Understanding Tokenization and Security Token Offerings RazeTeam May 15, 2024
tokenization and security tokens

Understanding Tokenization and Security Token Offerings

In the digital age, blockchain technology is transforming how we think about asset management and investment. Tokenization and Security Token Offerings (STO) are at the forefront of this revolution. Although they are often mentioned together, they serve distinct functions in the world of digital finance. This guide will delve into both concepts, helping you understand their mechanisms, differences, and the transformative potential they hold.

What is Tokenization?

Tokenization is the process of converting rights or ownership of an asset into digital tokens on a blockchain. This can be applied to any asset, such as real estate, art, intellectual property, or even equity and commodities. These tokens represent ownership or rights and are secured by blockchain technology, which ensures transparency and immutability.

Applications of Tokenization

The applications of tokenization are varied and impactful. Key applications include fractional ownership, which allows multiple individuals to hold a portion of an asset, making expensive assets more accessible. Additionally, tokenization enhances the liquidity of traditionally illiquid assets, simplifying their transfer and trading.

Security Token Offering (STO)

A Security Token Offering (STO) is a fundraising mechanism where a company issues digital tokens in exchange for investment capital. These security tokens are digital representations of traditional financial instruments like shares or bonds and are regulated by securities laws in relevant jurisdictions.

STOs are designed to target accredited or institutional investors, though some regions may permit participation from a broader investor base. This fundraising method is governed by strict regulatory standards, requiring full disclosure and adherence to investor qualifications and compliance laws.

The DNA of a Security Token

A security token is a digital representation of a financial security created using blockchain technology. Like traditional securities, they represent an ownership interest in assets or a claim against the issuer (equity, debt, real estate, etc.). These security tokens have a blockchain-based wrapper that encompasses the underlying asset according to a programmable set of rules, guidelines, and parameters. 

These instructions, which are baked into each token upon development, may include but are not limited to:

  • The amount of the underlying asset that each token represents
  • Type of investor allowed (Retail, Accredited, Qualified, Institutional)
  • Jurisdictions allowed for investors
  • Investment instrument type
  • Distributions (percentage, amount, tiers)
  • Lock-Up Periods or trading limits
  • Number of total tokens issued

All of these parameters can be coded into each security token via smart contract and self-governed with limited intermediary actions.

Tokenization Benefits for Companies & Funds

What these tokens at a protocol level or through smart contracts enable are the automatic execution of the pre-programmed rules (including the parameters listed above). These rules work in tandem with additional technology services covered in this report to create a healthy and thriving ecosystem that enables the fractionalization of ownership, real-time trading & settlement, global capital access, and reduced execution fees relative to the incumbent markets.

The following list of features can be enabled using tokenization: 

  • Representation of ownership on a distributed or blockchain ledger
    • Track ownership and other historical information on an immutable ledger
    • Also bring outside information onto the ledger 
  • Ability to program in securities law regulations
    • Check KYC/AML status of wallet
    • Check accreditation
    • Restrict transfers on time
    • Restrict transfers on user type
    • Register exemption type 
  • Send payments or dividends or assets to token holders programmatically
  • Enable voting participating using the token to qualify or issue voting tokens
  • Atomic swaps enabling instant transfers between two parties
    • Enables peer-to-peer transfers
    • Enables locked transfers (collateral, lending, etc.)
    • Enables secondary market trading / programmatic trading
  • Receive investment payments via atomic swap in exchange for tokens
  • Remove the need for custody agents
    • Enable self-custody for investors
  • Freeze, Burn, or Create new tokens for better investor governance controls
digitized and security token how to guide

Cap Table & Investor Management

This breakthrough in technology now allows companies the act of tokenizing the underlying  asset of the company by digitizing the capitalization table of ownership. Spreadsheets and proprietary 3rd party software will one day be replaced with on-chain equity management for any company with traditional shares.  

The beauty of tokenization and security tokens is the ability for each token to self-update its ownership records. As a capital raise is completed, the cap table is generated and may be handed to a security token developer or issuance platform. The issuance platform will create a supply of security tokens (per the request of an issuer) that represents the cap table of investors. Investors will then receive their pro rata shares of the asset or investment vehicle via security tokens. 

Should the tokens ever trade hands, or an investor buys more or sells any piece of their position, the tokens will recognize themselves leaving one digital wallet and being transferred to a new digital wallet. Upon recognition of this transfer, the cap table will update itself according to the ownership proportions across all tokens and wallets.

