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STOs: path to profit, or hall of mirrors?

Our deep read on entrepreneurs claiming use cases for what could be the leap enabling tokenization of assets.



Katrina Cokeng, Xen Technologies

Katrina Cokeng says that although her startup is launching an untested business model for securities tokens – that is, for regulated instruments traded over a blockchain – she doesn’t want customers to focus on that novelty. “I hope by the end of next year, the customer is unaware this is blockchain,” she said. “They’ll just want access to the products we can offer.”

Singapore-based Cokeng is co-founder and CEO of Xen Technologies, a new company domiciled in Mauritius that is at the vanguard of STOs, for securities-token offerings. She is among a handful of companies worldwide poised to enter beta testing or even go live, often within the framework of a regulatory sandbox. Are STOs going to be the framework that allows blockchain to match its hype? Or will they be felled by investor reluctance, legal fog, tech glitches or governance failures?

What sets securities tokens apart from their blockchain brethren is that they are designed to be regulated under a given jurisdiction’s regulatory laws. This is unlike utility tokens (which are supposedly more like loyalty or rewards points, with no connotation of owning an underlying income stream), stable coins, or last year’s craze of unregulated initial-coin offerings.

The fate of securities tokens will probably have less to do with regulation, however, than it will about use cases. If the business models have value and attract lots of demand, we may be on the cusp of an exciting, profound, transformative moment in fintech history.

Introducing securities tokens
Securities tokens are intended to trade like stocks, bonds or other instruments that provide an income stream. Some may be structured as actual stocks or bonds, but others are akin to derivatives such as non-deliverable forwards, or delta-one products like exchange-traded funds. One way to think of them may be as vehicles giving investors ownership of a protocol that transfers a share of revenues, rather than as a form of direct equity.

The argument goes that the regulated nature of STOs, in which trading exchanges (STXs) comply with local KYC and AML laws, will attract confidence and liquidity; and by combining these with the decentralized nature of blockchain and the programmability of smart contracts, vast swaths of illiquid assets, such as real estate, can be fractionalized, securitized, and made available to a broad, mobile-savvy audience.

Among the first out of the gate: Globacap in the U.K. tokenized its own shares from the sandbox of the securities regulator, and now has a pipeline of small companies to go STO. In Hong Kong, FinFabrik, a fintech with a capital-markets focus, is in talks with a local property developer to tokenize a building – while in New York, the first such real-estate deal has just taken place, sponsored by AirSwap, a company originally set up as a decentralized exchange. (See here for our story on decentralized exchanges.)

Use cases: the STO
Now in Singapore, Xen is about to launch a beta version of its token, designed to give affluent people access to alternative investments that would otherwise be available only to the ultra-rich or to institutional L.P.s.

And in the Philippines, a group of small businesses has been contracted by a provincial government to write its laws to optimize them for operating a securities-token exchange (STX).

Xen is tokenizing access to alternative investments for affluent investors in emerging markets, who are well off but not rich enough to gain entry to hedge funds, private equity or other vehicles.

The company will launch a beta product at the end of this month, taking fiat from customers in return for the XEN token, which is used to represent an interest in a partner quant hedge fund domiciled in Mauritius.

The fintech is applying for entry into a sandbox operated by the Mauritius regulator, with a business launch slated for February. In the beta version, the XEN tokens can’t be traded elsewhere: customers can only use them to buy units of exposure to the partner hedge fund. But the live version is meant to transform Xen into a fund of funds, in which it offers varying tokens to represent access to a variety of strategies, making it like a segregated managed account.

Using the Ethereum blockchain, the XEN tokens operate smart contracts that allow trading only with white-listed wallets, a compliance and KYC measure. “That’s the breakthrough,” Cokeng said, as she expects this to enable more liquidity to trade the tokens beyond Xen Tech’s own securities-token exchange. Such approved wallets will have to be other STXs, which are centralized to the point that they can ensure KYC, AML and other compliance.

Smart contracts can also be used to automate administration, lock-in periods for newly launched tokens, and other corporate actions. But from the underlying hedge fund’s point of view, Xen Tech will be just another L.P., with the same reporting and other processes. (Cokeng declined to name the quant hedge fund.) “It’s like an ETF for alternative investments,” she said of Xen’s offering.

Use cases: the STX
For the white-label business model to work, and to create lots of liquidity, there needs to be a market of other STXs: securities tokens can’t trade on exchanges that aren’t able to meet securities laws (which vary by jurisdiction). But none of these exist yet. Xen is launching its own STX, as part of its pilot, but it is betting that many more licensed venues will emerge.

One such STX in the making is Inbase Partners, a Taiwan-based advisory firm working with operators of a venue originally launched as an equity crowdfunding business in Singapore called Cezex. Inbase and Cezex have been working with the provincial authorities of Cagayan, in the far north of the Philippines.

By basically writing the legislation for Cagayan, Cezex will enjoy a 24-month exclusive license to operate. Its goal is to become the preeminent Asia-based STX, along the likes of tZERO in New York and OK Exchange, which moved from China to Malta; both of them are using broker-dealer licenses to preparing crypto exchanges for regulated securities.

