• CFRED CUHK Law

Towards Native Digital Securities

Thomas Lambert - Rotterdam School of Management;

Daniel Liebau - Rotterdam School of Management;

Peter Roosenboom - Rotterdam School of Management

-- Blockchain-based securities: New results, new perspective

Security token offerings (STOs) are not initial coin offerings (ICOs) or a subset thereof. In our recent paper, “Security Token Offerings,” we show that making this distinction has important implications for the study of entrepreneurial finance where startup financing and development are the outcomes under study. Tokens – either security tokens, utility tokens, or cryptocurrencies – are digital assets that are issued on a blockchain. As their names suggest, these tokens do not all serve the same purpose. The specificity of security tokens is that they are investment products (such as stocks, bonds, funds) coming under the purview of securities laws. Security tokens are issued through a STO and, as investment products, represent an alternative way for firms to raise external capital. However, utility tokens (issued through an ICO) are originally aimed at supporting and developing a community-based ecosystem by giving consumptive rights to users, while cryptocurrencies (or payment tokens) are means of payment in a blockchain-based ecosystem. In this view, ICOs cannot only be seen as another financing mechanism for startups, while STOs can.


Our study focuses on STOs and provides a first empirical evaluation of their primary market. We first document several key facts about the primary STO market: (i) it started in the second half of 2018 when the ICO bubble ebbed away, (ii) it is still nascent and thus rather immature, and (iii) it is dispersed across the globe but concentrated in jurisdictions with accommodating securities and tax laws. We then explore STO success factors and show two main sets of findings using a unique dataset. We find that various issuer and offering characteristics, traditionally used in the ICO literature such as source code available on a GitHub repository, Telegram presence, target amount, use of a softcap, and planned duration, matter as well for STO success. In addition, we find that STO success is associated with good governance practices. Specifically, our regression results reveal that, even in the STO, more “transparent” blockchain-based context, unbundling voting rights and cashflow rights negatively correlates with success outcomes, consistent with the traditional corporate finance view.


-- Blockchain-based securities: Challenges for startups

Although our results suggest that the STO market should be looked at in its own right, we do not think this is the end of the story. Blockchain-based securities have to continue to evolve to address several challenges faced by startup firms and their stakeholders. First, security tokens are “a digital representation” of an investment product, they are not the product itself. Therefore, legally, the primary record in many jurisdictions is still paper-based or stored in a government-owned, centralized database. This makes any amendments to records (such as the capitalization table) inefficient and costly for issuers and investors alike. For example, STO issuers and exchanges setup a complicated and dedicated trust structure off-chain (i.e., not natively on the blockchain) to enable the transfer of legal ownership of underlying securities, while the technical transfer of the token is simple.


Second, the widely used ERC-20 protocol to issue security tokens on a blockchain has limitations: it only supports the issuance of tokens, the fixing of the token supply, the verification of token balances, and the transfer of tokens from one wallet to another. A language to comprehensively describe investment products does not exist yet, which results in two main obstacles for entrepreneurs. The first is that the full lifecycle of a security – including corporate actions such as dividend payments, stock splits, mergers and acquisitions, rights issues, and spin-offs – cannot be depicted off the shelf. This increases complexity and costs as corporate actions are either documented off-chain or involve substantial and customized effort in terms of software development. The second obstacle is that comprehensive financial-product term sheets – that is, the description of features that are concerned with the securities’ maturity/expiration date, denomination, (floating) rates, and payoff schedule – cannot be represented. In this case, an off-chain record needs to document agreements on specific terms between entrepreneurs and investors. These agreements are costly to maintain as modifications often require wet signatures and third-party involvement (e.g., corporate secretarial firms).


Third, another important (technical) challenge for startup firms relates to forks. Forks represent a risk to security issuances because versions of a blockchain that are “abandoned” by nodes can become vulnerable to malicious hacker attacks, or can even cease to be operational. If the security issuance depends on features that the new fork does not support, both issuers and investors can suffer to the extent of loss of invested capital.


-- Blockchain-based securities: Towards the next generation

The next generation of securities is unlikely to be mere digital representations of existing paper securities. They are likely to come as digital natives on the blockchain; that is, programmable securities. We call them native digital securities or in short NDS. We define NDS as a legally accepted primary record of securities, created as smart contract on a distributed ledger. A jurisdiction that would support NDS is Liechtenstein with its Blockchain Act that came into force in January 2020. The Blockchain Act considers that primary records on a distributed ledger supersede those stored elsewhere. As such, all features of the security can be depicted and executed on-chain.


NDS have the potential to overcome the challenges discussed above. First, on-chain amendments (e.g., to the capitalization table) can easily and cheaply be executed and viewed by stakeholders, increasing in turn transparency. Second, a flexible description language depicting all possible features and variants of an investment product is in sight. Such contract description language exists in the centralized world but not (yet) on a blockchain. If migrated to a distributed ledger, this description language would enable digital creation of investment products with any combination of corporate actions and securities product features. Third, by opting for a protocol that is fork resistant when issuing NDS, related risks can be managed for the benefit of all stakeholders.

Programmable securities have further potential benefits. For example, NDS could enable barter-trade equity of one company against the other, without the involvement of a currency. In other words, everything can trade against everything. NDS can also display additional features that reduce legal disputes by increasing alignment of interests between entrepreneurs, investors, and employees. For example, entrepreneurial firms could develop smart contract-based warrants for outside investors in order to transfer collateral to them in the event of default. Entrepreneurial firms could also develop smart contract-based stock-option plans for employees which automatically exercise when agreed objectives are achieved.

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