We have recently published a research paper on tokenized equity, together with law firm Watson Law. The following is an adapted excerpt from our report; please download the full report here.

As educators, architects, project managers, and writers of the securitytoken.it newsletter, we are active in the tokenized securities (synonym: digital securities) space. But because this is such a new field, many people not yet know the concept of security tokens, or the tokenization of securities. Or if they do, they might not be clear about what the ‘tokenization of assets’ can mean. As a first article on our blog on this topic, we’d like to take a quick look at the potential benefits and limitations of one form of tokenized securities: Tokenized company shares, also known as share tokens or tokenized equity. We hope this will give you a good point to start from.

 

What are Tokenized Company Shares?

Before discussing the benefits and downsides of tokenizing company shares, we must first start with a definition. The ‘tokenization’ of securities is nothing more than using blockchain technology as a method of issuing, registering and transferring securities. In other words, the securities in question (shares in this case) are tokens that can be sent and transferred on a blockchain, such as Ethereum.

As we’ve explained on this blog before, cryptoassets consist of different categories. We often talk about tokens when we mean the ‘thing’ that is transferred on a blockchain, which could be a cryptocurrency or collectible; in other words, a cryptocurrency token or a collectible token. In the case of tokenized securities, or security tokens, we also speak of tokens as we mean something that is transferred on a blockchain. There’s a lot more to say about this and the semantics around tokenized securities vs security tokens, but we’ll leave that for another day (for a good explanation, see this article on CoinDesk). But the main point is that tokenized securities, such as tokenized shares, are in fact shares (or securities) that are transferred and registered by a blockchain — which can be private or public. 

Potential Benefits of Tokenized Shares

Now that we have an idea of what tokenized company shares are, you may ask: “What is the use of tokenized shares and why would you manage shares on a blockchain?” A good question. Most arguments in favor of tokenizing any security revolve around speed, liquidity, and cost reductions. Let’s briefly consider all three and apply them to company shares.

First, cryptocurrency trades are fast. A transaction on the Ethereum network generally settles under the hour, and often takes just a few minutes to effectuate. Other blockchains such as Stellar increase settlement speed to a few seconds. In contrast, the settlement of transactions of traditional securities generally takes one to two days. Evidently, there are different aspects that play a role in the settlement speed of security transactions. The reason that ‘T+2’ exists,  (transaction plus two business days) cannot be accounted for by just looking at the technology used. We should also consider legislation, legacy systems, operational efficiency and perhaps even path dependency. We will not go into these different aspects here. But the fact remains that blockchain technology can allow for immediate transactions and make the process more efficient in one go. Particularly through leapfrogging, the speed of security (and company share) transactions can increase significantly.

Second, we expect security tokens to offer liquidity where no liquidity existed before; investors can theoretically more easily buy or sell securities than they are used to. Consider for instance the international nature of cryptocurrencies, their transaction speed, reduced cost (see below) and the potential for peer-to-peer transactions (e.g. in case of a decentralized exchange). From the issuer’s point of view, this means that companies will have increased access to an international pool of investors. From the investor’s point of view, this means that there are more other investors to buy from or sell to.

In the specific case of company shares, illiquid markets exist in shares of companies that are relatively large, but not publicly traded. In other words, the shares of SMEs. Oftentimes, it is too expensive for such companies to do an Initial Public Offering and float their stock; and current investors (like private equity and venture capital firms) are unable to sell their SME shares on a secondary market. Tokenization may well turn SME company shares into a more liquid market. For more information about this topic, please see our research report on Tokenizing SME Equity.

Third, the decentralized nature of blockchain technology means that we require fewer middlemen to process a security transaction. In theory, no notary or lawyer is needed to approve a transaction of a company share from one person to the other. Instead, investors simply send their shares directly to someone else. In contrast, consider all the middlemen that currently make up the chain of a security transaction; we expect that the removal of middlemen makes issuing and transacting shares much cheaper.

These three benefits, speed, liquidity and cost reductions, are some of the most-often touted potential benefits of tokenized securities. However, they are most definitely not the only ones. Over the next few years, many will explore many more potential benefits, from automated compliance to self-custody. That will be the topic of another article.

 

Potential Limitations of Share Tokens

Aside from benefits, there are several limitations that tokenized shares or equity tokens may have. For instance, whether and when the mentioned benefits materialize is highly dependent on local regulation. In many European countries, privately-held company shares can only be transferred by means of a notarial deed. This means that it is not possible to transfer these via tokens on a blockchain. In case of the Netherlands, as one of the few countries, this restriction does not apply to depositary receipts of shares, providing companies a viable and compliant structure to tokenize equity. This is simply an example, but it shows that the potential benefits of tokenization are highly dependent on the jurisdiction your business operates in.

Considering other limitations, it quickly becomes clear that the technology used in tokenizing shares is a major factor. At the moment of writing, the Ethereum network is often used to issue and transact securities (and tokenized shares) on. However, the relatively low limit of Ethereum on its transactions per second (tps) can certainly be a bottleneck. Remember the cryptokitties debacle; a large number of transactions had a significant impact on other decentralized applications running on the same network. If you would want to sell your investment in a specific company in a similar situation, you may find the value of your investment decreasing significantly because you weren’t able to sell your shares soon enough. At the moment of writing, upgrades for Ethereum that would greatly boost the network’s transactions throughput have not yet been put in place.

Similarly, the risk of hard forking when using an open-source blockchain such as Ethereum can have a negative impact on the value of the security in question. Should Ethereum go through a hard fork process, it may be unclear what chain is the truth for a particular (security) token. Such a systemic shock will most likely have a negative impact on the security in question, particularly when it’s traded on an open market.

 

Not All Tokenized Securities Are Created Equal

Several other limitations of tokenized company shares should be considered by any company wishing to make use of their benefits. This includes the sometimes high costs involved, the absence of clear documentation, your shares getting in the hands of bad actors and more. But whatever list of benefits or limitations we can mention; in the end, it comes down to your specific case.

Who would you like to be able to purchase your company share? What are the KYC and AML requirements? What are the current laws surrounding share tokenization in your jurisdiction? And is that the right jurisdiction to issue tokenized shares from? Together, the answers to such questions will give a better indication of whether tokenization of shares in a specific case comes with more benefits than downsides.

And while this doesn’t mean we cannot make general conclusions about some of the potential benefits and limitations of security tokens — as we did above — it does mean that we should carefully consider how such aspects impact your specific case. If you would like to further explore that case, whether it concerns tokenized equity or another financial security like debt or derivatives, we’re happy to help. Simply send us a message, or if you want to know more about asset tokenization, sign up for our newsletter.

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