Why Investors Have Been Slow to Trust Security Tokens

Blockchain concepts such as digital wallets and smart contracts are not easily understood among traditional investors and regulators. That's where education comes in.

AccessTimeIconFeb 14, 2022 at 4:59 p.m. UTC
Updated May 11, 2023 at 4:59 p.m. UTC
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Security tokens, seemingly poised for a comeback several months ago, have not been accepted by the wider investment community as quickly as some might have hoped.

Blockchain concepts such as digital wallets and smart contracts are not easily understood among traditional investors and regulators. Also, there has been a lack of trust regarding the quality of offerings on security token platforms.

Security tokens represent ownership shares in a company that does business using blockchain technology.

U.S. regulators have already provided a framework that would allow private companies to bypass traditional initial public offerings (IPO) and use blockchain technology to digitize the capital-raising process. Companies such as tZERO, Securitize, and Texture Capital, for instance, facilitate the trading of tokenized securities, catering to a sophisticated investor base.

But educating the public about security tokens, and being transparent about offerings, has taken more time than expected.

"The security token space has been slower to adopt [by investors] than previously thought," Scott Harrigan, CEO of Securitize Markets, said during an interview with CoinDesk. The company launched its digital marketplace last year.

There is the potential for widespread adoption. Goldman Sachs has noted the efficiencies provided by security tokens for issuing digital debt. State Street wrote that "all financial markets will have to digitize their processes and tokenize their assets to remain relevant" in a December article.

“Investors are judging unique offerings based on the expected return on investment,” said Dave Hendricks, CEO of Vertalo, an Austin, Texas-based startup that helps issue and manage digital securities. But company "founders decided that issuing a security token would attract a class of investors that were more interested in how the security was formatted rather than the underlying quality of the offering.”

Unlocking private capital

Some issuers and investors are showing growing interest in the security token space.

A report last month by Arca Labs showed that 71% of 100 financial service professionals surveyed in July were interested in investing in digital asset securities, and they believed that most securities would be digitized and settled on a blockchain in the next five to 10 years.

A majority of investors, especially individuals, have been locked out of participating in early-stage deals despite the flood of new capital in private markets versus public markets. Most secondary market transactions are handled by private equity funds with long holding periods.

Theoretically, tokenizing securities could make it easier for retail investors to access and trade private offerings.

Private vs. public market capital and trading volume (Securitize)
Private vs. public market capital and trading volume (Securitize)

Gaining the trust of family offices, wealth managers and other accredited investors hasn't come easy.

Marketplaces need to grow demand and expand quickly, according to Richard Johnson, CEO of Texture Capital. "There's been some educational requirements for investors, and some weariness. There needs to be good deals," Johnson said during an interview with CoinDesk.

Blockchain-based alternative trading systems (ATS) provide greater transparency, increased speed and lower transaction costs, according to industry heads. The goal of security tokens is to make illiquid assets liquid, which requires a large pool of buyers and sellers that can easily trade on a digital exchange.

Gaining the trust of all stakeholders

The security token industry has been advocating for greater adoption through various events. "Momentum is picking up," Harrigan said during a Jan. 27 digital asset security event hosted by Arca Labs. "We're starting to see more trust in the system, which is key to liquidity."

"We recently launched two index funds with S&P, and we're seeing larger institutions take advantage of that. The biggest appeal is holding assets in digital wallets, which opens up the investor base," Harrigan said.

Experts on the panel also noted that regulators are more engaged in the security token industry despite onerous registration and compliance hurdles. Alternative trading systems have existed for securities for decades, Alex Vlastakis, president at tZERO ATS, said during the panel.

"What's new and exciting is the innovation around trading and clearing of securities" with blockchain technology, Vlastakis said.

But not everyone is convinced. "It has become unclear as to what purpose or what efficiencies security tokens would offer to the global securities marketplace," New York City law firm PKA Law stated in a February 2020 letter to the U.S. Securities and Exchange Commission on behalf of a client.

"It seems likely that the introduction and use of 'Security Tokens' will create undue burden on market participants, exchanges, custodians, clearing firms, retail and institutional investors," PKA Law stated.

Improving the security clearing process

Experts say regulators have not fully embraced the blockchain.

For example, despite recent improvements to the ATS settlement process, some digital security custodians are still required to maintain traditional book entries despite having an automated transparent record of ownership recorded on the blockchain.

Regulatory updates have allowed an ATS to "directly convey settlement instructions to custodians on behalf of customers, which is a critical step in moving digital asset securities to a more mainstream securities trading process," Sean Bowden, CEO of Symbridge Capital, said during the panel. The company plans to launch a digital asset exchange later this year and is talking to potential issuers.

"As the industry evolves, we look forward to ultimately getting on-chain settlement," Bowden said.

The compliance process can be cumbersome. It took 18 months for Texture Capital to receive regulatory approval versus the traditional five- to 12-month period for U.S. broker dealers.

Firms competing for a spot in the emerging arena are focused on attracting large-sized quality offerings in real estate, mining, sports leagues, and businesses who want to tokenize employee ownership.

"We're building a new market structure from scratch, but we need to reach critical mass to boost liquidity," Richard Johnson, CEO of Texture Capital said.


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Damanick Dantes

Damanick was a crypto market analyst at CoinDesk where he wrote the daily Market Wrap and provided technical analysis. He is a Chartered Market Technician designation holder and member of the CMT Association. Damanick is also a portfolio strategist and does not invest in digital assets.

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