The Potential Impact of Security Token on Private Capital Markets
As ICOs continue to falter, investors have quickly become interested in security token offerings (STO).
In contrast to ICO issued utility tokens, security tokens represent ownership of an underlying debt, equity, or real estate asset. Their issuance operates similarly to traditional debt and equity investment instruments. However, these digital assets are stored on the blockchain rather than “on paper” like stocks and bonds.
In step with increasing crypto adoption, financial institutions and regulators across Europe have begun to embrace security tokens. Just recently, the German Bafin approved Bitbond’s virtual bond financing. Signs of regulatory support like this are encouraging for the industry - the cost and revenue benefits of digital assets are vast.
But how do traditional investors access these virtual assets? Well, digital assets like security tokens can be accessed via blockchain wallets which are comparable to a traditional brokerage account. The difference is that only investors have access to their funds via the use of a “private key.” A private key operates similarly to a credit or debit card pin number. Without it, your account can’t be accessed nor can funds be withdrawn.
In utilizing a wallet only they can access, investors are “custodians” of their own digital assets. This self-custody has significant advantages compared to storing securities with an intermediary such as a bank.
We will assess how blockchain technology improves accessibility to the $5.2 trillion private capital market. Instead of forcing these assets into the existing expensive public market infrastructure, blockchain provides a new, more suitable way for smaller issue sizes and tickets. In this article, we’ll further explore these advantages along with the benefits of using blockchain in the primary and secondary market of private assets.
Primary Market Benefits: Costs Savings and Global Asset Distribution
Crowdfunding Platform - Working Example
As we analyze the benefits of blockchain technology in the primary market, we’ll take the example of a real estate crowdfunding platform. The company currently employs blockchain technology via Upvest’s software to offer real estate investment opportunities to retail investors.
The following scenario will be explored in the context of both the public capital market and the blockchain private market:
An $8,000,000 real estate security token is purchased by 2,000 retail investors with an average price of $4,000 per investor. The costs along the value chain are compared between the old method of distribution (Paper / ISIN / Clearstream) and the new (Token / Blockchain).
Public Capital Market Infrastructure:
Filing a public prospectus is required to approach retail customers. In addition, you must obtain an ISIN from a data service provider such as WM Datenservice at a cost averaging $1,000. Further, to distribute securities to retail customers, a banking partner with broker accounts is needed. Costs for a retail brokerage account can equate to more than $50 minimum per account per year.
In our working example, 2,000 broker accounts are needed to provide a seamless checkout experience on the crowdfunding platform. As the platform would need to fund these broker accounts, it would cost them up to $100,000 per year. With the average maturity of a real estate security at 10 years, it would be saddled with a lifetime cost of up to $1,000,000.
Blockchain Private Market Infrastructure:
In contrast to this market infrastructure, Upvest’s APIs provide investors with independent access to their assets on the blockchain. In providing this functionality via Upvest tools, the platform effectively eliminates the need for external brokerage accounts, saving up to $800,000 over the lifetime of a single security. These cost savings can then be passed on to investors, increasing their ROI.
Beyond this, the blockchain gives investment platforms the ability to issue securities globally via a seamless checkout experience. Rather than involving an intermediary custodian, transactions occur directly with investors in a single integrated platform. Unlike traditional markets, there is no interruption in the user experience - it’s all in their hands.
Secondary Market Benefits: Simplified and Faster Asset Settlement
Public Capital Market Infrastructure:
The majority of securities are actively traded in the secondary market. In traditional financial markets, public securities with an ISIN are traded on exchanges (or OTC) using a clearinghouse such as Clearstream. This arrangement facilitates the riskless swap of assets for fiat money.
Clearinghouses act as “super-custodians” and hold the physical global certificates of all custodians - swapping them in their internal database during a trade. Clearinghouses are connected to bank accounts on the buy and sell side of every exchange. During a trade's settlement period, the clearinghouse covers the counterparty risk.
This “private chain” of banks and clearing houses is very cost effective and works efficiently for public market instruments. However, the existing private capital market infrastructure is not nearly as efficient, pushing settlement periods up to 4 weeks.
If funds are blocked or delayed in today’s fast-moving market, interest and regulatory costs are a significant risk. Reducing settlement times in private capital markets is beneficial to all participants, and the blockchain can help.
Blockchain Private Market Infrastructure:
Because investors are custodians of their own digital assets, they can instantly transfer any asset to a counterparty anywhere in the world. This transferability is a paradigm shift compared to the exchange of securities which usually involves multiple custodians and local clearinghouses. Thus, using blockchain, two parties can instantly swap their digital assets using a smart contract without the need for an intermediary, eliminating counterparty risk.
However, depending on the settlement cryptocurrency, the parties are exposed to high volatility. As a result, the majority of market participants prefer to settle in fiat funds to lessen their exposure. However, in using fiat funds, a bank must be involved in the process. This slows down the swap process as money must first arrive in the seller’s bank account. As a result, the full counterparty risk is imposed on the seller or buyer depending on who transfers first.
In continuing to use fiat, the inefficiencies and risks associated with swapping a digital asset against fiat money are still prevalent. But there is a newly emerging solution to the problem. Acting as a bridge, stablecoins can facilitate instant, trustless swaps involving fiat currency.
Stablecoins, such as TrustUSD and DAI are backed 1:1 by the USD or a collateralized debt position (CDP) respectively. This means their value remains stable over time and experiences little to no volatility. As a result, digital securities can be instantly swapped for stablecoins via a smart contract with no price risk. These highly liquid stablecoins are then easily exchangeable for fiat currency.
With this price stability, self-sovereign access to digital assets, and the use of smart contracts, settlement periods can be significantly reduced. This is of particular interest to those engaged in the cross-border exchange of both digital and illiquid assets such as real estate and debt instruments. Regardless of the asset class, blockchain is poised to revolutionize secondary market infrastructure.
Upvest Empowers the next Generation Fintech Companies
Upvest provides a safe and reliable infrastructure that allows investors to keep custody of their funds.
We’re also in the process of developing a solution that will cooperate with fiat gateways and stablecoin exchanges. This will facilitate quick settlement when exchanging security tokens for stablecoins or fiat.
As the blockchain ecosystem recovers from the sudden fall of ICOs, we believe digital securities will empower a new generation of fintechs. In contrast to their utility-centric predecessor, security tokens are typically governed by existing financial regulations. In this regulated environment, Upvest provides the tools companies need to seamlessly and compliantly distribute any kind of digital asset online.
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CEO & Founder