to go public or having to pay millions of dollars in additional taxes. That is, if you have too many investors you might be forced to go public. If you have too few investors you might lose your tax status.
Joshua Stein: [00:24:25] Also, there are special restrictions on affiliates of the issuer, so think not just subsidiaries, but think about persons who have a controlling interest or controlling influence in the issuer. It rebounds on the issuer, on actions that they take, so there’s a whole host of issues that the issuer has to control for. The way they do that today with private securities, which exist in paper, is they put these tight transfer restrictions and you have to go to the issuer and manually get a waiver. Then they have to go try and find the counterpart usually. They may have 50 or 100 investors, they fax, they phone, they email, they expend a lot of elbow grease to fid somebody. As a result, when you have a private investment if you need liquidity it takes weeks or months. It takes a lot of elbow grease, it costs you $10,000 to repaper the transaction and then you get what’s called the illiquidity discount, you get a hit on the valuation. The academic literature says that’s 20-30%. In actuality, if you’re in a hurry it can be a lot deeper than that.
Clay Collins: [00:25:25] I can certainly see that coming into play with artwork. There might be a painting that’s worth $20 million, but if you want to sell that now there’s like 4 people in the world who might want it and you probably won’t be able to make that happen without taking a huge hit.
Clay Collins: [00:25:40] Hey, so this is a key point. Private securities often trade at a huge discount by virtue of there not being real secondary markets for them. This is known as the illiquidity discount. For more on this we’ll turn to my conversation with Professor Steven McIan.
Clay Collins: [00:25:56] In a lot of these valuation models they let all the money that you would spend on attorney’s fees and all these expensive bespoke activities, or I guess maybe ad hoc activities that require human time. They move those to the balance sheet of these networks and let the money you would spend on fees accrue to the network value.
Clay Collins: [00:26:25] I think another interesting idea is around liquidity and how something being more liquid actually increases its value. I’ve heard economists talk about one of the reasons why token are so expensive or why we’ve seen sharp rises in the prices of Ethereum, and Siacoin, and other cryto assets, or crypto commodities is because there is liquidity. That, in and of itself, adds to the value of the asset. Do you think as an economist putting your economist hat on, do you think tokenized properties or do you hypothesize that tokenized properties will be worth more because there is that the liquidity that comes with tokenization.
Stephen McKeon: [00:27:14] It’s definitely part of a thesis. It’s a central part of the thesis is this idea of a liquidity premium, or I should say mitigating the liquidity discount. You touched on two things there in that question. There’s a couple baskets of shifts in value. One is just becoming more efficient, taking some of these costs that are involved in transaction and automating them to some extent, which just makes it easier to transfer these things, and reduces the direct transactional costs relative to moving value.
Stephen McKeon: [00:27:49] Then another idea is this idea of liquidity premium. So if you just break it down and you think about why does this thing exist, when we think about measuring liquidity, we often look at … What economists do, financial economists, will look at price impact. If I need to sell this thing, say I own an asset and I need to sell it right now, how much would I have to discount the price or how much would the price move because I’m executing this trade? So you can measure these things with a bid-ask spread or you can look at how much did the price move in response to a particular trade. If I’m an investor and I know that once I buy this thing there’s going to be price impact when I want to go sell it at some point in the future, what that means is I’m not going to pay as much for it today because I’m anticipating that cost in the future. You can just follow that all the way through the chain and understand why the illiquidity discount exists.
Clay Collins: [00:28:48] That makes complete sense. I can see the liquidity premium applying to things other than maybe traditional securities into things like artwork. There might be a very rare piece of artwork and maybe it’s valued at $100 million or $150 million but there’s like 10 people in the world that would be willing to pay that much for that piece of art. Once you have a scenario where there’s fractional ownership and there’s liquid markets around it now we might get more accurate pricing in those instances. Is that something that people are contemplating around this space?
Stephen McKeon: [00:29:30] Absolutely. The idea that you’re touching on there is something called market depth. Market depth is an integral piece of this liquidity premium idea because as I’ve said before, just because you tokenize an asset that doesn’t automatically make it more liquid. It only becomes more liquid if it also increases market depth for the reasons that you touched on. If you have a high unit value asset and there’s very few people in the world that can wrangle the resources to purchase that asset, but if you were to fractionize ownership you now get a much larger pool of buyers. Then you’ve increased market depth, then you’ve potentially increased liquidity, like transferring that value would be less impacted by the trade because there’s more buyers out there that are interested in owning it. So yes, that’s a really important piece.
Clay Collins: [00:30:24] In addition to discussing the impact of security tokens on private companies we would also discuss the impact on public ones as well. Here to discuss this with me is Bruce Fenton, a Wall Street vet who’s been an asset manager and stock broker for over 20 years.
Clay Collins: [00:30:39] During this period that you’ve been involved in this highly regulated industry, how has trade execution changed?
Bruce Fenton: [00:30:49] A lot of people don’t really understand how things work. Some of the big changes, when I started they had what’s called T+5 settlement, so it was 5 business days. If you had a weekend, well you always had a weekend basically because it’s five business days. Then sometimes you’d have a holiday or something like that. You could end up taking a good part of a week to get your trade settled. Then that moved to T+3 and now T+2. With block chain technology you can get that down to basically minutes. That’s why the t0 chose the name t0, 0 day settlement.
Bruce Fenton: [00:31:24] The industry has moved along, but not very fast going from probably I don’t know how long T+5 was there before I came in, but I think it was decades probably. So going from 5 days when I started 25 years ago to 2 days isn’t a really big change when you can have the technology that a block chain has, which can enable that to be done in 10 minutes.
Clay Collins: [00:31:47] What intelligence or analytics have issues historically had about their shares, the liquidity of those shares, holders of those shares, whales, et cetera, what has been known by companies about what is being done with their stock.
Bruce Fenton: [00:32:05] They don’t know anything. For public companies they don’t know anything and that’s a really important thing to note because a lot of people in the block chain, bitcoin space are from startup environment. They assume that everything works like startups. They assume that oh you’re company you do a round, you do another round, you have a database, you have your cap table and you know who owns what. That is not the case for publicly traded companies. When we talk about taking on Wall Street, when we talk about truly disrupting the global financial system we’re not talking about a startup raising $30 million. We’re talking about a completely different type of scenario. Up until recently there’s been a very, very big difference between private companies and public companies. That’s why it’s been so hard and expensive to become public. That’s why you need so many professionals and other people involved, and there’s so much intermediary, some of which add value, some of which don’t. There’s tons of lawyers, and exchanges, and regulators, and brokers, and transfer agents, and all kinds of things like that that you need in that system. It’s important to note that it’s two different things basically.
Clay Collins: [00:33:09] I guess within that system, and you might not know the answer to this, but within that system how do they do basic accounting around outstanding shares? They can certainly know what they’ve issued, but if they do want to find out what’s in circulation … You mentioned something that happened in 1996 with the DTCC, could you speak a little bit to that?
Bruce Fenton: [00:33:31] Yeah that’s an important point. What happened is if you’re thinking of it from a startup angle, as a lot of people do, they say, “Okay, you have a company. The company tracks who owns what and people have their shares.” They can change it if somebody changes it, the company can change that out. People who think of it that way don’t see the advantage of a block chain and there’s a lot of critics who will say … and I’ve spent a lot of effort trying to explain why this is incorrect, because these are typically very smart people who know a lot about block chain, some of them are bitcoin Maximalists. On this particular subject they’re wrong because they’re misunderstanding that is being solved for. They’re assuming that a block chain is going to solve for making it so that the company doesn’t have to keep the database, but that’s not correct. The company never kept the database.
Bruce Fenton: [00:34:17] To answer your question, the way that public companies do it now is a real mess. What happens is Apple doesn’t know who their shareholders are. They have no way of really getting that. The reason they can’t know that is there’s millions and millions of transactions a day. You’d need a department of 100 people at Apple just to figure out who owns what and it would never work because they would have to interact with a whole bunch of other people. A lot of people who think that a block chain is the solution they say things like, “Oh you just have GPG keys,” or all these other centralized solutions, but those won’t work, because again, it’s not the issuer that actually keeps the database because there’s so many trades.
Bruce Fenton: [00:34:56] You have all of these brokers involved, so who keeps the database, who keeps the list of who owns Apple? Well nobody really. It’s a distributed database, which kind of sounds good at first until you look into how it actually works. It’s distributed but also centralized. It’s distributed in the sense that Merrill Lynch knows how many shareholders own Apple at Merrill and Morgan Stanley how many at Morgan, and Goldman knows how many they own, but they don’t tell each other. They don’t communicate with each other.
Bruce Fenton: [00:35:22] What happened is this got so untenable and they couldn’t even keep track of who owned what. So throughout the 60s, 70s, and 80s, 90s, they would drive around in bicycles and deliver certificates between offices and then they’d have interoffice curriers and messengers. So Goldman would net it out at the end of the day and Merrill would net out this, and people would transfer physical shares between offices. They did that all the way up until the 80s and 90s basically. Then they tried to create a system that would be more electronic and more modern. The thing is, Wall Street doesn’t sleep, it’s constantly going. You can’t just shut it down for a year and build a better system. You have to just constantly build on, build, and build. The system that’s built now has been built layers and layers on it going back 100 years. A lot of the things that we have are legacy systems that are going back from the 50s, 60s, 70s.
Bruce Fenton: [00:36:09] In 1996 this capacity issue, you could call it the capacity debate on Wall Street, there wasn’t much of a debate about it though because they don’t think about things like decentralization. They said, “All right, this isn’t working. It’s a big mess. We can’t figure out who owns what. There’s fake shares being issued. There’s all of this stuff. Merrill Lynch and Morgan Stanley won’t communicate with each other. Nobody knows who owns what.
Bruce Fenton: [00:36:31] Companies, in order to send out a proxy statement or a voting statement, have to hire a consultant company who can come in and figure out who the shareholders are so they can send it, which they’re legally required to do. So they trust a third party to do that. In 1996 what they did is they said, “Well let’s just put everybody’s money in one name. Forget about trying to pretend that his is Bob’s stock, and Susan’s stock, and ABC company’s stock, and Bruce’s stock. We’ll just put it in one name. We’ll put it in one big company name. We’ll call that company CD & Co and we’ll make sure that it’s protected by having a whole bunch of complex legal trusts, and documents, and stuff to make sure CD doesn’t steal the stock, which they haven’t. CD will have all the money. Then the DTCC, the Depository Trust Company will work with them in a complex system to figure out and net out at the end of the day or the end of the week who actually owns what and when those brokers want to contact us and figure out who actually owns what, and we settle up.
Bruce Fenton: [00:37:27] They can do that through centralized parties like DTCC. That’s the system that exists right now. It’s a distributed, but centralized ledger. It’s distributed because there’s a whole bunch of parties, there’s brokers, transfer agents, issues, a whole bunch of other people and organizations involved, exchanges, everything else, but they haven’t had any way that they could solve the byzantine general’s problem and trust other people, so they just put it in one organization and they all agreed that they would trust that organization.
Bruce Fenton: [00:37:57] Some aspects of it have worked better than the old way, certainty, but it has a lot of drawbacks. For example, right now to go from broker to broker it takes between two and three weeks or more to transfer your shares. Even if you’re going from one department of company to another, you could go from within Merrill Lynch to another part of Merrill Lynch, it could take 10 days to move your money. If you’re Amish or you don’t have a driver’s license, or you changed your address, or you’re part of a trust, or an estate, or you had a divorce, or you had a death, or any number of 100 other things your “I” isn’t properly doted. That three week period could stretch to four, five, six, seven weeks. It’s very common. Pretty much any broker will have some horror story, it’s called the A-CAT process, is the internal system.
Bruce Fenton: [00:38:42] By the way, when I talk about DTCC and A-CAT, sometimes I’ve mentioned that and people say, “Oh you’re trying to just replace one company.” This isn’t just one company. It is the entire industry. It is all brokers. It is all publicly traded companies in the Unites States, it isn’t some. This isn’t some little billion dollar company out there that somebody’s trying to displace, this is trillions, and trillions, and trillions of dollars, it’s all the money in all the system pretty much. There are a couple very, very rare examples where certain founders will have special 144 stock that’s not listed and they control it themselves. Maybe Elon may have his own shares or something. Generally, even those examples are rare. So pretty much all the stock in the world … Certainly, if you’re a stock holder any of your listeners, people who own stock in their 401k, even multi-millionaires, even deca-millionaires, even billionaires, I’ve served billionaire clients for years, all of them same way, it’s in the same system.
Bruce Fenton: [00:39:38] You could talk to brokers about the A-CAT process and say, “What’s the worst A-CAT you ever had?” Everybody has a horror story, sometimes it takes 11-12 weeks. I had a client where they had a death in the family and death certificates and stuff like that could take weeks, and weeks, and weeks. Whereas, with a block chain type asset it would be instant.
Clay Collins: [00:39:54] That’s super interesting. I think most people, because the infrastructure around it appears to be very efficient they don’t see what happens on the back end of those trades. Maybe Scottrade said something, but you don’t have it yet.
Bruce Fenton: [00:40:10] You don’t actually own your stock. When you open a brokerage account at Charles Schwab or Scottrade you have 12 pages of documents. When I started in the business, this is funny, this shows how the industry has changed, when I became a broker in ’92 you could open an account over the phone with no ID and you didn’t even need any money.
Clay Collins: [00:40:30] Wow.
Bruce Fenton: [00:40:30] They had the same five business day settlement, the had five days to get the money in. You could literally have somebody call in and say, “Hey, I want to open an account. I want to buy IBM.” They could buy it. You just took down their name and address and then hopefully they paid you. It’s funny, as crazy as that is there was very cases of fraud. What you could do obviously with that front run, you could call five brokers and short sell IBM at five of them and buy at long at IBM at five of them. Surprisingly, those things didn’t happen. It’s the kind of thing that happens once every couple years. You’re going to have fraud in any business. It wasn’t as common as you think.
Bruce Fenton: [00:41:08] People tend to know … Brokerage was more community based back then. You had a stockbroker and they could spot something that seemed unusual, and we’d have unusual trades, and people would come in, but nobody actually owns the stock that they think they own. If you have accounts at a brokerage firm when you read those 12 pages in the back you’ll see that you don’t actually own it. You have these pledges and hypothecation agreements. Your actual share or legal ownership, if you were to have a certificate, if you were to go to Apple and request a certificate, which I don’t think they’ll do any more, but if you could it wouldn’t have your name on it. It would have DTCC’s name on it.
Clay Collins: [00:41:42] Thinking through what security tokens actually solve for it seems like there’s a number of things that it solves for. One, it solves for analytics on the part of the issuer. Two, it solves for inefficiencies with the current infrastructure. It seems like for issuers it also solves a liquidity problem. For investors as well it solves for
Clay Collins: [00:42:00] … solves a liquidity problem and for investors as well it solves for a liquidity problem. This isn’t about turning shares of your company into bitcoin. All the normal laws still apply, all the normal regulations still apply. In your view, what are the main categories of problems being solved through security tokens?
Bruce Fenton: [00:42:20] That’s a great question. A lot of people misunderstand what the problem is, especially if you go back to that example I mentioned of people looking at the startup environment assuming that you’re solving for a company database, saying well, it’s already centralized anyway, which is true. Companies are centralized so if you have Disney and Disney stock, Disney’s centralized. It’s a place. It has a CEO. It has headquarters. It has offices. It had parks that you can go and visit.