Since the wallets are whitelisted and compliant, per some guidelines in the next section, each wallet gets tallied for tokens. This new registry of tokens acts as the cap table, and therefore the cap table updates itself upon each and every transaction. Given this, tokenization enables the compliant and scalable method to cap table management even in a high-velocity asset where ownership may trade hands or be managed by thousands of different investors. This is a feature that is simply arduous for manual accounting and management.

KYC/AML (Know-Your-Customer/Anti Money Laundering)

When raising capital and onboarding investors or owners, KYC/AML is a crucial step for the efficacy of the process. In a manual world, this consists of human-to-human checks. While some of the data entry can be passed from the prospective investor through a database, verifications are typically handled manually – this means a designated employee must be on hand representing the fund/group to guarantee these identity verifications of new investors. Time is an evident factor here, as this verification process rarely scales well being limited to human capacity. Through blockchain technology there exists multiple functions to improve this KYC/AML process.

Whitelisting

Funds can gain access to a universal list of Accredited Investors and choose to make their platforms accessible only to identities on that whitelist. There are some security token issuers that currently employ this method to ensure that token sales are only accessible to Accredited Investors (for example, Polymesh).

Real-Time Verification

Without accessing a universal list, funds can ensure that their investors and users are Accredited on a one-by-one basis by integrating services like Raze. This service walks users through the Accreditation process and confirms/verifies this designation once complete. From there, the fund platform can accept these identities as prospective investors, fully knowing that their credentials are reliable. There would not need the same level of human oversight since these credentials can be stored on the blockchain directly from the verification platform.

In terms of distributions & reporting, blockchain technology is the pinnacle of “cut out the middleman.” There is no delay in payment, and distributions can be made however frequently the platform managers decide – even daily. Cryptocurrency payments and transfers usually settle within minutes whereas fiat transfers can lag for upwards of a full business week. WIth the issuance platforms and providers in the industry, distributions can be made via fiat currency, cryptocurrency, or stablecoins.

Restrictions and Considerations for Token Issuance

The current process for issuing tokens varies based on country & jurisdiction. In the United States, security tokens are not compliant simply by being minted and sold on a blockchain. 

Since security tokens can be created and issued by traditional issuers (ie companies raising capital) or in conjunction with a licensed Transfer Agent, security token issuance platforms can “burn” lost or stolen tokens and “mint” or reissue new ones at the equivalent value. With these developments, security token investors are always protected and not at risk of misplacing a private key and forever losing access to the investment. Some token developers even formulated a more cost-effective method of restoring & saving lost or stolen tokens without fully burning and reissuing tokens.

Additional designations that benefit security token issuance platforms include Broker-Dealer (BD) licenses to legally solicit investors, Alternative Trading Systems (ATS) to facilitate secondary trading, and the Regulation Crowdfund (Reg CF) license to offer securities to retail investors.

Secondary Trading Venues

The main feature of security tokens that unlocks liquidity across tokenized assets is the secondary trading component. Much like shares of stock can be traded on an exchange, security token buyers and sellers can be matched up on secondary trading venues. Given the nascent stage of the industry, most US trading venues are classified as Alternative Trading Systems (ATS) – not exchanges – and solely rely on their abilities to match orders rather than to manage client assets and books. As more firms obtain Broker-Dealer and ATS licenses, additional volume will pile into the secondary trading space and venues could even begin specializing in certain asset classes, or catering towards certain investor bases. 

Please note that certain international offerings trade through decentralized exchanges (DEX) or international marketplaces as they do not fall under the SEC’s jurisdiction and guidelines. Comparable international licenses include the Multilateral Trading Facility (MTF) License in the UK, Markets in Financial Instruments Directive (MiFID) in the European Union, and Registered Market Operator (RMO) License in Singapore.

A look at the existing Tokenization markets

The Primary Issuance Market refers to the market in which securities are created and sold to investors for the first time. Not traded. So while the secondary trading market may have a collective value of roughly $20 billion as of mid-2022, up from $1 billion just one year ago and expected to grow into the trillions with the entrance of traditional financial institutions and issuers, the entire security token industry must encompass all primary issuance tokens that are created and represent underlying assets regardless of lock-up periods, tradability, or circulation.

The first step in the scope of the primary issuance market in this case falls under the term “tokenization” — taking assets that currently have value and securitizing them on the blockchain for 1) storage & management or 2) future tradability.

The general life cycle of a security token is:

  1. Securitization
  2. Token Development
  3. Token Issuance & Offering
  4. Secondary Trading

Any actions within the first 3 points contribute to the Primary Issuance Market.

