The number of and capital raised through ICOs have been in steep decline since mid-2018. Non-existing regulatory frameworks, fraud, and the decline of cryptocurrency prices were among the reasons. So called security token offerings promise to fill the gap approaches to compliant offerings based on actual assets. Will asset-backed STOs initiate a second wave of token offerings? How do typical STO projects look like, and where will security tokens be traded? For this meetup, we invited Richard Olsen, Founder, and CEO of Lykke as well as Dr. Markus Kaulartz, Senior Attorney at CMS Hasche Sigle to talk about the impact of security tokens on financial assets markets and regulatory aspects of STOs, respectively.

After the hype about ICOs in 2017 with billions of dollars raised, ICOs became less popular in 2018 due to missing regulatory frameworks as well as quite a number of fraudulent projects and the decline of overall cryptocurrency prices. ICO’s were initially attractive to projects because they enabled project teams to raise relatively large amounts of capital in an unregulated environment mostly based on white papers and promises of future project/product development. This changed rapidly following the beginning of the “Crypto Winter”.

Since then, security tokens have become more popular as token-based capital markets have continued to mature. In contrast to utility tokens from “traditional” ICOs, security tokens represent real physical value, such as a share in the company who issued them or specific assets like a power plant for instance. Security Tokens are comparable to actual shares on the stock markets, which represent partial ownership, have a price and sometimes provisions for profit sharing schemes such as dividends.

Richard Olsen

The first speaker of the event was Richard Olsen, Founder, and CEO of Lykke, a Swiss-based exchange for financial assets targeting B2B and B2C clients. He presented the development of the Lykke exchange and its transformation from a ‘prototypical startup’ to a mature ‘regulated entity with global potential’.

Richard calls himself the “grandfather” of crypto both due to his age and his experience. Richard can boast of decades of experience on the leading edge of global finance. He founded the forex company, Oanda in 1985 with the goal of forecasting financial markets using computers, before moving into innovating the provision of second by second interest payments and some of the earliest frequency trading facilities.

After an “Aha” moment in 2011 where he realized that bitcoin wasn’t just bitcoin but rather the first DLT and a concept which would transform the world, Richard began planning to build the Lykke exchange. Since Oanda’s board wasn’t ready to enter the world of crypto, Richard needed to raise money. Of course, he then looked to crypto. Once the market was ripe the Lykke STO was ready to go. While most projects were offering promises of future development in exchange for money as part of their ICOs, Lykke was already doing an STO. Few people can report from first-hand experience about the benefits and risks of executing a security token offering. Richard has done this three times in as compliant a manner as possible. Lykke’s first STO was with the LKK token which promises the delivery of Lykke company equity to bearers of the token. The first STO brought in 1.8 million USD.  Further rounds included LKK-1y and LKK-2y forwards which raised more than 4 million additional USD.

Licenses, Liquidity and High-Frequency Trading

Richard brought up a very important question – namely, why were they allowed to sell these security tokens? In this case, they were selling their own equity. In order to provide an exchange for third-party security tokens, they will need an Organised Trading Facility (OTF) license which Richard sees as the next logical step for the company. OTF licenses are part of the MiFID II EU financial regulations and according to the Dutch Authority for the Financial Markets (AFM), OTF’s are intended level the playing field between the various venues for the execution of orders.

Specifically, once Lykke obtains an OTF license, they will be “a multilateral trading venue in which third-party buying and selling interests in bonds, derivatives or structured products are able to interact in the system in a way which results in a contract”. OTF’s have all the compliance regulations of an investment firm. In contrast to multilateral trading facilities (MTF) however, according to AFM, the “definition of OTF is intentionally broad, so that it can contain as many (future) forms of organized execution of transactions as possible”, which leaves space for innovation by exchanges and market makers such as Lykke.

Richard also discussed the macroeconomic aspects of the current financial system, in particular pointing out that liquidity and transparency are sorely lacking in much of the system and that blockchain-based solutions can make processes faster, easier and more transparent. Richard claimed, that tokenization will get more and more popular as soon as regulation catches up with the technology Everything that can be tokenized is going to be tokenized. One of the reasons for this is that tokenization enables risk sharing. Exchanging tokens instead of cash spreads the risk on multiple parties. That’s why it’s so important that any token be exchangeable for any other token. The more liquid the market the greater the likelihood that systemic risks are shared widely and unwound quickly before they grow to massively disruptive proportions.

He also dispelled a myth about high-frequency trading or rather clarified it with a metaphor. A question came up about whether or not high-speed trading was necessary or could be healthy for a system. Richard argued essentially that while the high-speed arbitrage-based trading of the past years was quite destructive, overall, trading in a financial system is much like blood circulation in a human body. Just as blood needs to move relatively rapidly through the body to enable waste removal and homeostasis, a financial system needs deep markets with lots of high-speed trading in order to clear the gunk and keep things competitive.

At the exchange level, he noted, the key is liquidity, which means that there should be enough tokens available to trade. This is currently made by bots all over the exchange business but there’s a lot of inefficiency in this model. Richard argues for well-designed matching engines which efficiency earn their keep. Moreover, people should be empowered through technology and crowd intelligence while staying within the legal system. Richard pointed out the self-regulatory success of Airbnb’s reputation system as a model for this kind of feedback system. He further emphasized that the laws and regulations have to be designed to incentivize the right behavior in spite of the corrupting effect of money.