Bruce Fenton: [00:42:47] That’s always going to be centralized, at least in the foreseeable future. Maybe in a couple hundred years, somebody will figure out another way with VR or something, but for now all companies that we know in general corporate law and the general world of the global economy are centralized. So you’re not going to decentralize a company. There’s no way that a blockchain can become aware of Disney or Apple or anything else.
Bruce Fenton: [00:43:09] So that’s not what it’s solving for. What it is solving for is the custody issues of how equities, how stocks are actually held around the world. In the case of larger publicly traded companies, it’s a very complex, messy, consing system that I just mentioned that has lots of layers that don’t make any sense and don’t need to be there. What those layers do is they cause a lot of inefficiency. It takes you a minimum of a week or two to move your money from one broker to another.
Bruce Fenton: [00:43:36] I’m not talking about trading. Another misconception people have is they mistake trading and custody and asset movement. Wall Street is very good at certain tech. They can trade millions of shares in a second. They have huge, robust capabilities to do high frequency trading. Trading is different from settlement. They’re not actually moving the money. It’s kind of like Coin Base when they do off-chain transactions.
Bruce Fenton: [00:43:59] If you’re doing transactions within Coin Base, that doesn’t show up on the blockchain. If you send money from one Coin Base user to another and then they trade it back and forth, that doesn’t show up on the blockchain. That’s an internal Coin Base thing. So the current movement, all this high frequency trading is what we would call, it will become off-chain transactions basically. It will be done by brokers using the existing technology and systems that they have.
Bruce Fenton: [00:44:24] The money won’t be able to be moving. You know, a high frequency trader, somebody who does 80 trades of a stock in a day, they’re not actually sending shares to somebody and back. They’re just making a marker to figure out what settles up at the end of the day. So it will solve for that, which will make it much more efficient to move money around. It’s not going to change the high frequency trading thing, but it will make it easier for money to move around.
Bruce Fenton: [00:44:46] The other thing it will do, it will give people more control of their own money. You asked if I had stock certificates. Almost nobody has them anymore other than for small companies. Publicly traded companies very rarely issue them. They’re really not used, brokers don’t really recognize them. Most of the younger brokers now who came in 10 or 15 years after me have probably barely ever seen these certificates.
Bruce Fenton: [00:45:07] So we’re not solving for the trading aspects and we’re not solving for our company database. We’re solving for this overall complex system of intermediaries which don’t add value, that add a lot of delays, so we’re making that more streamlined, more efficient. That’s what a token can do. And what that does, it enables people to control more of their own money, which is if you believe in bitcoin you should believe that people should control their own wealth. You have a lot more liquidity options and things like that if you control your own money.
Clay Collins: [00:45:40] One of the new liquidity options that comes with security tokenization is the option for public and private security token holders to sell their tokens in a peer-to-peer fashion. A lot of early adopters report buying their first bitcoins at a coffee shop or over eBay from another person. Unfortunately, these types of transactions aren’t possible with securities right now, but not because peer- to-peer transactions are prohibited by the law. Back to Bruce Fenton to explain more.
Bruce Fenton: [00:46:05] You have the right to sell your property. If you own Apple shares, you can sell those to me legally. People don’t understand that. They’ve been so beaten down by this system of compliance and laws and you know, nonsensical rent-seeking intermediaries that they’ve forgotten something as basic as the fact that yeah, if you own your own property you don’t need a broker to sell it. You could sell it to somebody.
Bruce Fenton: [00:46:29] It’s going to be very, very interesting to see the rise of decentralized exchanges and if you look at the wording and the way that a lot of the laws are written, as soon as the SSC really figures this out, and some people there are quite smart and so they probably already figured it out, it’s a big deal for the way the things will work because you’re not going to need exchange as much. The biggest control point that they have is issuers and exchanges.
Bruce Fenton: [00:46:51] Issuers is pretty easy. Just comply with the law and either be exempt or register or make it not a security or you get in trouble. Those are your four options. But the secondary market is going to be a very interesting thing and that’s where I’ve been focusing most of my efforts for the last three years because I saw this secondary market as being the key. I think a lot of these ICOs are missing the boat. They’re focusing on the primary market, which is a big pain in the neck, and a lot of them are going to get in trouble.
Bruce Fenton: [00:47:16] But once you get the shares out there, if they’re legally issued the first time people can do whatever they want with them. I can buy a share of Bayer stock, if it exists anymore, I can buy that from somebody and I can make a deal with somebody at a coffee house to buy their Apple stock. Now the problem is that the systems, not the law, law doesn’t have a problem with me buying Apple stock from somebody. It’s the systems that have a problem.
Clay Collins: [00:47:41] As long as it’s public. If it’s private placement or like reg D or something like that.
Bruce Fenton: [00:47:46] Yeah. Well, if it’s Apple, I mean if it’s Apple it’s already public. The trick with Apple is that you need to have a registrar and everything say that you actually own that or you’d have to have it in some kind of vehicle or something like that. There isn’t really a way to have somebody else on it, but with a blockchain token, then ownership would be determined by whoever controls the private keys.
Clay Collins: [00:48:05] So we’ve spoken about the benefits of security tokenization for public and private companies, but it’s important to note that tokenization isn’t a great fit for everyone. For example, venture-backed companies are just one kind of company where tokenization might not make sense. Here’s more from Harbor CEO Josh Stein. When you think about maybe venture-backed companies or you know, startups in general, what do you see as the pros and cons of going this route and what might a startup founder think about when they’re going to do a raise? At what point should they start considering using a security token? How would they go about doing it?
Joshua Stein: [00:48:41] So I think security tokens actually do not offer transformative value for what we think of as a classic high tech startup. That’s because those startups are not capital-constrained. They’ve got far more people wanting to invest and far more potential capital than they can take on. They’re being choosey about their investors and they certainly don’t want their investors to freely trade. So you can tokenize for some better cap table management, but you would not as a company lift the transfer restrictions on those investors.
Joshua Stein: [00:49:10] You wouldn’t want to. But I think what we often forget is that the high tech startup that’s got more capital than it knows what to do with is a tiny fraction of a percent of all the companies out there in America and around the world. So your typical company is the neighborhood coffee shop, it’s the franchise of autobody shops that needs capital to expand, it’s real estate investments that are capital intensive and sensitive to the cost of capital.
Joshua Stein: [00:49:35] Anywhere where you are relatively indifferent to the identity of the investor but you’re sensitive to the ability to raise capital and the cost of that capital, that is where the transformative use of tokenization comes in. Eventually every private security will tokenize because there is inefficiencies to ring out. You do need liquidity sometimes and tokenization enables that, but if there’s going to be very little trading, then tokenization doesn’t offer anything particularly transformative.
Joshua Stein: [00:50:03] On the other hand, if let’s say you’re trying to gather investment in real estate, let’s say to use the good example, you’ve got a beautiful class A office building, it’s worth maybe 50 million dollars in a major metropolitan area, it’s on the National Historic Register. There are tons of people around the world who would love to get into US real estate, who’d love to be able to invest at the asset level in a single asset, something they can touch and feel and understand.
Joshua Stein: [00:50:28] So today in paper they would never hear about it. They’d have no practical way to get into it and they would have no liquidity, which is really daunting, but if you tokenize, if you now make this digital and it’s faster, cheaper and easier to gather in a larger worldwide base of investors, and if it’s faster, cheaper, easier by orders of magnitude to trade that later to get the liquidity people want, suddenly you can raise far more capital from far more people at a lower cost of capital, and that is really transformative to that industry.
Clay Collins: [00:50:58] So we’re about to get into the nitty gritty details around use cases and how security tokens work, but before we do that it’s worth taking a second to take stock of the benefits of security tokens that we’ve encountered thus far. Security tokens one, increase liquidity and market depth. Two, give control back to security owners. Three, increase the number of liquidity options for security owners such as peer-to-peer exchange and decentralized exchanges.
Clay Collins: [00:51:23] Four, remove rent-seeking intermediaries. Five, maintain the cap table for private companies. Six, provide cap table analytics to public companies. Seven, allow for fractional ownership of property like paintings. Eight, reduce settlement times from two days to minutes, and nine, make it cheaper to go public.
Clay Collins: [00:51:42] Almost all of these benefits fall under the category of cheaper compliance. By allowing regulatory compliance to scale without rent-seeking intermediaries and reducing the number of hours required from expensive service providers like accountants and attorneys, security tokens allow smaller companies to afford the kind of regulatory compliance that’s previously only been available to the Fortune 1000. Here’s Professor McKean with more on this.
Stephen McKeon: [00:52:05] In all cases where you see regulation, you know, there’s some effort to sort of keep things on the up and up. Right? But the problem is the regulation can create friction and so I think moving forward the goal, and this would be, you know, what Harbor’s working on as well as many others, is to try and make the regulation not so cumbersome, right? So kind of work within the existing environment, but make it sort of easier to comply with the regulation.
Stephen McKeon: [00:52:33] So Chris [Burnesky [00:52:34] recently wrote about the need for regulation to scale as crypto space scales, and I think that’s right. There are two ways to think about that. One is maybe we need new bespoke regulation around securities. I think this is what he was getting at, but the other idea is that we need systems to scale the regulation we’ve got. So I think that’s where things like Harbor’s R Token Protocol come into place. So in other words, using the existing regulatory environment, but making it less cumbersome to comply.
Clay Collins: [00:53:04] Professor McKean’s thoughts on this are important. One of the main criticisms I’ve heard about security tokens is that they won’t do for securities what bitcoin did for money. These criticisms I believe miss the point. Efforts to tokenize securities aren’t an attempt to turn equity or real world assets into decentralized digital cash and it’s a mistake to consider security tokens through the lens of bitcoin.
Clay Collins: [00:53:24] Instead, one should think of security token infrastructures as providing cheap scalable compliance. At their best security token technology provides open source protocols for frictionalist trading and increased liquidity outside of proprietary walled gardens. Here’s Josh Stein from Harbor with more.
Joshua Stein: [00:53:40] The fundamental value prop of Harbor is compliance as a service. There’s additional layers of value that get built on top of that, but that is the fundamental layer that has to operate or none of it works. If you can’t ensure compliance with the securities laws and contractual restrictions at the token level wherever this trades, then everything else doesn’t work. It’s the foundation to the building of value that we’re building.
Clay Collins: [00:54:03] That’s fascinating. I know of a SASS company that does HIPAA compliance to service and so maybe another way to think about what you guys are doing is it’s a securities loss compliance as a service. It’s very cool.
Joshua Stein: [00:54:13] It is because to get secondary liquidity on tokenized securities you need to be able to ensure that they’re trading compliantly no matter where it is, 24/7, 365 around the globe. The only way to do that is at the token level and those controls have to work reliably. Once you have that, then you can lift the tight transfer restrictions on the tokens and you can allow them to trade as liquidly to the limit of the inherent limitations of the investment. But if you don’t have that compliance as a service, you don’t have that compliance baked in at the token level, that can’t happen.
Clay Collins: [00:54:47] I think a lot of people think about the blockchain is a trustless system and then they go to securities tokens and they’re like, “Well, this isn’t a trustless system,” but I think what they’re missing out on is that the trustlessness doesn’t need to happen necessarily at the protocol level, it needs to happen at the liquidity level in an issue where allowed people to trade amongst themselves in a trustless manner when the stakes or the cost of noncompliance is so incredibly high to a business.
Joshua Stein: [00:55:13] That’s correct. Compliance can’t be trustless. If the compliance is provided, the rest of it can then be trustless. Then you’re in this great decentralized world in which buyer and seller can trade 24/7, 365 around the globe with instantaneous [inaudible [00:55:28] and no counter party risk.
Clay Collins: [00:55:30] Yeah, because the cost of waking up one day and realizing that you have to go public because you have more shareholders than you would like or whatever, that’s just a really bad place to be in.
Joshua Stein: [00:55:40] Yes, or that all your investors are subject to 30% tax withholding.
Clay Collins: [00:55:44] I live in Minneapolis. It’s not a startup hub. What’s an example of maybe a business that would be in a, you know, sort of that average Midwestern city that’s not real estate, that would most benefit from security tokens? You mentioned like an auto dealership. What do you think is like kind of like the prime candidate for this use case?
Joshua Stein: [00:56:03] I think folks who are looking to expand or franchise. So whether it’s restaurants, autobody shops, whatever it is. You’ve got say five, 10 locations, you have a business model that works but now you need a ton of capital to expand. If you go get capital from one, two, five, 10 investors, they’re going to bargain for some really hard control rights. They’re going to take a big chunk of your equity.
Joshua Stein: [00:56:24] You may not be able to get the amount of capital that you want. When you tokenize it’s easier to advertise out through a general solicitation out to a broader base of investors. It’s easier to onboard them. You should get a better cost of capital because liquidity brings value, so if you think that the liquidity discount is 20 to 30%, if you can eliminate half of that, that means your cost of capital should be roughly 10 to 15% lower. Or the price that you get on their shares should be 10 to 15% higher. For all those reasons, those are great examples where tokenization should help.
Clay Collins: [00:56:58] So not only do you give us less control, but you also gain a liquidity premium and potentially a higher valuation. That’s fantastic. What do you think are the downsides for that business that’s looking to franchise? Do they lose anything through going this route?
Joshua Stein: [00:57:16] What you lose is once you pull the transfer restrictions and you allow these shares to be freely traded, you have now lost control over the identity of your investors. You don’t have to do that, but the more tightly you control the investor base, the less liquidity, the less value that tokenization is delivering. Those are two fundamental trade offs.
Joshua Stein: [00:57:37] So to give an example, Harbor can enforce custom white list because we always know the real world identity, so you could say that you know what? I’m going to vet investors coming into the company and then I’m going to let existing investors freely trade amongst themselves, but I’m not going to allow someone new onto the white list unless I’ve approved them ahead of time. So that’s great. That would allow, and if you think of a large startup like an Uber, you could imagine a fair amount of liquidity and trading going on in all those different shares.
Joshua Stein: [00:58:07] But for a much smaller company you don’t have a large number of investors, you’re not going to have much liquidity. I think what becomes really interesting is what happens if say the top 100 VC firms and PE firms all decide that in their investments going forward they want to insist that they can freely trade amongst that group of 100. So now they can get liquidity, there’s a fairly diverse base of people that they can freely trade in and out fairly well, but it’s not wide open to any person around the world who’s unknown, who may be litigious or who you may not want to share financial info with.
Joshua Stein: [00:58:43] So there are varying ways to go about it, but the fundamental trade off is, is the greater the potential pool of investors that you allow and the more freely you allow them to trade, the greater the liquidity, the greater the value that you’re bringing. But the trade off is, is less control over the identity of those investors. So fundamentally we think that the best candidates for tokenization early on are where you want to lock up the capital but not the investor.
Clay Collins: [00:59:10] Security tokens represent ownership claims in all the things you’d normally think of as investment vehicles, stocks, bonds, treasury notes, mutual funds, LP interest in funds, et cetera. And this is important because as Bruce Fenton reminded me during our interview, only one-third of the world’s wealth is in cash. I’ll let Bruce close out part one of this documentary with a reminder of this.
Bruce Fenton: [00:59:31] Only a third of the world’s wealth is in cash, so we’re fighting this great, valuable, noble fight to say let’s make bitcoin or things like bitcoin become the new global reserve currency. Wonderful, I’m all there, but it’s only a third of the world’s money. Even if you win you still haven’t change the whole global economy. You need to give people that kind of same power for their equities.
