What will the future of securities be like if tokenization becomes a reality? We could gain insight by comparing the jump from trading stock certificates to digital entries representing stocks. The current trading system is electronic. There are no longer paper trades. Unlike two decades ago, every transaction you initiate with your broker goes through an automated algorithm, which is then executed electronically.
In the same way that you used to have stock certificates, you now have entries, digital entries, representing stock. Eventually, all of these securities may end up being tokenized.
What Is a Security Token?
Security tokens are, in essence, liquid digital contracts that represent fractions of assets that already have value, such as real estate, cars, or equities. In order for a security token to generate value, an external, tradable asset must be present. Stocks or real estate are common examples. When you buy a tokenized stock, you get the same rights as when you buy the stock through a traditional stockbroker.
There is only one difference: the token is digital.
Any token sale must be registered as a financial market transaction with the relevant agency. Having more regulatory oversight should significantly improve the safety of STOs and make them less vulnerable to fraud and abuse.
How Does Security Tokens Affect Investor Relations as We Know It?
An STO offers a number of benefits to investors and companies. Here are some of the security token investor relations:
● Broader types of investors are available
● Global access to investors
● Democratizing private equity opportunities
Businesses can gain more flexibility via security token offering projects since they determine a token’s rights and terms of ownership. In contrast to other types of equity ownership, where investors usually must invest in the entire company, companies can raise funds solely for a specific project or division. Tokenized securities also have low barriers to investing, allowing for fractional ownership. This could allow companies to attract and retain a broad pool of investors, including risk-averse ones.
Limitations of Traditional Fundraising Channels
Capital raising processes currently carry high costs for companies. Traditional fundraising channels are most effective for mature companies in established industries, or more recently, for technology and biotech companies. Hong Kong’s fundraising channels are also predicated on financial infrastructure that was developed decades ago. Inefficient payment and settlement systems, for example, increase fundraising costs.
Further, confirming beneficial security holders is challenging since registrars only record information about the nominee security holder, even though the G20 has agreed to implement beneficial ownership transparency requirements. In addition, fundraising is costly and only cost-effective when a company has reached a certain level of scale.
Besides, while issuers are required to update the information provided to investors, there continues to be a lag because real-time information is rarely available, data tends to be outdated, and live updates are expensive. It can take at least 30 days for investors to receive remittance reports for certain debt financing instruments and for company actions such as dividend distributions. Due to the complexity of the current systems, complex, duplicate, and nontransparent processes are more visible on the private market.
The traditional capital market is accessible to a very narrow group of companies:
• Companies that are relatively mature
• Unrestricted sectors/traditional sectors
• Physically possessed assets
Consequently, a large chunk of the corporate world is unserviced, including growth stage businesses and new economy businesses. Companies in this category often do not satisfy the eligibility requirements of large stock exchanges. Moreover, they find it difficult to procure bank loans because they lack operating experience and collateral.
Start-up companies may access venture capital, private equity, and their networks depending on how lucky they are. Unless they do, they must rely on their own savings or upon friends and family for funding.
Technological Advantages of Security Tokens
Another question that might arise is: What are the technological advantages of security tokens? Let’s have a more detailed view of the three obvious ones:
● Exceptional liquidity: fractionalization
● Security: stability of records
● Automation of Corporate Action: smart contracts
Exceptional Liquidity: Fractionalization
As a result of blockchain enabling fractionalization of assets, investors are able to invest with lower minimums. By bringing unprecedented liquidity to these asset classes, private markets, securities, real estate, and collectibles can more easily be accessed.
Security: Stability of Records
Besides increased liquidity, another advantage of this technology is the immutability of ownership records relative to the security token’s underlying asset. Because each block in the chain contains a cryptographic hash of the previous one, the records cannot be altered. To change the record, someone would have to change the hash of all previous blocks, which is theoretically not possible.
Automation of Corporate Action: Smart Contracts
Through a smart contract, STO investors can benefit from utilizing blockchain technology and automated execution of certain operations. The execution of corporate actions is an example of such automated execution. The smart contract automatically instructs dividend coupon distribution on a predetermined pay date and amortizes the residuals. Instead of using traditional proxy forms, smart contracts can also make voting easier for investors.
Tokenized debt also offers enhanced transparency and greater certainty and a specific and automatic valuation report that can be incorporated into the smart contract. By reducing error-prone processes and improving operational efficiency, these capabilities greatly simplify audits.
Despite STOs being in their relative infancy in terms of development and regulation, it is clear that security token capital raising is a real solution to some of the issues encountered in fundraising. By updating the regulatory framework and upgrading the infrastructure, tokenization will continue to gain relevance in the near term, driving STO prominence in the financial and investment landscape. Using advanced technology, issuers will raise funds from a larger audience, and many more people will have the opportunity to invest.