“Who’s going to be the Binance of securities tokens?” said Carlos Salas, managing partner at Inbase, referring to the prominent but unregulated crypto exchange. “We’re going to surpass Binance and disrupt Nasdaq.”

Another Asia-based platform is being designed in Singapore by ConsenSys, a company dedicated to Ethereum-based applications. Darren Frankel, director at ConsenSys in Singapore, says the company’s STO platform is designed to enable small businesses to raise capital, and to make private securities more liquid. “We’re not targeting publicly listed companies, because there’s no immediate benefit,” he said at a recent talk.

Cezek’s backers say it’s not a crypto exchange, but a traditionally regulated exchange that can host digital assets of various types: crypto-currencies like bitcoin and ethereum, asset-backed tokens for gold or real estate, STOs from blockchain-tech companies, and tokenized derivatives on famous stocks like Apple or Berkshire Hathaway.

These exposures don’t give owners voting rights – they’re not shares – but they should let investors use them as collateral or other forms of value.

Like with Xen’s idea of tokenizing a hedge fund, the idea of tokenizing Apple stock involves buying or borrowing the actual stock, tokenizing it on an STX, and trading it like a derivative or depository receipt. Cezex has partnered with the Phnom Penh Derivatives Exchange to tokenize its products and invest in these via bitcoin or ether.

“We’re taking crypto and turning it into financial products,” Salas said. “It’s easy for investors in the U.S. or Europe to get access to Apple or Facebook stock. But it’s not the case for people in Vietnam or Taiwan,” as the process involves more middlemen and extra fees. “We’re creating a new market.” Similarly, he argues small businesses will be able to conduct STOs to conduct the sort of capital-raising currently limited to much bigger companies.

Cezex is slated to launch by the end of the year with five STOs, its backers say, while it will then launch an app to serve as a wallet for users.

Real deal, or more blockchain B.S.?
Given the disappointment around many blockchain-related projects, not least the ICO boom and bust, there’s skepticism about digital assets. For STOs, the questions will come down to use cases and legal definitions, which remain speculative.

“With any token, you have to start your analysis with fundamentals,” said Joyce Lai, a New York-based law and technology specialist at ConsenSys, speaking at a recent event hosted by law firm Latham & Watkins. “What are the actual rights you receive when you own the token?” Is it the right to access software, or to receive an income stream, or upside to a company’s success?

Simon Hawkins, a Hong Kong-based partner at law-firm Latham & Watkins, says the legal questions are even broader.

Should tokens be treated as shares? Laws in places like the U.S., Hong Kong and Singapore define that as share capital in a corporation. Does an STO have the same rights related to the underlying assets? Regulators such as Singapore’s MAS responded to last year’s ICO wave by conceiving of tokenizing a special-purpose vehicle of actual stocks in a company, but is that arrangement actually true of an STO? If STOs are regulated in a given domicile, who can you sell them to, and on what venues?

Beyond these existential questions are practical ones. The tech is still clunky, the user interfaces poor: digital assets still involve physical custody, which seems incongruous with the notion of a virtual asset, and a step backward given that stock exchanges have already dematerialized.

There’s a lengthy education process for the broader trading population. There are no standards yet to make different STXs compatible. Laws in one jurisdiction won’t match laws in another. For example, Cagayan is creating a legal framework that is digitally native. But U.S. securities laws assume the presence of a licensed intermediary. Other governments have set up sandboxes in which STOs could launch, as is the case in the U.K., but regulators are going to ask who these products are suitable for, and why they should back STOs when traditional routes to raising funds already exist.

“STX projects are blending real-world assets with a digitized platform,” said Hawkins. “There’s a physical input, documents…it’s not easy to get rid of these because tokenholders want assurance the underlying assets exist, and that the cashflows will go to them.”

Therefore assets require trustees and paperwork. “This surprises people who think of this as a completely digital process,” Hawkins said.

Frankel at ConsenSys says a big challenge is getting regulators and investors to accept that such functions need to be carried out by a decentralized network of machines, rather than an appointed fiduciary.

These factors take the industry back to many questions around what blockchain technology is actually bringing to the industry.

“The risk is using distributed-ledger technology to replicate the status quo, rather than to rethink [financial services] and improve them,” said Lai at ConsenSys.

Over time a lot of the paperwork will probably gravitate onto blockchain platforms. We will see a gradual shift in which STOs become more viable as more information is digitized.

For now, the buy side is forcing the issue. Hedge funds and other instituions want access to the asset class. One hedge fund in New York told DigFin that it has already raised $50 million for a digital-asset fund, and expects to have $250 million raised by the end of the year. “People want access to blockchain 3.0 and they want to be part of Wall Street 3.0,” he said, referring to the tokenization of many types of assets.

These use cases are still works in progress, though. Xen Technology’s Cokeng says she has yet to settle on aspects of the company’s business model, such as what hurdle rates make sense, or whether she’ll need market makers to support the price of STOs. Moreover, today she is confident about launching a product based on a quant fund, where liquidity is robust – but she hasn’t worked out yet how the model will work with, say, a private-equity fund with a 10-year lockup. For those ideas to work, there will need to be secondary-market liquidity and plenty of volume on other exchanges…none of which yet exist.

“This will take time,” she said.

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