Clay Collins: [01:00:03] This concludes part one of Tokenize The World. In part two we’ll be digging into the nitty gritty specifics of how security token issuance and exchange works with the founders of Harbor and Polymath, two of the top security token standards. Stay tuned. This podcast was produced by me, Clay Collins. My audio producer and collaborator is the talented Arison Cain. Special thanks to our guests and everyone who helped make this series possible.
Clay Collins: [01:00:28] If you have questions or comments you can contact me @ClayCollins. Thanks for listening. That’s it for this week. To sign up for our free crypto investing newsletter, listen to other episodes or get the show notes from this episode please visit Flippenining.com. I also invite you to check out the startup that funds this podcast, Nomics, spelled N-O-M-I-C-S, at Nomics.com. Finally, if you got value from the show, the biggest thing you can do to help us out is to leave a five star review with some comments and feedback on iTunes, Stitcher or wherever you listen to podcasts. Thanks for listening and see you next week.
Tokenize The World, Part 2: How Security Token Platforms Actually Work
Thanks To Our Sponsor: BlockTrade.com
Blocktrade will be the first fully licensed security token exchange in Europe, focused on listing crypto assets, security tokens, and other tokenized financial instruments. By being fully MiFID II compliant they will enable crypto trading to institutional traders while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few things to announce in the next couple of weeks, including their public beta launch. Be sure to go to Blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.
This episode is a deep dive into the mechanics of how security token issuance and secondary trading fundamentally works.
Indeed, for all the talk about the merits and drawbacks of security tokenization, I’ve found that there’s very little discussion of the mechanics of token issuance and trading.
My purpose in this second installment is to enrich the debate so we can move beyond high-level philosophy to a deeper discussion of the technologies, methods, and mechanisms required of competent security token platform.
In this part of our series, you’ll hear the story of two different tokenized security platforms, Harbor and Polymath. We’ll go into detail about how they work, in an effort to provide a better understanding of the constituents, processes, and technical mechanics of the broader security token ecosystem.
Special thanks to all of our guests including Professor Stephen McKeon, securities attorney Zach Robins, Harbor CEO Joshua Stein, and Bruce Fenton (CEO Chainstone Labs/Atlantic Financial and Board Member at Medici Ventures, tZero & the Bitcoin Foundation). Thanks also to Polymath’s CEO Trevor Koverko & COO Chris Housser.
Part 2 Topics include:
- How Bruce Fenton tokenized his company on a live stream in about ten minutes.
- How security token platforms and protocols work.
- The main players in the security token ecosystem.
- The two notable ways in which Polymath and Harbor differ.
- The role of whitelisting on Polymath.
- The life cycle of token issuance on the Harbor platform.
- What the secondary market for security tokens looks like.
- Why decentralized exchanges make a lot of sense for security tokens.
- What happens when a user wants to withdraw security tokens from a security token exchange.
- How trust differs among security tokens, traditional private securities, and cryptocurrencies.
- The roles that jurisdictions play when it comes to the initial issuance of security tokens.
- The pros and cons of Polymath and Harbor.
- A glimpse at the inner workings of both platforms.
Links Relevant To This Episode:
- Trevor Koverko
- Chris Housser
- Josh Stein
- Bruce Fenton
- Atlantic Financial
- Blockchain Capital
- Craft Ventures
- David Sacks
- OPEN Finance
Terms Mentioned in the Episode:
Part 2 Transcript:
Clay Collins: Welcome to Flippening. The first and original podcast for full-time, professional, and institutional crypto investors. I’m your host, Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the front lines of financial disruption. Go to Flippening.com to join our newsletter for cryptocurrency investors, and find out just why this podcast is called Flippening.
Automated: Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion [00:00:30] and do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.
Clay Collins: Welcome to part two of Tokenize the World: A Security Token Documentary. This episode is a deep dive into the mechanics of how security token issuance and secondary trading fundamentally works. My purpose with this series is to tell the stories of the projects, makers, issuers, investors, and influencers driving adoption of security tokens, and this episode picks up [00:01:00] where the last one left off. To the few folks who’ve written in asking why we’re spending three entire episodes of this podcast talking about tokenized securities, I want to remind you that only 30% of the world’s wealth is in cash, and much more than this, it’s held as property and securities.
In the previous installment of this documentary, we discussed three misconceptions about security tokens. The first misconception is that security tokens are not valuable because they are centralized around the issuer, and in many cases, not censorship resistant. The second misconception is that security should not be represented [00:01:30] with a blockchain because securities are not, at their core, digital assets. And the third misconception is that security tokens are overkill, and that all that is needed is a highly efficient database, rather than a blockchain, to address the needs of issuers and traders.
Part one of this documentary addressed the first two misconceptions. The third is addressed in this episode. Part one also discussed one, how blockchain technology has changed trade execution. Two, how tokenization unlocks liquidity. Three, how security tokenization provides different kinds of value [00:02:00] to public versus private companies. Four, ideal versus non-ideal security token use cases, and five, which average businesses could benefit most from tokenization.
If you haven’t listened to part one, I’d encourage you to start there. In this second installation of this series, we’re digging deep into how security token issuance and secondary trading works. Indeed, for all the talk about the merits and drawbacks of security tokenization, I found that there’s very little discussion of the mechanics of token issuance and trading for security [00:02:30] tokens, and it is a downright shame. My purpose here today, in this second installment, is to enrich the debate so that we can move beyond high level philosophy to a deeper discussion of the technologies, methods, and mechanisms required of a competent security token platform.
I am especially happy to tell you that this episode of Tokenize the World is made possible by our sponsor, Blocktrade.com. Blocktrade.com will be the first fully licensed security token exchange in Europe, focused on listing crypto-assets, security tokens, and other [00:03:00] tokenized financial instruments. By being fully method two compliant, they will enable crypto-trading to institutional traders while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few huge announcements coming in the next few weeks, including their public beta launch. Be sure to go to Blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.
And just to go off-script here, I had a chance to speak with their CEO, Luka Gubo, and came away really impressed. That guy has a [00:03:30] deep experience in the space, and they’re building something that I find to be pretty impressive. For example, their backend is set up to process more than one million trades per second, which is going to be pretty important for the institutional investors who they’re targeting. I do think this is a company you should keep your eye on, and I’m proud to have them as a sponsor. So thanks to BlockTrade for stepping in and stepping up and making today’s show possible.
Okay, now let’s kick off part two of Tokenize the World: A Documentary about Tokenized Securities.
[00:04:00] I started getting interested in security tokens after watching a Periscope in April of 2018 by a guy named Bruce Fenton, who created a security token live on the internet for the world to watch, he was doing this in real time. He was actually tokenizing ownership of his company, Atlantic Financial, and he did it in about ten minutes using a [00:04:30] web browser, a piece of paper, and ten dollars. Bruce’s stated purpose in creating this video was to show that a legal, real, compliant security could be tokenized on a blockchain. And in my view, I think Bruce proved his point. Bruce’s video is actually a pretty great place to start things off. Here’s a highly edited version of Bruce’s live Periscope demo. Thanks to Bruce for giving me permission to use this.
Bruce Fenton: I’m going to create a security using what’s called the counterparty protocol, which is a protocol that [00:05:00] runs using the Bitcoin network. The reason I’m using that is because Bitcoin is a very secure chain.
All the purpose of today’s broadcast is to do is to show that yes, it is possible to tokenize a security. All this covers is, can you tokenize a security? And the answer is yes, and I’m going to do it right now and show it beyond any doubt, hopefully.
Securities, and companies, and shares are a creation of humans, they’re a creation of law. They only exist in the real world. [00:05:30] There isn’t any way to digitize them, so people know that, which is this much knowledge, and then they’re learning stops. You’re not putting a security on a blockchain. What you’re doing is changing the way a security is recognized.
So first, the thing to recognize is shares are a thing, okay? They’re a thing, they’re always going to be centralized. I’ve never heard of any way to completely decentralize the existence of corporations itself. If you have Disney, that’s a corporation, it’s going to have an office, it’s going to be centralized. Apple is centralized. Google is centralized. Their shares are centralized. [00:06:00] You’re already trusting that, you’re sure to follow the hundreds of years of law we have governing corporations and how these things work.
So the security we’re going to use for this example is my own company, Atlantic Financial. I own 100% of the stock, it’s an eighteen year old company, it’s incorporated in Delaware, it’s a real company and has real revenue, it owns stuff. That doesn’t really matter. What matters is that it’s a company, and I own all the shares, and I have the authorization to do this. But I’m going to do it in a super, super simple way to show you how it can be done. Just to show you how simple, I wrote it [00:06:30] right here.
Clay Collins: It’s me. So if you were watching this video, you’d see Bruce holding up a piece of yellow lined notebook paper with his handwriting on it. It looks like he hastily scrawled some notes on a piece of notebook paper that he just had lying around his office.
Bruce Fenton: I, Bruce Fenton, designate all shares of Atlantic Financial Inc. to be represented by tokens, trading on the counterparty protocol.
Clay Collins: Me again. It’s important to know that he’s written the name of the counterparty token that represents shares in his company on his hand scratched contract. [00:07:00] Essentially, the contract is saying that if you hold a counterparty token with a name listed on the contract, then you hold a token that represents ownership in Bruce’s company, Atlantic Financial. If you don’t know what counterparty is, it’s a peer to peer opensource protocol that allows you to create your own tokens that run on top of, and are secured by, the Bitcoin protocol. Back to Bruce.
Bruce Fenton: Now, is this silly? Is this not legally binding? You bet it’s legally binding. It’s silly and simple, but if I wrote on here, “I’m selling my tractor to Phil for $ [00:07:30] 500.” And I didn’t give him my tractor, Phil can bring me to court. If I say that I’m selling my car for $100,000, then this is binding.
Once you have shares, this kind of document designating the shares of something is legal. You better believe that if Bill Gates met you and loved your business plan and didn’t happen to have any staff with him or something like that and grabbed a little note, and said, “I, Bill Gates, promise to give you 10,000 shares of Microsoft [00:08:00] if you present X Bitcoin address.” And he wrote it, you better believe that’s legal. That is legally binding.
So as a company, as a stock issuer, securities issuer, you’re centralized anyway. Bitcoin purists might say, “Oh my gosh, he just admitted he’s centralized.” Well yeah, that’s what companies are. Disney is centralized, Apple is centralized. I can issue a million new shares if I want, I can dilute you, I can do every other thing, and that’s not a failure of blockchain and it’s not a failure of this governance or anything else. That’s just the reality of the world. [00:08:30] Issuers are centralized. I’m a securities issuer, I’m centralized.
Clay Collins: So let’s transition now to the part where he created the token with counterparty. It’s really fast and simple. The process could even be said to be unremarkable from an operational perspective.
Bruce Fenton: So basically, you have … this is what counterparty looks like. I’ve put an address in there, you can put an address and you can say, “create a token”, it has the token name, and you can say what you want the description to be, how many you want. I can say I want 1,000, [00:09:00] I want to call it the AF token for Atlantic Financial, and I’m going to say, “create token”, okay?
That’s it. If I go ahead and cut and paste this token number, I’m going to say A151482398425338000.
Clay Collins: So if you were to be watching the video that I’m referring you to, you’d see Bruce [00:09:30] write the name of the Atlantic Financial token on his contract, which essentially says that if you possess an Atlantic Financial token on the counterparty protocol, then you possess a share of Bruce’s company.
Bruce Fenton: So I wrote it on the paper. Again, you would want to do that a little more carefully.
This is a truly legal document, and again, this, believe me, something as simple as this has been held up in court many, many, many times.
So that’s created. If I write this down and then I sign it right here, ta-da, [00:10:00] this is legal. I can hand this to someone, or make a copy of this, or now put it on the internet. This is legally binding. Again, this is for example purposes. This is not the kind of thing you want to use with your lawyers, it doesn’t have enough detail in it, it hasn’t been properly done, but this, believe me, if you gave me $500,000 and said, “Bruce, I’m taking your word for it. I’m taking this piece of paper.” You gave me $500,000 and I gave you some percentage of the business, I think you’d have a pretty good case. It would be a weird [00:10:30] case because they’d say, “That’s a pretty bizarre document.” Especially with the video as evidence, it’s very clear that I have intended to have this.
Clay Collins: There you go. Just like that, Bruce tokenized his company in a legal binding and enforceable way. And of course, this isn’t the first time that this has been done. Blockchain Capital used a platform called TokenHub to issue its B-Cap token, which represented ownership in one of its venture capital funds. And the public company Overstock issued a tokenized security using a platform called RegionLabs in 2017. [00:11:00] These companies aren’t speculating that all of this is legally enforceable. The SCC has recognized tokenized securities, and the state of Delaware has specifically stated that a distributed ledger can be used to issue and record shares.
Now that we’ve seen perhaps the most basic example of security tokenization possible, let’s transition to a high level overview [00:11:30] of how security token platforms actually work. Are you ready? Here goes.
At a very high level, security token platforms and protocols pretty much work the same way. Essentially, these systems that companies, AKA issuers, issue security tokens that represent ownership claims in companies. These issuers are allowed to create and curate white lists of wallet addresses, usually Ethereum wallet addressed, of investors that are allowed to buy ownership stakes in the company. This is how compliance is enforced because when these wallet address white lists are properly set up, [00:12:00] compliance is enforced because the issuer only admits qualified investors to the white list.
So if someone isn’t permitted to purchase shares in a given company because of compliance issues with applicable laws, they are not allowed to hold a security token for that company. It’s important to point out here that issuers can also outsource curation of one or more white lists to trusted third parties like AMLKYC providers, accredited investor checking services, and exchanges that might only admit accredited investors to the platform.
[00:12:30] These white lists of investors qualified to purchase security tokens from a given company comprise a liquidity pool of sorts. This liquidity pool is essentially a network that can execute secondary trades of that stock with each other. What this really means is that everyone on the white list can trade with each other. And that’s where the real power lies. It’s unlocking liquidity for secondary trading.
If all this were done with just a centralized database, trades would be restricted to [inaudible [00:12:56], and we couldn’t have peer to peer security token trades happening, for [00:13:00] example, at a coffee shop, a decentralized exchange, an OTC desk, or via whatever permission list innovation happens in the future that allows folks to swap these things. But because security tokens are built with and on top of opensource protocols like Ethereum, anyone is allowed to innovate at the exchange layer because token level restrictions are prohibiting non-authorized investors to receive or buy shares of a company.
So the main players in this security token ecosystem are one, security token [00:13:30] issuers, AKA companies issuing stock in their company. Two, folks who are on white lists of crypto wallet addresses that are allowed to receive security tokens, so people who are cleared to buy and trade these tokens. Three, trusted third party white list curation services, so AMLKYC providers, accredited investor checking services, et cetera. Four, security token platforms that power the underlying technology that make issuance of these tokens possible, and five, parties [00:14:00] that facilitate exchanges, like exchanges, OTC desks, decentralized exchanges, or potentially a service akin to local Bitcoins, where people can just arrange to meet up and exchange these things in a peer to peer fashion.
There are of course other players as well. For example, lawyers help issuers decide who can legally purchase the stock, and create disclosure docs, file with the right entities, all that stuff. And software engineers who write and audit smart contracts and play a vital role in everything happening here. So that’s [00:14:30] basically security token technology in a nut shell. Of course, all of this gets infinitely more complicated once you go just one level deeper, and everything I’ve said thus far is an oversimplification.