In the same vein, Richard cautioned that at the moment it is difficult to determine which actors in the STO market are legit and which may be rather dubious. Essentially many say that they are issuing an STO but due to the lack of clear standards and transparency, it’s difficult to separate the wheat from the chaff. According to Richard, investors should pay attention to the jurisdiction of the asset, the reputation of the company issuing the asset, the rigor of the regulatory structures where that company is based and finally the question of where the secondary market for the asset takes place. If these aspects aren’t all covered within a reputable regulated environment, it’s pretty clear that something may be fishy with the STO or the platform involved.

If you want to learn more about Lykke and its products, go on their website or download the Lykke wallet.

Markus Kaulartz

Following Richard’s presentation, Dr. Markus Kaulartz presented the legal implications of STOs as the second speaker of the night. He is a senior attorney at CMS Hasche Sigle and specializes in IT-Law, IT-Security, and Privacy.

Markus firstly explained that tokens generally always incorporate a connection between the token and a representation of ‘something else’, for example, a voting right, shares or licenses. In the case of security tokens, the underlying asset is generally either equity in an enterprise or debt. The only exception to this is tokens and coins which serve a pure currency function with no underlying value underlying utility or asset.

First a Slight of Hand

As a result, a critical legal issue is the separation between the token itself and the rights “granted” by the token. It may be possible that the token and the rights associated with it might be separated.

Markus illustrated this with a simple example involving his physical leather wallet. For his example he let the leather wallet stand-in in for a security token and a 5 euro bill inside illustrate an underlying security. He noted that if he as the token issuer were to sell the wallet with it’s included right to the underlying security (and thereby dividends) to someone it might be possible that they could subsequently sell the token onward to a third party (Just the empty wallet) without also passing along the underlying linked security. That would result in a situation with two potential claimants for the dividends issued by the security issuer. In such a situation, the token issuer might end up paying a dividend twice.

One legal approach is to limit the original buyer contractually and prevent them from selling the rights to the underlying token to a third party without also selling the token.  There is not however currently any clear solution to this problem at a systemic level inside the German legal system. It’s currently being discussed on both the legislative and regulatory levels but is not yet solved. Essentially you can issue a security token at this time but it’s not possible to definitively link the token to the security it represents without some significant contractual acrobatics. Markus is hoping for changes to the law which would essentially make blockchain transactions equivalent legally to a written contract transaction transferring ownership of a given security.

Prospectus or No Prospectus? That is the question.

Markus also outlined the legal options available currently for organisations who wish to issue a security token. The first significant question for prospective STO issuers is whether or not they will need a prospectus for the project. This prospectus contains potential risk factors, information about the issuer and a description of the security as well as deep financial disclosures about the issuing company.  Such documentation must be approved by Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin (German Federal Financial Supervisory Authority).

The process is pretty much the same as for issuing any other kind of stock or blond and is very expensive.  Legal costs for producing such a document are likely to exceed 100,000 Euros at a minimum and getting a prospectus approved by BaFIN often takes months of waiting and working through numerous drafts prior to approval. The idea of a prospectus is that it is a document which contains reliable information regarding the risks and benefits of an asset and serves to protect “mom and pop” investors from unknowingly spending too much money on projects they know essentially nothing about. The major advantage for issuers if they choose to issue a security with a prospectus is that it can be rapidly “passported” into all other EU jurisdictions and traded in a compliant manner without further examination by the individual member states. 

Exceptions, Alternatives and SPVs

The alternative to this process is to issue the STO under one of three exceptions designed to allow funds to be raised without offering consumers the “protection” of a prospectus. The rules are designed to protect the mass of average investors and there is some flexibility for situations which don’t have a substancial impact on everyday asset consumers.

• Exception 1: If the token will be sold to less that 150 people. This is intended to support startups by allowing investment by small groups of friends and family.
• Exception 2: If the token is sold exclusively to investors who each invest over 100,000 euros. Individuals rich enough to invest more than 100k are deemed to be defacto professional investors who don’t require state protection and “know what they’re doing”.
• Exception 3: If the token sale raises less than 8 million euro.  This is the exception under which most crowd investing happens.  The logic is that at this level the damage from such an issuance can’t become significant at a structural level.

Lastly, Markus described the process of buying tokens and approaches to token issuance. Classical approaches follow the simple structure that the investor buys and gets the token and the right directly from the emitter who runs the business.

One new approach to token issuances uses a Special Purpose Vehicle (SPV) which has the right from the emitter to sale the tokens. For the issuer, this guarantees that the emitter is completely disconnected from the investor in a contractual manner. Despite the fact that this strategy reduces the risks for the token issuer, it increases the risks to the investor because the investor has no legal claim on the underlying assets being securitized. Markus essentially said that the use of an SPV could be a red flag for investors especially when in conjunction with the issuance of STOs from jurisdictions with lax regulatory oversight.

Another approach is to securitize subordinated loans either with or without an SPV. This is a common approach within the crowdinvesting area but it’s rapidly being adopted for STOs as well due to the relatively lax regulations on this type of debt and to the established procedures / regulatory framework for ordinary subordinated debt. Investors should be aware however that subordinated debts are services last behind all other commercial obligations in the case of a bankruptcy.

Thank you very much to Richard and Markus for giving these interesting presentations! Also, thank you to Deloitte for hosting our Meetup. Also, a big thank you again to our community for coming and participating! We hope you enjoyed the meetup and we encourage you to give feedback over the known channels!

Our next meetup will be about Blockchain in PropTech on July 23rd and we would love to see you again there!