There’s been a lot of talk about security tokens recently. But what is a security token in the first place? How do they work? And how might they impact your job or business? That is, why should you care about them?
Before diving into the rest of these questions, it makes sense to first start with: what is a security?
A security is a fungible (mutually interchangeable) financial instrument that hold some monetary value. Broadly, securities can be categorized as either equity or debt.
An equity security represents an ownership interest in a company (like a share of Apple stock), and a debt security represents money that is borrowed and must be repaid, so the holder is entitled to the payments made on that debt by the issuer (like a corporate bond or U.S. Treasury bond).
Now, what are security tokens?
What is a Security Token?
Tokenized securities are simply securities with an electronic wrapper around them.
The value of this electronic wrapper is that it makes security tokens easier to trade in a way that complies with the appropriate regulations. There isn’t much upside to tokenizing public equities like Procter & Gamble stock because they are already so liquid: Almost anyone can buy and sell them without much of an issue.
You may have a good investment hypothesis that the apartment building down the street is going to appreciate, but you may not have a couple million bucks to put up to buy it — and if you do, you better be really confident because it’s going to be hard to sell. Because it’s difficult to sell (AKA illiquid), it’s worth less- that is, there is an illiquidity discount (usually cited as 20–30% in the academic literature).
There is currently a large amount of capital that would like to invest in illiquid securities like small Real Estate Investment Trusts (REITs) which may own the apartment building down the street from you or small businesses, but in order to do that, they have to lock up their capital for a long time. You can invest in a pizza shop, but there’s no way to get that money out if you need it for anything else: you have to wait until the pizza place is sold or pays dividends.
By contrast, if you want to buy stock in Apple, you can buy a single share for a couple hundred bucks and sell it in minutes if you change your mind.
Tokenized securities allow for businesses to lock in funds without locking investors in because the tokens are tradable on a secondary market. The business still gets to use the capital, but investors can exchange shares with each other.
Take, for example, a small, private American REIT: There are restrictions both at the fund level and regulatory level (e.g. less than 50% of shares can be owned by non-Americans, and you must have more than 100 investors to receive favorable tax treatment, but less than 2000 or you have to go public).
In effect, this means that if any of the investors want to trade their shares of the REIT with another investor, they have to call up the fund manager to get permission, and they have to find someone who wants to buy their shares who has been approved to trade by the fund manager as well.
This is a lot harder to do than just logging on to your Schwab or TD Ameritrade account, so today securities like small REITs and shares in a small business suffer from an illiquidity discount. The academic literature places this illiquidity at 20–30%. So if you own 100% of a small business worth $1 million, tokenizing the equity in the company would instantly move the value to $1.2 million.
The major reason for the illiquidity discount, and the benefit from using security tokens, is that these securities can be traded around the world. It is still very difficult for investors to buy securities in other countries.
With a token, you could code restrictions into the token, enabling buyers and sellers to trade in a secondary market as long as the trade doesn’t violate the hardcoded restrictions.
Tokenizing equity in startups probably isn’t that valuable at least today because most startups are overfunded rather than capital constrained.
One possible early use case of security tokenization is a local business or franchise that has a proven concept and a few locations, but needs capital to expand. Currently, their funding options are limited. Having a more liquid tokenized security would let them get better funding terms, potentially removing a large chunk of the 20–30% illiquidity discount.
Broadly, you can think about security tokens as “Compliance as a Service.” By coding in compliance at the token level, you allow for more efficient markets with fewer rent-seeking intermediaries.