Security tokens can contain transfer restrictions, loading rights, dividend rights, and can be configured differently for different classes of shares and a whole lot more. It all gets pretty complicated pretty fast, so with this high level introduction to security token mechanics established, we’re going to dive into specific use cases, examples, and scenarios. To help [00:15:00] dive into the nuance, we’re going to consider different scenarios through the lens of two top security token platforms, Polymath and Harbor. I should note that both of these platforms were started because their founders wanted to issue security tokens, found the process unnecessarily cumbersome, and decided to start platforms to help others automate what they found to be so difficult.
Here’s Polymath’s CEO, Trevor Koverko, describing the Polymath origin story.
Trevor Koverko: So my idea was I was going to take my fund that was operational and profitable and tokenize [00:15:30] it, and we were going to become the world’s first dividend paying crypto. And after a few months of getting tons of good feedback and tons of demand, we ran into reality, which was the SCC, and it turns out what we were trying to create was a security. And we didn’t really expect that. Back then, there was no distinction between what a utility coin and a security coin was. We actually coined the term security coin back in those days. And that’s what led us on this journey to say, “Hey, maybe [00:16:00] there’s a better way to do things.” It was very complicated, it was very expensive to do a fully compliant security token, so we said, “At the protocol level, why don’t we build a product and an ecosystem that can help launch the next ten thousand security tokens?”
Clay Collins: Polymath was founded by the guy you just heard from and securities attorney Chris Housser. They raised $59 million in January and February of 2018 through a private SCC compliant token sale. Polymath differs [00:16:30] from the other company we’re about to talk about in at least two notable ways. First, Polymath has issued a token, which Harbor has not. It’s called Poly. Second, the Polymath organization is not required for the underlying protocol to operate. Harbor, on the other hand, is designed to fail closed. So if Harbor ever goes away, the issuer would have to reissue tokens with a new provider, which might take some leg work, but in many cases, wouldn’t be an overly cumbersome thing to do.
Harbor, which we’re going to dive into in a bit, has a similar story to Polymath’s [00:17:00] and was incubated at Craft Ventures. As the story goes, David Sacks was interested in tokenizing Craft Ventures, and realized that there was no compliant way to do this. And that gave him the realization that a business opportunity existed here. It’s worth noting that the guy I just mentioned, David Sacks, is Harbor’s most famous founder. David was a co-founder and COO of PayPal, so one of the members of the PayPal mafia, along with Peter Thiel, Elon Musk, and Reid Hoffman. His other two co-founders are the former VP of Engineering and VP of Product at Zenefits, [00:17:30] where David was once CEO, and which was, at one time, the fastest growing SAS company of all time.
Neither Harbor nor Polymath have handled initial issuance for a company just yet, but both have plans to do so this summer. With both of these platforms, the big concept here is really the white list. Here’s what I mean. There’s just no way that a security token protocol can have the rules of 100 plus jurisdictions baked into it, but the vast majority of regulations can be complied with by restricting who can own a security token, [00:18:00] such as accredited investors, US citizens only, qualified purchasers, et cetera. White list curation also allows you to restrict how many total investors can own a stock. And this is important because some laws and exemptions require a minimum or maximum number of shareholders to qualify for a given status.
So both the number of shareholders and the type of shareholders, such as accredited investors only, can be controlled via the curation, maintenance, and grooming of these white lists of addresses [00:18:30] and wallets that are allowed to receive security tokens. Here’s Chris Housser, COO of Polymath, talking about the role of white lists on their platform.
Chris Housser: The way our platform works is it creates a white list on Ethereum, so the issuer defines a set of criteria that an investor needs to have to be able to hold their particular token. So let’s assume to have a token, someone needs to be an accredited American investor. They would go through the process to demonstrate that [00:19:00] they are American and that they are accredited, and their Ether address would be added to a white list. Now people on that particular white list are able to trade amongst each other, and how they do that? It’s up to them.
If your friend or your neighbor John is also on the white list, he’s gone through the process, you can transfer to his Ether address, and then he can pay you, he can go over with your house with a bag of cash, or he can mow your lawn. Whatever your deal with that particular investor was, you can trade those tokens. [00:19:30] It requires that everyone be on the white list, whereas right now, in most blockchains, any two addresses can transfer between each other, but our standard is really creating restrictions so only a specific set of people is able to hold that token.
Clay Collins: Because of the need for KYC and non-compliance to be either a qualified purchaser or an accredited investor, you couldn’t just sit in a coffee shop with two computers that aren’t connected to the internet [00:20:00] and trade these tokens. There is some dialing of home, or dialing into different systems to verify things. Could you walk us through, just step by step, who is calling who and what connections are being made to execute a trade? And I realize that this is different in different jurisdictions, and that there’s different pools of white lists and stuff like that, but just to make it super specific, let’s say it’s an accredited investor [00:20:30] swapping securities with another accredited investor on tZERO. Let’s say we’re at the part in the flow where I’m a buyer and I’ve put in an order and there’s a seller on the other end who decides they like the price that they’re going to be on the other side of that trade. What happens next?
Chris Housser: The beautiful thing about blockchain platforms and just cryptocurrencies in general is people [00:21:00] are able to be their own bank. You’re able to hold your asset yourself, you’re not reliant on putting it into a bank account where a third party, i.e. the bank, is the one that actually holds your assets. Now the way the majority of these exchanges work, and I imagine this is how tZERO will work, we’re still working on our partnership with them, but my understanding is they will hold custody of those tokens. If you’re [00:21:30] a seller and you want to sell your tokens on tZERO, you’ll actually have to transfer them to a tZERO controlled address and then it will be represented in your account. You log in, it will be on your account, and then you’d create a cell order, and then there could be a buyer who has funded their account. They make a buy order, those two are put together, so now the buyer would transfer his, let’s say Ether, and the seller’s securities would transfer to the buyer. However, that transfer will not be happening [00:22:00] on chin, it won’t be happening on the Ethereum blockchain, it’s
Speaker 1: On chain. It won’t be happening on the ethereum blockchain, it’s just going to occur on tZero’ internal database, so its internal ledger that would say, “this person’s account now holds this, and the seller’s account now holds this. If they buyer, once the buyer wants to withdraw the securities off the exchange and into their own ethereum address, into their own account, provided that they’re on the whitelist, and they’ve gone through the KYC process, then withdraw those securities off of tZero, [00:22:30] and hold them themselves.
Clay Collins: I think this is a good explanation of the importance of whitelists. And I should really state here that the existence of these whitelists not only helps to ensure compliance with security’s laws, they also improve the overall security of the systems in general. For example, if a security token exchange were to be hacked, tokens could only be moved off the exchange to whitelisted addresses. All of which have known identities associated with them because of KYC AML checks. Since we’ve heard from [00:23:00] Polymath, let’s hear from Harbor for a high-level review of how their system works.
So Josh, can you walk us through the lifecycle of a company using the Harbor platform to issue a token on your system?
Joshua Stein: So issuer comes to us. I would use the example of the classy office building, let’s say it’s worth $50 million. Harbor will provide the website that markets the investment, we set it up, it’s the issuers [00:23:30] URL, so it might be www.awesomebuilding.com. But we’ll help set up the website. They can do it themselves, or we can set it up, it depends on the technical sophistication of the issuer. It’ll show a little bit about the investment, it’ll have some nice shots of the building, it’ll say a little bit about the tenants, it’ll say a little about the operator. And the investment opportunity. It’ll say, “are you interested? Click here.” That then takes the person, the interested investor, to the Harbor website, where they set up an account. It’s much like account set-ups you’re used to before, you provide name, address, other basic biographical [00:24:00] info, you provide a copy of a government-issued identification. We then take you through a KYC AML check. We take you through an accredited-investor certification, if that’s necessary. Once you’ve gone through that, you get shown the actual investment documents, so you get showed the offering memorandum, or the perspectives, you get showed the investor agreement. You get showed whatever other detailed disclosures the issuer wants to provide. You sign the documents right there on the website.
You then get put through a purchase-order flow. So [00:24:30] if you’re raising $50 million, and you’re a private [inaudible [00:24:33] with a maximum of 2,000 shareholders, then that’s an increment of $25,000 in investment. So you want four shares, or four tokens, at $25,000 each, that’s $100,000. You can wire in funds to the issuer’s bank account. Dollars. Or you can pay in bitcoin or ether if the issuer wants to accept that. Or if you want to pay in cryptocurrency, and then the issuer wants [inaudible [00:24:58] there’s a service whereby you [00:25:00] can send bitcoin or ether, you get a spot price that’s good for a limited amount of time. And then you send in the bitcoin or ether at the spot price, and it gets converted on the backend into dollars for the issuer.
Once you’ve made the investment, then Harbor goes through an audit process, where we use an outside firm to go in and audit all the records, and to tie everything together to make sure it all lines up. Once the audit process is done, you formally close the fund. You issue notices to the investors that their investment [00:25:30] has been accepted. We then create the security tokens. We then re-audit the code. We audit the code generically that we’ve developed, but then once we’ve actually dripped the tokens we re-audit it. The tokens get dripped into a wallet with a qualified custodian that can set up for the investor. And then there’s an education campaign, just letting the investors know, “here’s where your documents are housed, here’s where you get more information from the issuer. Here are the venues that are licensed to trade, and here’s when liquidity [00:26:00] is possible under the rules that your issuer set for your security.” And then once that time, that holding period has passed, whether it’s 90 days or a year or whatever’s set up, then at that time they can trade in any compliantly licensed venue that the issuer has approved.
Clay Collins: Got it. It really sounds like you do a lot for issuers, essentially holding their hand through the whole process. And I think at its core, one of the main differences between you and other companies more focused on maintaining open-source protocols [00:26:30] is that you’ve seamlessly coupled your services around the initial issuance with a protocol for secondary trading post-issuance.
Let’s talk about what Harbor does after the initial issuance of a token, when owners of security tokens which were supplied by your platform want to trade with each other and engage in secondary trading. How does Harbor address that?
Joshua Stein: Harbor’s a platform for the initial issuance. In terms of secondary trading, we’re not making markets, we’re not operating exchanges. [00:27:00] That is an industry and expertise all of its own. That has very different requirement across different asset classes, different types of securities, and different jurisdictions around the world. And there’s a lot of really smart people attacking that problem. There’s people like Open Finance, there’s people like Templum, you know, there’s people developing the 0X protocol, there’s AirSwap, there’s all these folks who have different takes on it, are providing different sets of services and technology. So we don’t see that as our role, we are simply … we are a component of the later secondary liquidity, which is that compliance [00:27:30] cog, or that compliance layer, that allows this token to trade wherever it is around the world. Whether it’s peer-to-peer or on an exchange. Harbor allows that to happen so that you’re not limited to only one venue. Because if you put the controls in at the venue level, at the exchange level, then you can’t allow that token to trade peer-to-peer, and you can’t allow it to trade anywhere else. Because then, again, you would loose control of your cap, you wouldn’t be able to enforce these rules.
Clay Collins: I can definitely see the advantages of being able to [00:28:00] work with all these other trading platforms, right, you don’t want to restrict it in any way. And perhaps that’s maybe the best case for not including an order book at the security token level.
I think it’s time to transition here. After diving into the essentials of how these systems work, let’s talk about secondary trading and how security tokens powered by Harbor and Polymath trade hands after initial issuance. A lot of people report buying their first [00:28:30] bitcoin over Ebay or Craigslist, so let’s discuss secondary peer-to-peer trades. For example, where person A might just meet with person B, and together decide that they want to trade tokens without any intermediary facilitating the process. My first question about this topic is directed to Chris at Polymath.
Where will people be able to exchange? Does a security token only exchange have to be used? Or can [00:29:00] people swap peer-to-peer, like over Craigslist? How does the execution of trades take place once holders, you know, have the tokens, and decide they want to trade them?
Chris Housser: I really think liquidity is king. And that’s what investors want. They want to know if they buy something that they’re going to be able to trade it at some point. Right now with private placements and exempt offerings, there’s generally long hold periods and there’s no exit for five to ten years. And I think what the blockchain [00:29:30] space brings is more liquidity to these types of offerings. And so that’s really what we’re trying to focus on and work with. So we’ve partnered with tZero, they’re an ATS …
Clay Collins: Hey, it’s me cutting in from the editor’s booth. So, ATS stands for “Alternative Trading System.” An ATS is a non-exchange trading venue that matches buyers and sellers to find counter parties for transactions. Alternative Trading Systems are typically regulated as broker-dealers rather than as exchanges. And for all intents and purposes might be interacted [00:30:00] with like an exchange from the end user or trader’s perspective.
Chris Housser: And we’d like to have tokens that are created by Polymath to be able to go on tZero, to be exchanged there. And they’ll have an orderbook, and they’ll have mechanisms to put buyers and sellers together.
Clay Collins: We’ve heard from Polymath’s COO Chris Housser about the topic. Let’s talk to Polymath’s CEO, Trevor Koverko, about peer-to-peer trading as well.
So getting back to the example of how you got started in the bitcoin [00:30:30] space, you know, buying your first bitcoin over Ebay. Theoretically it sounds like you’re saying it’d be possible for that transaction to happen with a Polymath token as well, provided that you were an accredited investor, or otherwise whitelisted by the issuer. You could actually take part in a peer-to-peer transaction with a polymath token. That’s facilitated through whatever means. Is that correct?
Trevor Koverko: Yeah, I never thought of that but that’s the beauty of what I said earlier, programmable ownership. [00:31:00] That’s what it means. And that’s why regulators love it to, because it’s more secure, it’s more transparent, it’s more immutable than the current way things are done. A lot of the legacy infrastructure was built in 1980, it’s astounding even today, that underpin Wallstreet. But yeah, that’s the whole point, is that there’s this master white list that lives in the cloud, that’s secure, and private, and transparent, ironically, at the same time. But yeah, that’s the whole point, is that we could do it at a very granular, tradable level, that I could trade [00:31:30] my coin for something else. And the regulators we’ve talked to are cool with it, because that’s what they care about, is making sure only authorized, accredited investors are trading with each other. It’s kind of like a secondary trade, you know, it’s like I have shares of Uber, I’ll trade you for your shares of Airbnb. And that’s perfectly okay.
Clay Collins: It sounds like eventually if security token exchanges do become decentralized, that’s not a problem because whitelisting happens at the token level, [00:32:00] versus at the exchange level.
Trevor Koverko: You just made a very profound statement, and the implications are very profound, and there was some crypto shock waves that just went out as you said that. But yes. I’m not gonna go down that road, and we think the next phase is gonna be, you know, tZero, and security token exchanges, commercializing. But don’t think for a second that Patrick’s not thinking of decentralized solutions to what the future of trade is gonna look like. And we [00:32:30] want to be front and center there too.
Clay Collins: Sure, just to OTC desks, or like the local bitcoins for security, I mean, there’s so many different ways this could go down. We’ve just heard Polymath’s take on this topic. Let’s also hear what Harbor’s CEO Joshua Stein, had to say about the topic when I asked him about peer-to-peer trading.
Josh, can an owner of a security token powered by Harbor meet someone who’s approved to buy those tokens, because they’re on the whitelist, for example, [00:33:00] can they meet with someone at a coffee shop and exchange that token? You know, if they coordinate through Craigslist, or Ebay, or local bitcoins, or wherever, can one person just trade these coins with another without an intermediary or a rent-seeking intermediary in the middle?
