Security Token Exchanges May be the Next Phase in the Finance Evolution

In 1996, there were over 8,000 public companies listed on exchanges in the United States. Fast forward to 2020 and there are only approximately 4,400 — a drop of 46% despite the fact that the S&P 500 quadrupled in value. Conventional wisdom would lead readers to think they are looking at a misprint. This paradox has led to efforts from both the public and private sectors to help jump-start initial public offerings. Unfortunately, legislation like the Jumpstart Our Business Startups Act, or JOBS, has not had the desired impact, and companies have instead elected to stay private longer than they once did. While we could chalk this up to capital being freely available via private equity and venture funds, the simple fact is that, for smaller companies, the benefits do not currently outweigh the burden and expense of going public.

Legislation like Sarbanes-Oxley Act, or SOX, the additional scrutiny that comes with being a public company, and byzantine U.S. equity market structure are all partially to blame. Fortunately, the pace of formation of private companies is at a record high and entrepreneurism is alive and well in the U.S. There has been a 106% growth in the number of private equity-backed companies from 4,000 in 2006 to more than 8,000 in 2017. While we champion the formation of new innovative companies, the shift from public to private ownership has had the negative side effect of locking out most public investors from the rewards of ownership. AOL, Microsoft, Intel, Facebook and many other successful companies went public early in their evolution. Now, with large companies going public later, private investors reap most of the financial gains by the timeshares that are available on a listed exchange.

Secondary equity market trading has been transformed by technology, but capital raising on public markets is stuck in the past.

Technological innovations have so far not significantly improved the process of going public on an exchange. Transformational tech companies are going public in an almost identical fashion as did their grandfather’s rail and industrial companies decades ago. However, there are green shoots to be seen in fintech today that could help the financial markets evolve and improve the path to becoming a public company. Novel technologies such as blockchain are starting to be embraced by stakeholders in financial industries. One application of blockchain technology that has been getting particular notice is security token exchanges.

It is time to consider the benefits of security token exchanges

Security token exchanges would allow blockchain technology to simplify the complexities of custody, clearing and trading. The outcome is a simple exchange listing venue with price discovery that has the potential to encourage more issuers to go public to reach new investors. In turn, investors would benefit by gaining access to previously closely held assets — a virtuous circle for capital markets.

New token exchanges would comply with traditional regulated public exchange processes but have the benefits of the computer programmability features of smart contracts. Compliance processes, ownership restrictions, contractual terms and conditions would be automatically implemented and embedded via a distributed network of computers that maintain a shared source of immutable information.

Issuer’s choice for going public is limited in the U.S.

In Canada and Europe, there are options, namely the TSX Venture Exchange and the AIM Market, respectively, for small to mid-sized companies to access public markets. Currently, there is no U.S. venture market equivalent. In the U.S., if a company is considering public routes for capital raising and attracting new investors, their options are limited to:

• Traditional IPO: Expensive, requires outside expertise, risk of poor trading quality.
• OTC markets: Limited number of institutional investors, negative public opinion, non-compliance with U.S. accounting standards, low liquidity and no price discovery.
• Crypto exchange, ICO: Negative investor and regulatory sentiment from the 2018 crash, few investors, and little in the way of corporate governance and investor protection doctrine.
• Alternative trading system: No price transparency and limited investor interest.
• Regulation A offering: Regulated but only reaches a fraction of the investor pool that companies would otherwise have access to with a traditional listing.

All of these options need improvement one way or another. However, regulated security token exchanges have the potential to improve on all the current incumbent options and offer price discovery, corporate governance and investor protection. In addition, security token exchanges can also offer a less complex path to an IPO. These are the central functions that regulated exchanges do well for large-cap issuers. Furthermore, a security token exchange is not limited to just accredited and institutional investors but is open to all participants — thereby providing issuers exposure to a greater number and variety of investors.

Prospectuses and earnings reports are used by investors to gauge the risk factors involved in investing in companies listed on a public exchange. Regulated security token exchanges will be equal to the incumbent exchanges by imposing high corporate governance standards and investor protections as part of their responsibilities as regulated listing venues.

Security token exchanges will follow the same rules that govern the trading of companies on incumbent exchanges. They will also have a responsibility to maintain fair and orderly markets and provide oversight and surveillance. Security token exchanges will take a role in helping corporate issuers understand their disclosure and regulatory requirements of being a publicly-traded company, and all listing candidates will undergo a comprehensive review to ensure they meet the listing standards of the security token exchanges.

Tokens: Lower frictional costs of capital for issuers via a direct listing

Mid-sized companies looking for a quicker route to access and receiving funding from the public market may also find the direct listing of a token on a security token exchange to be the more efficient path when compared to a traditional IPO process.

For starters, listing on a security token exchange costs less, as there are lower frictional costs involved. Costly registration fees that are charged by the incumbent exchanges for IPOs are avoided on a security token exchange, and listing fees are logically based on market capitalization rather than public share count. This results in lower costs for equity tokens versus traditional listings. A token offering would provide a more streamlined process at a lower cost for a mid-sized startup that is looking to raise money, create monetization opportunities for early investors and employees, restructure a cap table, or take the next step to go public.

The ability for investors to participate in a wider variety of investment opportunities

From the public investor standpoint, being able to buy and trade security tokens on an exchange opens up access to a new universe of assets that were previously closely held and traded. Ownership limitations of closely held assets have primarily benefited sophisticated institutions and accredited investors.

Furthermore, a token can represent ownership not only of traditional listed equity and debt securities but also securitized assets, such as real estate, income streams, art and wine. Tokenization can enable difficult-to-hold assets to be divided into smaller units, which, in turn, allows investors a chance to own a share of the underlying assets previously unavailable to the investing public.

Maintain market liquidity

Security token exchanges would allow secondary trading of tokens through a transparent and regulated platform. This would streamline the process to boost liquidity and provide exit options for investors who might have otherwise had to go through a more complicated route to liquidate their investment.

Through owning a token, which would represent vested interest in a security, disposing of an investment would take the form of a traditional clearing process with a potentially quicker settlement process.

Financial systems that balance efficiency and accountability

From a regulatory perspective, a security token exchange gives greater transparency on asset ownership throughout its lifecycle since records are maintained on a decentralized network of computers that share the same source of information. Trust is further enabled, as data is stored in a cryptographic algorithm that ensures immutability of data.

Moreover, since records are shared, there is no need for reconciliation among network participants. This, coupled with the higher degree of automation that exists in smart contracts, could remove the need for registrars and nominees, which could shorten overall settlement times and increase the efficiency of financial markets in general.

Leveraging the technology available today and improving capital formation

In the future, tokenization could introduce a new option for raising capital, improve liquidity for issuers and their employees and investors, speed up settlement times, and lower costs overall for both the listed company and market participants.

Security tokens and the exchanges on which they operate could prove to be the next phase in finance as they are technologically more efficient, safe and transparent — all of which are qualities that are embraced by stakeholders in the industry who range from investors to regulators.

Although the concept of tokenization will need to be socialized to the many participants in capital markets, they hold promise to jump-start the IPO process where other efforts have faltered. Security token exchanges could be the future for small to mid-cap companies and the inevitable securitization of closely held assets.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.