How is Money Going to be Raised Using Digital Securities?
The shift from ICOs to STOs is underway. But it’s not just about adapting the remaining successful cryptocurrency platforms to digital securities. To be successful the digital security industry needs to provide validated high value assets and embrace the ecosystem of financial professional roles and regulations.
By Jeffrey Sweeney, Chairman and CEO at US Capital Global.
Evolving from ICOs to STOs
There was a brief surge in the ICO market place, but that has been short lived and is under multiple attacks as we write this.
The regulators as well as a general investor revolt will show this to be a very short-lived exercise in fraudulent, worthless securities offered illegally to the investing public. Most reputable platforms avoided this scam.
This rise of cryptocurrencies has proven the value of the digital marketplace. The numerous successful crypto exchanges have validated and demonstrated the scaling of digital assets and transactions in a regulated environment. This experience has proved the key issues of:
• Validity of a digital marketplace where people generally don’t get ripped off
• Ability for investor identification via digital KYC and AML
• Safety of regulated custodianship and account management of digital assets
Some remaining issues involve some or all the following:
• Suitability check for the investment by a give investor
• Trusted platforms to find High Value Investments
• High Value assets themselves to select from
• Standardized Due diligence and Valuations of those investments
• Standardized investment agreements
While the cryptocurrency digital markets have identified a technology platform that works, that early crypto market appears to have hit a wall in terms of overall market value and numerical investor interests. With attention shifting to digital securities and STOs, we now move to a new phase of using these blockchain platforms for broad access to fractional interest in digital securities, but what type of securities?
A shift to high value assets
A current and sustainable trend is for popular cryptocurrency platforms to begin offering equity in assets via STO’s. They are doing this to complement their cryptocurrency offerings and transactions to their cryptocurrency investors. There are billions of dollars of value held or transacted on these sites and those investors are prime candidates for selling equities to diversify their cryptocurrency portfolio. These investors are early adopters and financial risk takers and ideal candidates to consider diversifying into properly offered digital securities in valuable companies and assets.
As happens in the public markets, investors like to mix their assets and change that mix depending on market conditions. As markets in one asset decline they often shift to more stable assets that are less volatile or not correlated with the broader market. This is anticipated to happen in the digital market place where investors will shift assets from cryptocurrencies to STO’s of different asset classes. And traditional issuers will seek the efficiency and liquidity of digital markets. Now is the time to provide those asset classes.
Evolving blockchain market technology to digital securities is about an underlying shift in the type of security this digital investor wants or is willing to hold. Currently there is a shortage of high value, easy to identify assets in the digital market. It is of course problematic for early stage, angel round investments to document recognizable value, so when we talk about ‘high value assets’ we are talking about later stage, growth and expansion investment opportunities. Another asset class noticeably absent is the appreciating asset such as marquee Real Estate. There are certainly anecdotal offerings in the marketplace but there is still a real general absence of these valuable assets. Instead, the conversation is currently dominated by failed ICO’s and startups. This is rapidly changing, however. To attract high value assets the platforms must not just provide the technical functions of digital ledgers, but also must incorporate the asset valuation and validation standards of traditional capital markets.
Securities regulations and digital securities markets
Selling securities is and will always be a matter of keen interest to regulators. Selling securities on a digital platform may be easier and faster than traditional methods but all the issues of interest to the regulators remain unaffected. Digital securities show promise of making the job of the regulators more effective, but there is little to no chance any regulations will not be enforced.
Some of the remaining issues identified above are regulatory issues. The trusted and high value Cryptocurrency platforms I’m in communication with are cognizant of these regulatory requirements for offering Securities (STO’s) on their platforms. In several cases these companies are at billion-dollar valuations. They have no intention of risking their reputation and treasure associating their brands with regulatory risk. Smart Companies with digital distribution platforms are embracing the traditional and regulated behaviors of the public markets.
In their business model they want to collect commissions on the securities sales they market, and they must be a Broker to do this legally. So they themselves are becoming Broker Dealers and have regulated and licensed platforms. But they also want to push the risk of valuation and due diligence onto the “listing broker”. So they are requiring licensed Broker Dealers to provide due diligence and valuation work on issuers before they will consider allowing them on their platforms. The key nature of this ecosystem is the platforms are requiring a “broker of record” or” listing broker” before they will consider placing an offering on their platform. This way they have their offerings screened professionally before taking on the reputational and regulatory risk of an un-vetted offering.
Investor suitability is another matter that is little understood. Not only does an investor need to be “sophisticated” or “accredited” but the investment must be suitable to his age and investment portfolio. The platforms do not want to be responsible for this and can push it off appropriately to the listing brokers and other investment professionals. We are currently involved in some of the first STO’s being launched on the largest crypto issuance and exchange platforms. This gives us deep insight into the thinking at these levels.
The future – an integrated digital market
Beyond documenting and attracting high value assets into the emerging digital securities markets, we will also need to grow the interoperability of those platforms. In today’s emerging digital securities markets, an issuer is generally restricted to secondary offerings only executed via the same platform as the primary issuance. This is an attractive capability and business for the issuing platform, but a narrow effective market for the issuer and a fragmented market for investors and advisors. In this worst case, offering the security on a different secondary market, will require completely recoding the smart contract token. Standardized practices will result in reduced friction to platform interoperability and thereby greater opportunity for issuers and investors.
This won’t happen overnight, and it won’t happen without collective effort. While standardization will result in lower on-boarding costs for platforms, the platform providers are generally not yet highly incentivized to promote industry standardization. Current platforms easily support the fundamental offering and transaction elements. How many shares, at what price, with any specified trading restrictions, KYC/AML, etc. But for real ‘success’ we need asset value specifications to be built into digital securities specifications and for those specifications to support market interoperability. This will come from greater participation and integration of the traditional capital markets ecosystem of broker dealers, KYC / AML services, custodians, transfer agents and existing secondary markets… the obvious focus for the emergence of digital security industry practices.
This article was originally published in The Fintech Times on February 28, 2019.
Jeffrey Sweeney is an investment professional and fund manager with decades of experience in direct lending and corporate finance for small to lower-middle-market businesses. He is Chairman and CEO at US Capital Global (www.uscapglobal.com) and founder of US Capital Investment Management, LLC, an innovative fund manager headquartered in San Francisco, CA.
This article does not constitute an offer to sell or a solicitation of an offer to buy any security, and may not be relied upon in connection with the purchase or sale of any security. All investing is risky, and any investor should always first consult with a competent professional adviser. Some or all invested funds can be lost.