Joshua Stein: Yes. So what you would think of as over the counter trades, or technically you think of as peer-to-peer trades, Harbor’s controls still work. So you can think of Harbor as essentially [00:33:30] a trade-compliance oracle in the ethereum ecosystem. So that that token that has a little bit of a smart contract in it that pings the oracle Harbor, every time that token goes to change wallet addresses, it pings Harbor, and Harbor checks the who what and where of the transaction to make sure it’s compliant. It checks who the buyer and seller are, it checks what the trade is, and it checks where it’s occurring to make sure that all of those match. If all of those are compliant, no one knows Harbor was every involved, and the trade goes through. [00:34:00] If it’s not, the trade throws an error and it never happens.
Clay Collins: So the Harbor Oracle, which is the referee on a trade here, it doesn’t have embedded within it security lies, right? Is it the case that the issuer decides what the rules are, and then the Harbor oracle makes calls based on those rules?
Joshua Stein: Correct. So think of … Harbor is a platform plus a protocol. So we onboard issuers, we onboard the investors. So we can always correlate a real- [00:34:30] world identity with the walled address, or blockchain identity. If you don’t always have an up-to-date database correlating the two, there’s no way you can properly enforce compliance with the securities laws, and whatever additional contractual restrictions the issuer wants to impose. You have to always be able to correlate the two.
Clay Collins: Let’s talk about the role of identity, and where identity sits within this protocol stack, or this tech stack. Where does identity live in the system, [00:35:00] and are you using Civic, are you using KYCAML providers?
Joshua Stein: So we think of it just in terms of the categories you have in the real world today. You have to go through a KYCAML check. For certain types of investments you have to go through a credit investor check. You have to go through an OFAC check. And other sanctions list. So those are the checks that you have to do so that you can be vetted that you’re allowed to transact in these securities.
Clay Collins: Is identity then associated with a wallet address? [00:35:30] Like, can you have, I know this is really technical, is it the case that there’s like multiple wallet addresses that can be associated with a single identity, the receiver of the security tokens, is it like a one-to-one ratio between identities and wallet addresses, or is there something else going on?
Joshua Stein: Users can have multiple wallet addresses, they just simply have to register it with Harbor. So that way we can correlate the blockchain identity with the real world identity. Our expectation is lots of folks will have multiple wallet addresses.
Clay Collins: [00:36:00] Now that we’ve spoken about how secondary trading might happen in a peer-to-peer fashion, let’s transition to discussing how secondary trades might happen on security token exchanges. Again, here’s Harbor’s CEO, Josh Stein.
How does Harbor interact with exchanges, and how do you think about security token exchanges, and the necessity of them?
Joshua Stein: So the way Harbor works is by whitelisting the exchange wallet address. [00:36:30] We’re big fans of decentralized exchanges, so the 0X protocol, AirSwap, some of the others that are springing up. We think it’s a great model, where you don’t have an intermediary custodying funds, and custodying securities. But there are lots of other models that work very well too. And you can think of folks with that sort of hybrid models where the order book is off-chain, but then they’re settling trades on chain. Or they’re essentially electronically facilitating an OTC market. From our point of view, what [00:37:00] works best is where the trades are settled on the ain chain, on the main ethereum blockchain. Because that’s what triggers the Harbor protocol.
I think the one place where we have a little bit of difficulty is where it’s a centralized exchange that does not timely settle trades back to the main chain. That’s a difficulty because then you can’t see the trades that are happening, you don’t know the actual ownership of the securities.
Clay Collins: I agree with your affinity for decentralized exchanges. I think they make a lot more sense for security tokens than they [00:37:30] do for perhaps other types of tokens. And I certainly would want to, like, actually posses my securities versus having them in an exchange which could be hacked, and who knows what recourse I’d have if those tokens were stolen.
Joshua Stein: So we should talk about that. So let’s talk about the security aspects. Because I actually take the view of the opposite of that. So security tokens actually have a far lower risk of theft. Because the token itself is not the security. [00:38:00] On a technical level, the token is an electronic representation of an uncertified interest. And remember, someone can’t even steal, or take your token, unless their wallet has been whitelisted.
Clay Collins: Right. So they couldn’t even get them off the exchange unless …
Joshua Stein: They couldn’t get them anywhere. I mean, they can’t hack it out of your wallet unless their wallet has been whitelisted. And that is always associated with a real world ID. And we have the ability to transfer that ownership, to move that token back to a different [00:38:30] wallet address. And by we, I don’t mean harbor, I mean the issuer. That’s something that the issuer, the company, has a legal obligation to do. They have to be able to assign ownership of their shares. If there’s a divorce, and the court orders a split of assets, they have to be able to reassign ownership on their books. If there’s been a fraudulent conveyance, and the court orders ownership to be transferred, you have to change the ownership on the books and records of the corporation, which is the ethereum blockchain. Unlike cryptocurrencies, where once it’s [00:39:00] gone, it’s gone, it’s very different in a security token world, because you always know the real world identity, and you always have the technological ability to transfer the signifier of ownership. And remember, the security token just simply represents a real-world asset. The asset doesn’t go away.
Clay Collins: Right. It’s an ownership claim but not the actual ownership.
Joshua Stein: That’s correct. So it’s very different than with a cryptocurrency, where the asset itself is gone. And the asset itself is a bare instrument that [00:39:30] is not tied to a real-world identity, it’s not being tracked and controlled. Security tokens are very different.
Clay Collins: Hey, this is me again, your host, and I think a really important aspect of this which Josh touched upon is what happens when a user goes to withdraw security tokens from an exchange. We learned a little bit about how Harbor addresses this. Let’s hear from Chris Housser at Polymath about how their platform addresses on-chain activity and withdrawal from exchanges.
What happens if you don’t have a shared whitelist [00:40:00] with an exchange, in that circumstance? Help me understand the withdrawal aspect.
Joshua Stein: That’s a really good question. For Polymath and for the issuers, the way we see it working is the issuer will actually be able to create multiple whitelists. So let’s say they create their security token, and they create three whitelists. Now, at the onset the issuer would control all three of those whitelists. And provided, an Ethereum address is on any one of those lists, [00:40:30] it would be eligible to hold that security. And so the issuer will control those three lists. And then let’s say six months in they decide, oh, tZero’ interesting, we’d love to have the added liquidity by putting it on that exchange. They would then transfer one of the whitelists to tZero’ control. And now tZero is able to add, update, and modify that one whitelist, as per their verification checks.
Clay Collins: So tZero isn’t controlling the whitelist, and you guys [00:41:00] aren’t controlling the whitelist, it’s the issuer that’s controlling the whitelist, it sounds like.
Joshua Stein: Well, the issuer controls the whitelist, but then they can divest, if you will, or send control of one of the whitelists to another party.
Clay Collins: Like a verification service, for example?
Joshua Stein: Or like tZero. Because I imagine if let’s say there’s 1,000 users on tZero, every one of those users will need a different deposit address for their security [00:41:30] tokens. So if you log in, it’ll say, “send your tokens to 0X123,” whereas if I logged in it would say, “send your tokens to 0X567.” They need to have the ability to update that whitelist to manage multiple different addresses. And it would be a big delay if that particular exchange, be it tZero or another exchange, then had to go back to the issuer and say, “can you add this address so we can get another deposit?” So that’s why we see having multiple whitelists is a [00:42:00] solution to that problem.
Clay Collins: So in this case, the issuer would outsource curation of one of the whitelists to tZero, who could effectively say, “we have verified this person, and we’re gonna add them to the list,” and provided that the issuer trusts tZero to do that, then those people on the whitelist can be receivers of tokens.
By putting this control in the hands of issuers, that’s how you guys get out of the [00:42:30] business of managing or automating compliance in a gazillion different jurisdictions.
Joshua Stein: Right, exactly, it’s the issues that have control, and they can then outsource to trusted third parties. And the way I see it is if, let’s say they’ve outsourced it to a party, and then the regulars say, “hey wait a sec, only accredited people can have it, and Joe the newspaper boy happens to own this token, we’ve discovered that he has it. How did he come to be in possession of this security that’s only [00:43:00] open to accredited people?” And then you could look through the whitelist, and say, “oh, he was added by company X’s whitelist procedure. And I’d say the regulars would then go ask company X, and wonder why they sold, or added this particular person, who’s not accredited, to the whitelist. And so the issuer would make its best efforts, it would have a defensible argument that, “yes, we only add people who go through proper verification processes, and we do due diligence on company [00:43:30] X, and I’m not sure what happened, but for some reason they added this nonaccredited person, and I think that would be a defensible argument to stay compliant.”
Clay Collins: So exchanges, OTC desks, et cetera have to whitelist addresses. But in order to move your money off of these exchanges, you need to be on a verified address. But tokens on these exchanges can only be withdrawn to other security token addresses that are on the whitelist for that company. [00:44:00] That doesn’t stop someone from buying and selling securities on exchanges if …
Clay Collins: That doesn’t stop someone from buying and selling securities on exchanges if they aren’t qualified to own the token, but that’s where outsourcing of white list comes in. Centralized exchanges like blocktrade.com, tZERO, OpenFinance, et cetera, have to run their own KYC/AML checks and the issuer needs to trust them. As Chris points out, if someone who shouldn’t own a token ends up owning it, the issuers can show in a court of law that they have the right checks in place and attempted to enforce compliance of the law.
Another interesting topic, [00:44:30] which I believe needs more attention, is how the nature of trust is different and the same with tokenized securities, cryptocurrencies and traditional private securities. I’m about to pose a question about this topic to Josh from Harbor. Josh, how is trust different verus the same when it comes to security tokens versus traditional private securities and cryptocurrencies? How does trust differ among these systems?
Joshua Stein: Compared to a traditional private security, one aspect of trust [00:45:00] doesn’t change at all just because you have tokenized security and that’s the investment itself. You’re still handing over funds that a third party agent is administering and you have to trust that it’s good investment. If you have a bad investment and you tokenize it, you now have a more liquid bad investment. Your need for due diligence and the level of trust you have to have in the people managing the money is the same regardless of whether you use the blockchain or not.
What becomes incrementally better, and this goes back to the administrative [00:45:30] efficiency we were talking about, is the evidence of your ownership you can have more trust in. There’s a real problem today. Every private company I’ve known, there cap table is always messed up in some way. It is amazingly hard to keep track of your cap table no matter how much money you spend on high priced law firms to track it for you. There’s an infamous case of Dole Foods from 2017 I believe. They thought they had 34 million shares outstanding. Investors thought they had [00:46:00] 46 million shares outstanding. That was a rude shock.
When there was litigation, the court kind of threw up its hands and said, “Well, you know, it’s up to the broker dealers that held the accounts with a transfer agent to go figure it out.” It was this classic problem that blockchain is designed to solve of no single source of truth. Not having one ledger that records ownership. Using crypto or blockchain doesn’t change the trust they need to have in the person managing the money or the investment. It gives me more confidence in my ownership. At least I know [00:46:30] I can see my ownership on the blockchain. I know it’s not being double counted and there’s not phantom shares out there.
Then what becomes really transformative is the secondary liquidity is the fact that I can trade 24/7, 365 around the globe with near instantaneous settlement and no counterparty risk. That is what is truly transformative about using the blockchain with private securities.
Clay Collins: I think that this last point is really important. Security tokens enable for the very first time securities to be [00:47:00] traded 24/7, 365 around the globe with near instantaneous settlement and no counterparty risk. This has never existed before at any meaningful scale. While fast settlement and around the clock trading is a nice incremental improvement, the absolutely transformational piece here is the ability to trade securities around the globe because global trading unlocks international exposure to businesses who otherwise couldn’t gain a global investor base. Here’s Bruce [00:47:30] Fenton for more on this.
Bruce Fenton: To this day, here it is 2018, and it’s still very difficult for people in different countries to buy different stocks. How many Americans do you know who own Chinese stocks? Not that many. It’s a big pani. How many Chinese people own IBM stock? Not that many. It has to be done through funds and there’s ADRs and there’s AA shares and there’s all these different ways of doing it. It’s a big mess. That thing that I mentioned with DTCC and Cede and Co. is a big complex mess in [00:48:00] the United States. There’s similar versions to that all over. There’s no global security markets. I mean you think it’s bad to transfer your money from Merrill Lynch to the other Merrill Lynch down the street and it takes 10 days.
Think about how hard it is to transfer your money from Merrill Lynch India to Merrill Lynch London. Forget about it. If it’s Merrill Lynch go into Goldman, that’s even harder because then it’s a different system. I had accounts when I was a broker and a financial advisor where we’d have people coming in from other countries. It was very, very difficult. Typically we just have [00:48:30] them liquidate all the money, send it to a bank, and then wired into a fresh account. It’s pretty much impossible. I don’t even know how you would do it. Amazingly in 2008 we don’t even have the capability to easily own shares, but with tokens we could.
People all over the world own Ethereum and Bitcoin and Litecoin. It doesn’t matter if they’re from Taiwan or China or Kansas. They can do that. That’s the way that equities should be. Everybody in the world should be able to buy IBM stock if they want it or buy some Google or buy some companies [00:49:00] other than the American Clue Chips. There’s a lot of great companies in the world. Some of the biggest banks and auto companies and other ones are outside of the United States.
Clay Collins: Bruce just touched on how security tokenization unlocks capital from investors all over the world. This is relevant because frictionless global trading allows investors from around the world to access secondary markets. Let’s change gears here to explore how security tokens impact a company when it comes to the initial issuance of the securities. Here’s a question I asked Joshua Stein from [00:49:30] Harbor about this. Josh, how do you think about jurisdictions and the role that jurisdictions play when it comes to initial issuance of security tokens? It sounds like you guys are jurisdiction agnostic and can work with anyone located anywhere provided that they’re adhering to the law?
Joshua Stein: That’s correct. We are not fully up to speed on all the different foreign jurisdictions rules. There’s something like 186 different countries, but we’ve looked at a number of them and we’ve looked in particularly for US issuers of securities and then what rules [00:50:00] apply for other jurisdictions when the investors are overseas and the investment and the fund is in the US. We’ve already gotten inquiries from folks looking to tokenize assets in the UK and elsewhere. We’re very excited about the opportunities internationally as well.
If you go back to the promise of the blockchain and what we began this interview with, it really does allow from the issuer’s point of view, the people raising capital, to go jumpstart their business and power the economy. It allows them to draw from the investor base [00:50:30] around the world. Democratizes that investment. From the point of view of the investor, it allows them to look at investment opportunities around the world in a far easier way.
Clay Collins: With regards to how security tokens platforms like Harbor and Polymath work, we’ve discussed white listing, secondary trading, primary issuance and exchanges. Another issue that merits discussion are disclosures. In the United States and most other jurisdictions, laws require companies conducting a securities offering to tell potential investors all material information about [00:51:00] the company, its principles and the investment opportunity, including the risks of the investment that a reasonable person would want to know in order to make an informed investment decision. Let’s ask Trevor from Polymath about how they handle disclosures.
Does Polymath facilitate disclosures that are required by securities regulations like you’ve got to disclose risk factors, summary of terms, operating agreement, things like that? Is any of that facilitated by Polymath or do you still need to file those things?
Trevor Koverko: Short answer, [00:51:30] no. We’re not council. We don’t give legal advice and that’s something we don’t do. What we are working towards in kind of version two, version one is like get a lawyer and get going. Version two is we have a network of legal templates and kind of like GitHub for lawyers. We’re going to make it a lot more streamlined or LegalZoom for our security token offerings. Like all these things with KYC, Polymath and the ecosystem and the protocol we built is designed [00:52:00] to have all of these organic community members and stakeholders help an issuer get through that process in a decentralized way.
In our white paper, you’ll see that’s a big component of it is how can we incentivize this network of independent third parties to work together towards a common goal. We had this overwhelming demand. that’s why to win this market, we have to be self-serve. We have to be open. We have to let them be in control because there’s now way we could service that much demand if we did it as a high [00:52:30] touchpoint advisory business model.
Clay Collins: As you heard, Polymath doesn’t really handle the creation or publication of disclosures. They prefer to outsource that to their community believing that in order to scale, they need to pursue a self-service approach. They might just be right about that. Time will tell. There are of course disadvantages and advantages to the do-it-yourself approach that you need to take if you’re going to issue tokens on Polymath.
A disadvantage is that when it comes to initial issuance, everything from purchase flows to disclosure docs [00:53:00] must be handled by the issuer or at the very least an issuer will need to find a third party service provider that operates within the Polymath ecosystem to handle everything for them. At the end of the day, a company will need a team that likely will include blockchain developers in order to launch a security token with Polymath. Polymath doesn’t hold your hand through the process, audit your code, et cetera. Harbor, on the other hand, takes a different approach. They’ll set up your website, audit your code, construct the purchase flow, publish your disclosures, et cetera.
It’s [00:53:30] really an end-to-end solution for initial issuance. At its core, it’s a services business, at least right now. One advantage that Polymath has going for it at least in my view is censorship resistance and decentralization. Here’s what I mean, because Polymath doesn’t as a company directly handle issuance for an issuer, there’s less of a need for Polymath to exert control over the system. Here with more is Chris from Polymath.
Let’s say hypothetically [00:54:00] someone is using the POLY chain protocol in a way that you certainly hadn’t anticipated, but they are engaging in fraud or illegal activities. The SEC comes to you and says, “We’re investigating them. We have a warrant. Judge has approved this and we would like you to shut down their activities on chain.” Is that something that you guys can do or not?
Chris Housser: No. The Polymath core, it’s pushed out to the Ethereum [00:54:30] blockchain and it then is a decentralized application that we don’t control. We don’t have servers that house any data. It’s all entirely on the blockchain as a smart contract. If the SEC wanted to shut something down, they effectively have to try to shut down the whole Ethereum blockchain.
Clay Collins: Sort of a follow on question, let’s say all Polymath organizations go away and some sort of miraculous event [00:55:00] happened. I won’t use hit by a bus because that’s morbid, but everyone that works at Polymath is sucked into an alternate dimension that can’t interact with this world. What happens? Do things move forward?
Chris Housser: Yeah. That’s exactly it. I tell that to the team regularly that we’re still building some stuff out. Once it’s out and working, yeah, we get hit by a bus as you say. We’re not needed. That’s really the goal is that our team [00:55:30] is not needed, but this suite of tools is available online for the world to use. It’s the same as Bitcoin. Satoshi Nakamoto, no one knows who he is. He’s gone to our knowledge and he’s not helping out develop Bitcoin any further, but it’s thriving. I think the same could be said for Polymath and that’s our eventual hope.
Clay Collins: Hey, it’s Clay from the editor’s booth. I think that the question, what would happen if you were hit by a bus, is really a great point of differentiation [00:56:00] for understanding differences between Polymath and Harbor. Let me pose essentially the same question to Josh from Harbor. What is the boundary between Harbor the protocol and Harbor the business? If Harbor the business goes away, is it the case that the protocol still continues and these tokens can still be swapped indefinitely?
Joshua Stein: Harbor is designed to fail close. If Harbor went away, the tokens would not trade. [00:56:30] What that allows the issuer to do is then reissue the tokens with a new provider.
Clay Collins: Hey, Clay again cutting in from the editor’s booth, I think the fact that Harbor fails close is important, but I want to ensure that this is put into perspective. A token is just an electronic representation of a security and its primary purpose is making trading easier. If Harbor shuts down, that doesn’t mean that your ownership claim in a business goes away. It does however mean that you have to trust the issuer to do the right thing when it comes to suspending trading, reissuing tokens, moving tokens [00:57:00] to a new blockchain when that represents an advantage, and otherwise acting in the best interest of shareholders.
If an investor doesn’t trust a company to act ethically in the best interest of shareholders, then what they do with their tokens should be the least of an investor’s worries.
Joshua Stein: I think it’s actually the issuers contractually need to have the right to suspend trading at times because they may want to move to a different provider. They may want to move to a different blockchain. Suppose we made a big bet on Ethereum because it’s got the best developer community, but it maybe [00:57:30] for certain types of securities. It maybe two developments down the road, you’d be better off on a different blockchain. You could just simply suspend trading or ask the technology to freeze trading across an entire security issuance. You would freeze the trading and then you would just reissue tokens to people on that new blockchain technology.
Because remember the real world asset hasn’t gone away. That company, that piece of real estate, is still there. The token is just an electronic representation of the security that makes it easier to trade. [00:58:00] It’s like an email. You can send a new email very easily.
Clay Collins: Whereas Polymath is more of a DIY option, it’s also meant to be a censorship resistant, open and open source protocol that can survive the death of its parent company. The crypto purist in me really likes this aspect of Polymath, while the pragmatist in me likes that I could just go to one company like Harbor and have them handle almost everything for me. These platforms have their pros and cons. [00:58:30] Let’s learn a little bit more about the business behind the protocols starting with Chris from Polymath and the conversation I had with him.
Just kind of the inner workings of the organization, where is Polymath domiciled, how does Polymath make money, have you disclosed how much you raised during your ICO. Just at an operational level, how does the organization work and operate and how is it legally classified and all that stuff?
Chris Housser: I should say we have a few companies, but Polymath, Inc. is a Barbados [00:59:00] company. It’s the company that is creating the core protocol for people to work with on the Ethereum blockchain. It’s where DIP is housed. It’s where the POLY token is used to access the features and the suite of tools for Polymath. We have developers in Barbados. We have some foreign developers as well in Buenos Aires, London, England and around the world that are working on that core protocol, as well as the community. We’ve had a few [00:59:30] members just submit improvement protocols or procedures to the platform.
People want to work out and that’s what’s great about the blockchain space is that it creates this community of individuals that want to really push together to help the space grow. That’s our Barbados company. That’s where we did a sale for this Polymath token back in the fall of 2017. We filed an exempt offering with the SEC. Then we have a separate company that’s in Canada. [01:00:00] This company is an advisory company. It helps these issuers with additional development or custom development for their Polymath token offerings. They don’t even necessarily have to be Polymath offerings.
If they want to do something not related to the platform, that’s okay too. It’s essentially an advisory shop for blockchain offerings.
Clay Collins: Like a services business?
Chris Housser: Exactly.
Clay Collins: How much did you raise during the ICO?
Chris Housser: We didn’t do [01:00:30] an ICO. We did a private sale to our group of friends. Both Trevor and myself have been in the blockchain space ever since 2012. He always praises that he bought a Bitcoin for $20. Myself since 2013. We did a private offering to accredited people in the space and raised $58 or $59 million.
Clay Collins: I must be confused. I could have sworn I saw ads. Were those for a token offering or was that for something else?
Chris Housser: [01:01:00] That was post-offering.
Clay Collins: Oh okay. Got it.
Chris Housser: That was just to promote our platform and to promote our website and grow our community. The ad went up actually on Christmas Eve on the 24th of December, which was post-offering.
Clay Collins: Okay. Now let’s turn to Harbor’s CEO and learn a bit about their business and business model. How does Harbor make money? I understand that you guys have not issued a token, which is the primary [01:01:30] business model in this space. How are you guys set up? Are you a services business?
Joshua Stein: Yes. My check is we make money the old fashioned way. We earn it. We make money through direct charges. We charge as a technology company. We’re a technology provider. We charge for setting up and issuing the initial tokens and onboarding the initial investors. Then I think long term we’re going to develop additional value-add services. People have been asking about the ability to pay dividends. People have been asking about the ability to issue tax stocks. People have asked about the [01:02:00] ability for other cap table management tools. I think there’s a lot of value-add services there to provide down the road.
Clay Collins: Got it. It’s some kind of initial set up fee plus percentage of transaction volume?
Joshua Stein: I would divide it into the initial issuance, the secondary trades and other value-add services. On the initial raise or the initial issuance, we charge for our services then. We don’t currently plan on charging for later trades, but that may come in down the road. [01:02:30] We’ll just have to see what the cost is associated with that, what the volume is like. Then there’s the value-add services where you’re providing cap table management, where you’re facilitating the distribution of dividends via crypto means and other things like that.
Clay Collins: Well, it’s time to wrap up the second part of our audio documentary on tokenized securities. [01:03:00] My intention here was to consider how two different tokenize security platforms work in order to help you gain a broader understanding of the constituents, processes, and technical mechanics of a security token ecosystem and how they interact with each other. I chose Harbor and Polymath as a lens through which to view how these platforms generally work. I don’t want to in any way imply that these are the only two platforms out there. That would be far from the truth.
Platforms like Securitize.io, Region Labs, which did the tZERO launch, and Tokenhub, [01:03:30] which did Blockchain Capital’s token offering, have bene up and running here for a bit. That’s it. I hope this was helpful and that you leaned something. Of course, stay tuned for part three coming next week where we squint as hard as we can and stare into the future to explore what happens when digitized securities make it faster, cheaper and easier to unbundle and rebundle new financial instruments and derivative investments. The potential future here looks pretty compelling and crazy. Shout out again to Blocktrade.com for making all of this possible.
Blocktrade. [01:04:00] com will be the first fully licensed security token in Europe. I encourage you to go to their website Blocktrade.com. Hit the red subscribe button and follow what they’re doing. I think it’s pretty exciting. Okay. See you next week for part three of “Tokenize The World.” Take care. This podcast was produced by me, Clay Collins. My audio producer and collaborator is the talented Arison Cain. Special thanks to our guests and everyone who has helped to make this series possible, including our sponsor Blocktrade.com. If you have questions or comments, [01:04:30] you can contact me on Twitter @ClayCollins. Thanks for listening.
That’s it for this week. To sign up for our free crypto investing newsletter, listen to other episodes or get the show notes from this episode, please visit flippening.com. I also invite you to check out the startup that funds this podcast, Nomics, spelled N-O-M-I-C-S at nomics.com. Finally, if you got value from the show, the biggest thing you can do to help us out is to leave a five star review with some comments and feedback on iTunes, Stitcher or wherever [01:05:00] you listen to podcasts. Thanks for listening and see you next week.
Tokenize The World, Part 3: Seven Predictions About Our (Wild) Tokenized Future
Thanks To Our Sponsor: BlockTrade.com
Blocktrade will be the first fully licensed security token exchange in Europe, focused on listing crypto assets, security tokens, and other tokenized financial instruments. By being fully MiFID II compliant they will enable crypto trading to institutional traders while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few things to announce in the next couple of weeks, including their public beta launch. Be sure to go to Blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.
In this episode, we squint our eyes and stare into the future to explore how the world might change in the aftermath of widespread security tokenization. We’ll be walking you through 7 predictions about the future, as it relates to security tokenization. These forecasts for the future will move from expected to unexpected, from predictable to pretty wild (by financial product standards).
Special thanks to all of our guests including Professor Stephen McKeon, securities attorney Zach Robins, Harbor CEO Joshua Stein, and Bruce Fenton (CEO Chainstone Labs/Atlantic Financial and Board Member at Medici Ventures, tZero & the Bitcoin Foundation). Thanks also to Polymath’s CEO Trevor Koverko & COO Chris Housser.
Part 3 Topics include:
- The evolving role of exchanges over time.
- Why the security token ecosystem might run more efficiently if lawyers step out of it.
- Why the legal field, as well as other financial industries, might be overdue for disruption through tokenization.
- How tokenized securities affect the rest of the blockchain ecosystem.
- How property ownership can be unbundled and re-bundled to unlock new value.
- Why the most reliable stablecoins might be backed by real estate.
- The relationship between derivatives markets and asset backed tokens.
- Why the attorneys of the future may be the ones writing your smart contracts.
- An entire universe of financial products unlocked by security and property tokenization.
- Why Governments and the SEC might eventually mandate the adoption of tokenized securities.
Links Relevant To This Episode:
- Zach Robins
- Bruce Fenton
- Josh Stein
- Anthony Pompliano
- Blockchain Capital
- University of St. Thomas Law School
- Lightning Network
- Marc Andreessen
- How to Succeed in Business by Bundling – and Unbundling
- The SEC will mandate Security Tokens by Anthony Pompliano
Terms Mentioned in the Episode:
- Security Tokens
- AML/KYC Compliance
- Atomic Swaps
- Investment Advisers Act of 1940
- Securities Exchange Act of 1934
- ERC20 Token
Part 3 Transcript:
Clay Collins: Welcome to Flippening, the first and original podcast for full-time, professional and institutional crypto investors. I’m your host Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the front lines of financial disruption. Go to flippening.com to join our newsletter for cryptocurrency investors, and find out just why this podcast is called Flippening.
Announcer: Clay Collins is the CEO of Nomics. All opinions expressed by Clay, and podcast guests, are solely their own opinion [00:00:30] and do not reflect the opinion of Nomics, or any other company. This podcast is for informational and entertainment purposes only, and should not be relied upon as the basis for investment decisions.
Clay Collins: Welcome to part three of Tokenize The World: A Security Token Documentary. In this episode, we squint our eyes and stare into the future to explore how the world might change in the aftermath of widespread security tokenization. It’s probable that nearly everyone listening to this understands how Bitcoin and similar technologies are digitizing cash, but only 30% of the world’s wealth is in cash. [00:01:00] Far more is held as property and securities. In the spirit, this documentary tells the stories of the projects, makers, issuers, investors, and influencers who are tokenizing the world. But, before we dive in today’s material, let me review where we’ve come from.
In part one of this documentary, we discussed, one, how blockchain technology has changed trade execution. Two, how tokenization unlocks liquidity. Three, how security tokenization provides different kinds of value to public versus private companies. Four, [00:01:30] ideal versus non-ideal security token use cases. And five, which average businesses could benefit the most from tokenization. In the first installment of this documentary, we also discussed the three major misconceptions about security tokenization, such as the objection that security tokens are not valuable because they are centralized around the issuer, and in many cases, not censorship resistant.
In the previous episode, which was part two of this documentary, we dug deep into how security token issuance and secondary trading works. Indeed, for [00:02:00] all the talk about the merits and drawbacks of security tokenization, there is extremely little discussion of the mechanics of token issuance and trading. Our goal with the second installment was to enrich the debate, so we can move beyond high level philosophy to a deeper discussion of the technologies, methods, and mechanisms required of competent security token platforms
In today’s installment of this series, we propose seven specific predictions about the future as it relates to security tokenization. We also discuss the evolving role of exchanges over time, why the most [00:02:30] reliable stable coins might be backed by real estate, the relationship between derivatives, markets, and asset-backed tokens, and the entire potential universe of financial products unlocked by security and property tokenization. Before we get started, I want to thank blocktrade.com for their generous support of this documentary. Without them, Tokenize The World would not exist. If you’ve enjoyed this content, please do me a solid and thank blocktrade.com on Twitter for providing the support necessary for making this work possible. Here’s a little bit about them.
Blocktrade.com will be the first [00:03:00] fully licensed security token exchange in Europe, focused on listing crypto assets, security tokens, and other tokenized financial instruments. By being fully method to compliant, they will enable crypto trading to institutional traders, while unlocking huge amounts of liquidity with their primary market partners. If you’re someone who’s following the security token space, they have quite a few things to announce in the next couple of weeks, including their public beta launch. Be sure to go to blocktrade.com, hit the red subscribe button at the top, and get on their announcement newsletter.
As a side note, I really, really like [00:03:30] these guys. I had a great conversation with their CEO the other day, and like I said before, I was really impressed. In this episode, we’re going to cover lots of creative tokenized financial products that may exist in the future, and it will be progressive and forward-looking exchanges like blocktrade.com that will provide markets for these tokens. Thanks to Block Trade for stepping in and making today’s show possible. Again, if you’re a fan of Flippening and this series, please do me a favor and let them know that you heard about them here. It really helps the show out. Okay. With that established, [00:04:00] let’s kick off part three of Tokenize The World, a documentary about tokenized securities.
In this final installment of Tokenize The World, we’ll be walking you through seven specific predictions about the future. These forecasts for the future will move from expected to unexpected, from predictable to kind of wild. These predictions start out pretty tame, but get [00:04:30] kind of incredible by the end, at least by financial product standards. For our first prediction, let’s hear from Securities Attorney Zach Robins. How do you see this playing out, vis-a-vi, the law profession?
Zach Robins: I mean, this probably isn’t going to make people happy in my field, but I think that this will most sufficiently run if lawyers can step out of it to a certain extent. I think a state attorneys have to be very much involved with the assets that their clients may have. But for [00:05:00] a securities attorney like myself, I hate to say it, but I’m just creating more friction, and I am adding more costs to a potential transfer. If it’s possible to side step me, and use me only when necessary, when there’s an important question about accreditation, or citizenship, or voting rights, et cetera, that’s the best use of someone like myself. The best use of me is not to draw paperwork for each and every transfer, because it’s very costly. [00:05:30] To the extent that this can be automated and built on the blockchain, I think it’s going to decrease costs, and by decreasing costs, will increase the volume.
Clay Collins: That’s really interesting. At a personal level, what’s your reaction to that? I know you a little bit. I could see you actually being a little excited by that, because it would shift the focus of your time from repetitively drawing up the same kinds of deals and paperwork over and over again, to primarily [00:06:00] operating in a strategic capacity for most of the time, and I think you might enjoy that. What’s your reaction to how the future might play out for your profession?
Zach Robins: That’s right. There’s going to come a day, and I think it’s going to come a lot sooner than people expect, where the basic tasks that attorneys facilitate will be automated, and I think that’s a good thing. I think to the extent that I can add more value and spend my time on deeper customizable more important issues rather than, once again, drawing [00:06:30] up paperwork for a transfer where I’m not adding any value, is I think a better use of counsel. Having said that, there are going to be attorneys for instance, that are going to lose their jobs, because computers are going to do what they now presently do. I think the sooner that us, as an industry, can appreciate that, and build that into our business model, I think the better everyone will do in the future. Having said that, unfortunately, I don’t see many law firms preparing [00:07:00] for the day of smart contracts.
Clay Collins: When you think about most of your peers that you encounter at various conferences and events, do you think it’s likely that the majority of them will make this transition, or not?
Zach Robins: I think the moral of the story is, every other industry across the planet has gone through disruption over the past decade or two, and I really haven’t seen it very much in the legal field. I think it’s coming, and I think it’s coming sooner than people expect. [00:07:30] The sooner they can get on the bandwagon, I think the better it’s going to be for everyone.
Clay Collins: Do you envision highbred smart contract developers/attorneys? I can imagine that it would be incredibly useful to have both of those skillsets in one person.
Zach Robins: It’s actually happening today. There is a course taught at University of St. Thomas, where the law students are actually building smart contracts in the course. That is an incredible skillset. It’s really interesting, [00:08:00] because we don’t think of attorneys as coders. But in short time, attorneys are going to be doing some coding. Now, will that coding live in a sort of a really pretty, gooey environment? I think there’s great opportunity out there for developers to build legal tech that attorneys can use and build contracts off of. Those though, who are stuck in the Microsoft Word environment, are going to have to appreciate the fact that their Microsoft Word contracts, [00:08:30] you can’t do anything with them. You can print them, you can send them, you can sign them, but there’s no action built into that contract. That’s why it’s so exciting to have smart contracts that operate on the blockchain. They can run, and execute, and perform activities.
Clay Collins: In addition to the job of attorney, several other careers, businesses, and industries will be disrupted. There will no longer be a need for stock brokers, or at least the role of these brokers will evolve, and the jobs of investment [00:09:00] advisors, and wealth managers, RIAs, et cetera, will change over time as well. Here’s Bruce Fenton with more on this for our second prediction about the future.
Bruce Fenton: Here’s another interesting thing that will happen. The role of advisors will become decentralized. I think financial advisors … I used to advise a lot of institutional managers. I worked with the big Sovereign funds and private equity firms, both by side and cell side. I’d work with these companies to help them select and manage their investment portfolios. [00:09:30] As I was thinking about crypto, and as a lot of my crypto friends became ultra-high net-worth, it was funny, because I was thinking, “Boy, as a wealth manager, I would’ve loved to have all these friends who are extremely wealthy.” My earlier career, I would’ve loved to have meet all of these wealthy people.
But I got to thinking, how would I serve them if my 30 year old self was in this position of having all these connections with the wealthy crypto people? How would you serve them, because the old model in investing, is all about assets under management. [00:10:00] Every investment firm there is, it says right on their website, “Here’s what our assets under management is.” It’s the metric that everything I did for 20 years was based on. It’s all assets under management. Well, that has changed now, because there is no assets under management. I’m not going to call my crypto friends and tell them to send their crypto to me. They’re never going to do it. I wouldn’t even ask, and I wouldn’t want it. I don’t want five billion dollars worth of crypto sitting in my Trezor.
I got to thinking, “Well, [00:10:30] there needs to be a way that you can provide advice to them and not have custody of their assets.” Ideally, you maybe don’t even want to know who they are, because they may be private, and particularly in my case, thinking as a former sort of retail financial advisor and family office advisor, to the position I’m in now, to say, “How would I serve these people?” What I realized is that tokens will enable exactly that problem to be solved. You could have a financial advisor who could have portfolios [00:11:00] that are online. There’s the Prison Project through ShapeShift, allows you to create portfolios and have a fee. You could have an advisor that’s giving buy and sell recommendations. They don’t even need to know who their customers are.
Clay Collins: You don’t even need to know who they are. They could be someone in the middle of nowhere with a satellite connection.
Bruce Fenton: Right. It could be some guy in Bangladesh with a high school education who happens to be the next Warren Buffet. Maybe he’s a genius stock picker, and after two, three years, you see that his track record is so good that you want to invest with him, I don’t know.
Clay Collins: [00:11:30] So you can back his decisions and he can get carry, but there’s no custody issue. No, that’s brilliant.
Bruce Fenton: People say, “Oh my gosh, you’re willing to give your money to somebody in Bangladesh.” Well, what’s he going to do? You’re not giving him your money. He’s not going to steal it. All he could do is give you bad trades, and you can have parameters through a smart contract, just like you could with an investment policy statement. Say, “Okay, don’t do more than 10 trades a day,” or whatever your policy is. The whole world is going to change. The good news is if you’re offering value, that’s great. If you’re truly offering [00:12:00] value and an alpha, then that’s good. But, there’s a lot of parties that aren’t. They’re going to be replaced by better technology I think.
Clay Collins: Yeah. It’s really exciting. In terms of the risk, you can get a leaderboard on someone, on some of these websites, going back a couple years now. It’s pretty cool. I imagine that if you thought about it enough, you could envision other jobs, and industries, and businesses impacted by security tokenization. One of those is the exchange business. I’ll get to that in a second. [00:12:30] But first, I want to remind you that if you want to discuss these topics, or this podcast episode with others, feel free to join us in our Telegram Group at nomicstelegram.com. Back to the exchange business.
Our third prediction is that exchanges will become less custodial and less centralized over time. Indeed, as we discussed in part two of this documentary, security token platforms strongly favor on-chain exchange settlement. The incentives are in place for decentralization and non-custody, at [00:13:00] least within the security token ecosystem. Here’s Bruce Fenton with more thoughts on the role-
Clay Collins: … [inaudible [00:13:00] within the security token ecosystem. Here’s Bruce Fenton with more thoughts on the role of exchanges over time. This is our third prediction.
Do you think long-term this just moves to decentralized exchanges, people trading shares at coffee shops? What role do you think exchanges have to play in all of this, now and in the long term?
Bruce Fenton: Well as somebody who worked for exchanges for 20 years, I can say that I don’t really see how they’re going to add any value in this space. [00:13:30] I don’t see why you need exchanges any more. I worked at one. I was an exchange. I was broker, so I just don’t know why we would need them, in that I’ve never heard anybody who can explain why we’d need them. What would we need an exchange for? Why do you need an exchange? You have the ability, and with the Lightning Network on Atomic Swaps, you’ll be able to swap currencies for other currencies.
So if you believe that tokens are a thing and you believe blockchain’s a thing, and you believe Bitcoin’s a thing, and you believe this stuff’s going to grow, and you believe things are going to be tokenized, like [00:14:00] equities and stocks–stocks are going to be tokenized–then the natural conclusion of that line of thinking is that there’s not going to be exchanges as we know them, and the only reason I can think of for exchanges to exist is because the regulators want them to exist because that’s a good point where they have hooks in.
But those types of models don’t work, particularly when you have something now where we’re competing in a global economy now. ‘Cause all you need is you’re competing against the least statist politician. [00:14:30] Whoever the least dumb politician is in the world, the one who’s not stupid enough to interfere with the markets, the one who is looking for freedom, that’s who you’re competing with. So the days of the bureaucrats and politicians sitting on their laurels just thinking that everybody’s going to go through miles of paperwork to have exchanges I think is naïve. You don’t need an exchange, and the people aren’t going to do it, and they’re not going to want it. They’re going to work off-shore and it’s going to be very very very difficult for any major jurisdiction to just suddenly say, ” [00:15:00] You can’t have exchanges,” or whatever.
And I think the way that it will unfold, by the way, is probably very good and very healthy for both sides, for the statist and the freedom side, because it seems like it hopefully will go gradually. I think you’ll have a parallel track where you’ll have sort of the big exchanges will get a lot of regulations and they’ll do all of the ridiculous hoops that you have to jump through as a regulated company, and then meanwhile you’ll have decentralized parties where you have people just dealing with each other. Everything in the rules [00:15:30] when you look at the Investment Advisor Act of 1940, the ’33 Act, the Securities Exchange Act of 1934 is the real big one where it explains what exchanges are and how they have to work.
It’s all about, you’re under those requirements if you’re holding people’s money and you’re matching people and you’re managing order books. You don’t need to do any of that in the new world. Decentralized exchange, Lightning Network, Atomic Swap, people can do that on their own. If Bob has Apple stock and Alice has Bitcoin and they want to do a [00:16:00] trade, they don’t need Merrill Lynch. They don’t need me from my old job that I had for 20 years. They could just do that directly, if they have that in token form. And so the only reason you would have an intermediary in between that is because some government politician says, “I want a piece of that. I don’t want you guys making a transaction between you.”
And that’s hard, and there’s not actually a bunch of legal precedent for that. There’s tons of legal precedent for them to crack down on exchanges. You ain’t gonna go and set up a new exchange and start trading securities and not have [00:16:30] the SEC walk down to your door. But that’s a completely different matter from Bob and Alice working together to have an agreement that they mutually agree on. It’s not the SEC’s place, and I don’t think they have a lot of legal grounds to stand on to get in between that transaction. So hopefully it will unfold in a fairly healthy way where you have kind of this parallel track of the very heavily regulated exchanges and the regulated offerings and then you’ll have people who are doing peer-to-peer transactions on their own, just dealing with each other without an exchange.
Clay Collins: [00:17:00] The next few predictions about the future are from Josh Stein, Harbor CEO.
Josh and Harbor’s vision for the future is incredibly compelling, and I extended my interview with him for another 30 minutes in light of this material. For our fourth prediction, Josh forecasts that tokenized securities and real estate will form the foundation of the basis for Stablecoins. Here’s Josh’s take.
Josh, how do tokenized securities affect the rest of the blockchain ecosystem and economy?
Joshua Stein: I think [00:17:30] it has the potential to become the foundation or the basis for Stablecoins. So today, for example, I’m a big fan of the MakerDAO project and some of the other Stablecoin projects that are out there. There is so much friction involved because the cryptocurrencies are so volatile, and there’s so much commerce that wants to be done in what is essentially fiat, and folks are looking for crypto fiat, and that’s what the Stablecoin projects are about. The issues is, is let’s take the MakerDAO for example. You pledge collateral, and in order to get Dai, [00:18:00] the Stablecoin pegged to a dollar, you have significantly over-collateralize that contract if you’re using cryptocurrencies precisely because they’re so volatile. There’s a confidence issue in the value there. And you are vulnerable to a classic run on the bank, a classic loss of confidence that’s catastrophic and causes the currency peg to break, but now imagine a world in which you have a bunch of tokenized securities. You have all these security tokens based off real estate that’s unlevered, that’s high-quality real estate. So in other words, assets that are not volatile– [00:18:30] assets that are volatile 10% a year rather than 10% every 10 minutes. In that world, you can imagine folks using those security tokens, pledging them as collateral to produce Dai, and people really trusting these Stablecoins.
So now imagine a crypto economy powered by fiat currency that you can trust. What are the various things that you can do? When you have a blockchain-based ride-sharing solution. When you have a blockchain-based any other sort of service, look at Harbor’s potential [00:19:00] services down the road distributing dividends to folks. Rather than doing that in cryptocurrencies, you could do that in a crypto Stablecoin that people know and trust, and that opens up the crypto economy and the services you can provide in a way that I think’s truly transformative. So tokenizing securities doesn’t just have transformative effects on private capital formation liquidity. I think it will have transformative effects on the crypto economy.
Clay Collins: Oh, that’s super fascinating, yeah, so I always think about the guy who paid 10,000 Bitcoin for two pizzas, and [00:19:30] that cost him 75 million bucks, right? The most expensive pizza ever, and I think we’re pretty far away from an economy where you can pay for things in crypto assets if there’s so much risk you take on by making that exchange, but if you can collateralize with property, then you’ve got a much more stable foundation for the entire ecosystem. Yeah, that’s a fascinating point. That’s really interesting to think about. Is that something that’s short-term possible? Does MakerDAO allow you to collateralize [00:20:00] with security tokens?
Joshua Stein: Yes, you can collateralize with any ERC20 token. If you go back to MakerDAO’s white papers, they envisioned real-world asset tokens being used as collateral down the road. This isn’t some brilliant thought on our part.
Clay Collins: For our next prediction, we’re going to take some time to zero in on unbundling and rebundling. Famous entrepreneur and venture capitalist Marc Andreessen is noted for, among other things, claiming that there are only two ways to make money: bundling and rebundling of products and services. [00:20:30] I really like this theory, and there’s a good and notable Harvard Business Review article on this very topic called “How to Succeed in Business by Bundling and Unbundling.” So this topic is close to my heart. One of Josh’s predictions is that security tokenization allows for the creative bundling and unbundling of financial products in new and creative ways that will unlock tons of value and create an explosion of new tokenized financial products. Let’s hear from Josh.
So Josh, how does property ownership get unbundled and rebundled [00:21:00] to unlock value once you have this technology in place?
Joshua Stein: So similarly, we use email because email’s faster, cheaper, and easier by orders of magnitude. We use email for things that we never used a letter before. They’re both written communications, but email is transformative. No one in the history of the world ever sent a letter to the guy three cubicles down asking, “Where are you going to go to lunch?” But we send that email every day. We take photos of all sorts of things that we never did before ’cause it’s in our phone and it’s cheap. So what [00:21:30] happens when you digitize private securities, when you’ve made it faster, cheaper, and easier to unbundle and then rebundle and to trade private securities? What happens? Let me play out a scenario for you: You now tokenize at the single-asset level in real estate.
Let’s say you have a number of buildings. Either one property owner owns them or multiple property owners tokenize them. And now you’ve tokenized the major class A real estate throughout the New York area. You can now not only make a bet on an individual asset, you can use technologies or funds [00:22:00] to very quickly create very miniature micro ETFs. [SAT [00:22:04] is one startup that allows you to bundle together ERC20 tokens and create a token on top of that. It’s basically an on-the-fly ETF. But imagine if you could then have an ETF of downtown, an ETF of the Upper East Side, an ETF of Midtown, an ETF of Brooklyn, an ETF of Jersey, and using dYdX you could very quickly set up synthetic derivatives on top of this, so I can now go long downtown, short [00:22:30] the Upper East Side. I could go long Manhattan, short Jersey. I can go long the New York Metropolitan area, short San Francisco.
And it’s not just speculative activity. There’s some real-world economic value in that. If I’m a property developer and I’m pouring a ton of money into one neighborhood, maybe I want to hedge my risk with another neighborhood, hedge my risk with another city. It’s very hard to do today. You can do it, but it’s hard to do. Think about residential real estate. The average homeowner in the US has the vast majority of wealth tied [00:23:00] up in their home. That is their retirement plan. As we saw in 2008, it can be incredibly painful to the US economy, to the world economy, much less those investors when you get declines in the value of real estate.
Today you can get insurance on a mortgage. You can get PMI, private mortgage insurance. It has to be individually underwritten, it’s very expensive, and it’s tied to the mortgage, not the value of the house. But what happens if you have these hedge funds and other investors who own large chunks of residential real estate? What if they tokenized blocks [00:23:30] of those homes? You’re never going to tokenize individual homes. No one’s going to invest on an individual home basis, but you could see them bundling up a hundred homes at a time or a thousand homes at a time and tokenizing those. Now all of a sudden you have a price mark. You have an ability to track the value of that neighborhood or even a larger metropolitan area. So I know what the residential real estate is doing in the suburbs of Sacramento or the inner suburbs or the outer suburbs of Sacramento, for example. If I’m [00:24:00] a homeowner, an insurance company then could very cheaply hedge its exposure and offer an insurance product to homeowners. If the value of your home declines below 80% of an arbitrary value for more than three years at the time at which you retire, the insurance product pays out for example.
So you can now hedge, a homeowner can hedge the value of their home. Or if you tokenize those different aspects, you can then create synthetic derivatives on top of that that become very interesting. You’re creating baskets of essentially [00:24:30] ETFs.
Clay Collins: I’m thinking about futures markets, I’m thinking about credit default swaps, synthetic CDOs on top … We could do 2008 all over again.
Joshua Stein: But here’s what’s different about it. One is that you’re actually able to hedge your risk appropriately, but the other is … One of big problems with 2008 was the concentration of counterparty risk. So if you remember the Big Short and all that risk that got concentrated with AIG in the non-insurance unit on the credit default swaps, with a blockchain, the public will not know the identity [00:25:00] of all the wallet addresses, but you’ll be able to get a good sense of concentration, but the regulators will always know, because remember, we correlate real-world identity to blockchain identity. So a regulator, all they need is Harbor’s records and the blockchain readout, and they know exactly how much that counterparty risk is concentrated or not at any moment in time.
Clay Collins: Yes. You could have almost hour-by-hour assessments of risk in the system in the aggregate. Or I think can think about a security token or a real estate-based Air [00:25:30] BNB where you stake a part of your home that’s available and you can almost do DIY timeshares around the world. Or same with artwork. You can trade for equivalent amounts of art and circulate that around. The possibilities are endless.
Joshua Stein: Yes, because it’s faster, cheaper, and easier. You can unbundle and then rebundle property interests in very interesting ways.
Clay Collins: We now find ourselves at our sixth prediction, also from Josh. Here it is.
In addition to unbundling and rebundling [00:26:00] of financial products, tokenized security platforms and ecosystems will allow for an
Clay Collins: Financial products. Tokenized securities platforms and ecosystems will allow for, and encourage, the securitization of things that weren’t securities before. Here’s Josh with more on this.
Joshua Stein: Let’s talk a bit about securitizing things that traditionally aren’t today, and fine art is a great example. So, there have been some nascent efforts at securitizing art, but it’s been very clunky. It’s just hard to do in a paper based format, but imagine if you took, say, a work by Monet. Not many people are gonna to write a check for twenty million [00:26:30] dollars for a Monet, but there’s a lot of people who would write a check for two hundred thousand dollars to own one percent of a Monet.
And, then imagine if you then tokenize a series of works by Monet. Now, you could create a Monet fund. You could create a Monet ETF. You could do the same for Matisse. You could do the same for a series of French impressionists. Now, you could create a French impressionist ETF. You could go long Monet. You could go short Matisse. You could go long French impressionist. You could go short modern art.
And, [00:27:00] think about museums. Museums essentially have tens or hundreds of billions of dollars in working capital locked up on their walls. You can unbundle or disaggregate the right to exhibit an artwork from the right to the capital appreciation in the artwork. Those are two different property rights that, today, always go together. Disaggregate those. Securitize it, so that now you can attract fractional ownership, and museums can raise, keep what they want, the right to own, or the right to exhibit. They can sell off the appreciation [00:27:30] rights. They can raise a ton of money and they can increase engagement with their art.
Clay Collins: Rights you could unbundle the right to display from the right to own it, and maybe, they’d retain twenty percent ownership, and the right to display it twenty percent of the year, but the rest of the time it can be in circulation, or whatever particular situation they want, they can have.
Joshua Stein: Or, if you’re the museum, they would just keep the right to exhibit it all the time, and what they’d be selling off is the right to the capital appreciation of the piece. Now, think of it like a closed end [00:28:00] fund. Closed end funds trade at a discount to the net asset value, precisely because, that liquidity event isn’t apparent.
So, similarly, a painting that’s worth twenty million dollars, if you sell off the right to the appreciation, but you retain the right to exhibit it, that’s going to trade at a discount to the twenty million dollar nominal valuation. But, if you’re a museum you don’t care.
What also becomes interesting is you can then, between these two extremes, you can then sort of parse it out how you want. The museum could say, well, if you own … we’re going [00:28:30] to keep the right to exhibit it ninety percent of the time, and then we’ll apportion exhibition rights for ten percent of the time, for like for a month a year, to the top two shareholders. They’re share hold is more than ten percent of the ownership of the painting. There’s a lot of different ways you could do it, and people do it far more creatively than I just explained, but fundamentally, you can unbundle property interest, and then rebundle them in very interesting ways.
Clay Collins: I’ve never heard of … and I’m not super experienced with capital markets or whatever, but I’ve never heard of the right [00:29:00] to appreciation of the asset being unbundled from ownership, or the right to display, so that’s a really fascinating concept.
Joshua Stein: But, people have done this before. So, remember … what were they called? Tigers I think. Where people took treasury bills and stripped out the coupon from the principle repayment. So, it’s the same thing. It’s two different … things used to all go together, then tremendous value was unlocked. Some people just wanted a stable store of value, which was the coupon, and then, some people wanted the income stream.
So, let’s go back to the real estate example. That fifty million [00:29:30] dollar building, you could do a private REIT. You could do one class of stock. You’re traditional investors are going to be looking for yield from that. They’re going to be looking for the dividend stream.
But, there’s a lot of crypto investors, and a lot of crypto investors … so think foreign investors, who are looking for a stable sort of value. Crypto investors looking for a stable sort of value. Crypto investors that want a stable sort of value to then pledge for a stable coin to enable Crypto commerce. All of them don’t want a dividend stream. There the dividend is a bug, not a feature. So, what if you then took that private [00:30:00] REIT and you did two share of stock. You did a preferred, that got all the yield, and a common that got none of the yield, they just got capital appreciation equal to the preferred. Right. Now, all of a sudden, the common could be pledge for stable coins, and used as a stable store of value, for those investors seeking that. Those investors seeking yield could get yield, essentially your arbitraging, you’re segmenting out investor interest.
Clay Collins: Wow. So, I can see a lot of people going into retirement thinking about tokenizing ownership of their home. They’ve fully [00:30:30] paid it off, and the token holders get a right of first refusal to purchase the property at market prices when it goes live, or at least they can … I don’t know, I’m trying to think about how someone could fund their retirement with this if they own their home.
Joshua Stein: Well, so think of, right to the capital appreciation, real estate that’s not highly levered is a lot like tips. It appreciates at a few percent over the rate of inflation, generally. Particularly the more you diversify it, versus, there’s the income stream, which is in dividend yield.
[00:31:00] So, there are different ways to look at it, depends … they have different components in peoples portfolios, and different people are going to be engaged in different things, but that idea of do a preferred and a common and separate out the yield from the other, that idea was driven out of a podcast we were listening to about Brazilian investors, who were looking for a stable store of value, and putting ten to twenty percent of their net worth in bitcoin.
So, folks around the world are comfortable with crypto channels, like the liquidity [00:31:30] and the control, but they’re looking for a stable store of value, and if you’ll choose bitcoin as a stable store of value, the assumption is you’ll choose U.S. real estate as a stable store of value.
Clay Collins: Wow. So, this could unlock an explosion in financial instruments.
So, we’re now at our last prediction. The seventh prediction. And, this is, at face value at least, the most outlandish prediction of them all.
So, our final prediction is this. Governments and the SEC will eventually mandate the adoption of tokenized securities. This idea [00:32:00] comes from an article published by Anthony Pompliano, who argues that tokenized security technology will create more compliance, rather than less. The logic is that, while most of the hype around tokenizing securities comes from the perspective of investors or issuers. The most important advantages that tokenized securities create is from the regulator’s perspective, because when you move asset ownership onto the block chain, you are able to build a more regulatory compliance system.
Pompliano aka Pomp argues that forced technology adoption is a regulator’s response to new technology [00:32:30] that:
1. Sidesteps current regulations.
2. Enhances the data accuracy and transparency for market participants. Or.
3. Creates a more efficient and compliant system.
This framework has led Pomp to believe that the SEC will eventually mandate the adoption of tokenized securities. Indeed, with tokenized securities, regulators can become more proactive and save time by being able to ensure that current laws are accurately written into protocols . Pomp wrote a great article on this topic and we’ll link to it in the show notes.
[00:33:00] Harbor CEO, Josh Stein had a lot of thoughts that are in support of this argument from Anthony. Here’s the final word from Josh Stein.
Joshua Stein: The other thing is, is so what’s the interaction between the securities regulations and Harbor, when you tokenize securities? Just like Harbor makes secondary liquidity issuance, and especially the secondary trading of tokenized securities faster, cheaper, and easier, we actually make enforcement of the regulatory rules faster, cheaper, and easier. All these restrictions [00:33:30] on private securities, the fact that only a credited investor can buy according to certain exemptions, and that you can’t encumber it, other restrictions, KYCMO vetting the buyer, all those sorts of things, those rules today are often honored in the breach.
Something blows up and then you go in and you figure out what went wrong. But, those rules aren’t enforced ex ante very well. Harbor, on the other hand, enforces those with a high degree of confidence, so all these rules ex ante are getting enforced in preventing a breach. Ex post, if you do have [00:34:00] a securities law violation, because there are some things that Harbor can’t control for, like the underlying investment.
If you have a problem, enforcement of the rules ex post is faster, cheaper, and easier, because rather than subpoena fifty different actors and try to cobble together a whole bunch of disparate paper records, between the block chain and Harbor’s records, you have a perfect record of who owned what, when.
Clay Collins: Do you anticipate that at some point the U.S. government, and other governments around the world, might actually require [00:34:30] the tokenization of securities because of the enforcement benefits that come with it?
Joshua Stein: You know, That’s a great question. I think it’s a great candidate to require down the road once proven out, precisely because, you get such great enforcement of the rules. A great rule example is Reg D versus Reg S securities. So, Reg D can only be offered to credited investors in the U.S. Reg S securities are offered overseas. One of the things you’re required to do by the regulation is to make reasonable precautions against those Reg S securities filtering back to the U.S.
[00:35:00] Well, tokenized securities, because they trade so freely, there’s no practical way to do it without something like Harbor, where you know the real world nationality, and you can prevent Reg S overseas securities from filtering back into the U.S., unless it’s pursuant to a valid exemption.
So, if you think about these Reg D plus Reg S offerings in private securities, which happen all the time today in the non-tokenized format, those things can filter back and no one knows it’s happening, but once you’ve tokenized, and you have a compliance protocol, you can actually prevent the violation in the first place.
Clay Collins: [00:35:30] So, to wrap up, our seven predictions were the following:
Prediction 1 is that attorneys will be needed much less in the future and they’ll eventually be writing smart contracts.
Prediction #2 is that the required role qualifications locations in nature of wealth management will change significantly in the future.
Prediction #3 is that exchanges will become less custodial [00:36:00] and more decentralized over time
Prediction #4 is that tokenized securities will be the basis for stable coins.
Prediction #5 is that security tokenization will pave the way for an explosion in tokenized financial products by unlocking value through the creative unbundling and rebundling of financial products.
Prediction #6 is that things will be securitized that weren’t securitized before.
And, the final prediction is that the SEC will someday mandate the tokenization of securities.
So, that’s it. [00:36:30] I hope this was helpful and that you learned something in this three part series. If you’ve enjoyed this format and would like us to offer similar documentaries in the future, please let me know on Twitter or in our Telegram group.
And, if you’d like to support this content and get your message in front of the over thirty thousand people who download each episode, please consider sponsoring. To do so, just contact me via the contact form on nomics.com or reach out to me on Twitter.
In closing, I’d like to thank our guests and everyone who has helped to make this series possible, including our sponsor, blocktrade.com. As a reminder, blocktrade.com [00:37:00] will allow for the purchase and exchange of security tokens. Bloctrade.com will be the first fully licensed security token exchange in Europe, focus on listing cryptoasset security tokens, and other tokenized financial instruments.
So, we’re done. See you in two weeks as we prepare to resume our regularly scheduled program. Stay tuned and goodbye.
This podcast was produced by me, Clay Collins. My audio producer and collaborator is the talented [Errison Kane [00:37:23]. Special thanks to our guests and everyone who has helped make this series possible, including our sponsor blocktrade.com. If you [00:37:30] have questions or comments, you can contact me on Twitter @claycollins. Thanks for listening.
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