Traditionally, company shares are considered to hit the primary market upon IPO when the shares are actually created and offered for the first time via an investment bank (or direct listing). After that point, the shares are subjected to a seasoning period, or lock-up period, which prevents the shares from being traded for a certain period of time, depending on the fundraising regulations used for the primary issuance. Following that period, the token is then able to be listed at which point it may trade on various secondary markets, which is where the majority of the crowd may buy or sell. In the case of security tokens, that primary offering (initial creation) is offered to investors ranging from retail to institutional through a security token issuance portal or broker. These numbers are not always accounted for or even publicly known, but the projects and issuances certainly exist.

With a current secondary trading market cap of roughly $20 billion and an estimated primary issuance market to already be worth over $60 billion, per Security Token Advisors, there is significant ammo in the primary markets that will likely spillover into the secondary trading pipeline and activate the secondary market cap’s ascent.

Keep in mind, security tokens are global and can span all types of assets — tangible and intangible. This enables the Total Addressable Market to include (but not be limited to):

Growth in the Tokenization Industry:

  • Private securities market to grow from $7 trillion to $30 trillion by 2030 (source)
  • An institutional study through Arca and Coalition Greenwich finds 77% of capital markets participants believe traditional securities will be digitized within 5-10 years; this, in conjunction with the $30 trillion private securities estimate, can be used to triangulate an estimated tokenized securities market of $20+ trillion by the end of the decade (source)
  • Equity Crowdfunding capital raises grew by 1,021% in 2021 (source)
  • Major players who are actively engaging in tokenization initiatives include Goldman Sachs, JP Morgan, State Street, BlackRock, abrdn, Hamilton Lane, Societe Generale, and Perella Weinberg Partners

Primary Market Size Estimate: $70-$80 billion

  • Includes assets securitized on the blockchain, onboarded to blockchain-enabled transfer agents, and projects that announced direct listings on Alternative Trading Systems (ATS) and marketplaces

Secondary Market Size: around $20 billion

  • Includes tokenized assets that are trading on SEC-regulated Alternative Trading Systems (ATSs) and foreign marketplaces like Multilateral Trading Facility (MTF) and general securities exchanges
  • Also includes certain assets that trade on DEXes (like LevinSwap, IX Swap)
  • Trading and Pricing Data on STM.co

Issuing a Security Token on Raze

Raze has built a platform to allow any company to easily tokenize assets for raising capital and managing equity, from funding to exit, all within US securities regulatory compliance. Raze’s fundraising operating system and set of services are poised to become a leader in an emergent multi-trillion dollar market. Utilizing a partnership with Polymesh, Raze offers a truly accessible and affordable technology platform with services to develop, issue, and market a private STO within current U.S. law.

Why Raze Chose Polymesh

Polymesh is an institutional–grade permissioned blockchain built specifically for regulated assets. It streamlines antiquated processes and opens the door to new financial instruments by solving challenges around governance, identity, compliance, confidentiality, and settlement. 

Regulated markets require identity, compliance, confidentiality, and deterministic finality. Yet most existing blockchains were built for pseudonymity, censorship resistance, and transparency, and rely on probabilistic settlement. Polymesh was built to incorporate governance, identity, compliance, confidentiality, and deterministic finality into the chain’s core. 

The open-source nature of the protocol also allowed Raze to gain an edge by integrating their existing issuance platform for digital securities with a framework that supported STOs. Recognizing the immense advantages Polymesh offers in creating, issuing, and managing security tokens, this integration will empower Raze to provide our clients with an unparalleled on-chain fundraising and equity management experience. 

Raze has created five simple steps to create an STO. Learn more at Raze.Finance.

Conclusion

In today’s digital age, blockchain technology is revolutionizing the way we handle asset management and investment through innovative concepts like tokenization and Security Token Offerings (STOs). Tokenization converts the ownership of various assets, including real estate, art, and equity, into digital tokens on a blockchain, ensuring transparency and immutability. This process democratizes access to high-value assets by enabling fractional ownership and enhancing the liquidity of traditionally illiquid assets, making them easier to trade.

Security Token Offerings (STOs) take this a step further by providing a regulated method for companies to raise capital. By issuing digital tokens that represent ownership in financial instruments like shares or bonds, STOs combine the benefits of blockchain with stringent compliance measures. These tokens can automate rule execution, facilitate real-time trading and settlement, and ensure adherence to investor qualifications and KYC/AML regulations.

The benefits of these technologies extend to efficient cap table management, automatic and secure distribution of dividends, and seamless secondary market trading. Platforms like Raze leverage the power of tokenization and STOs to offer a robust system for raising capital and managing equity. Through partnerships with blockchain networks such as Polymesh, Raze ensures regulatory compliance while providing a streamlined, cost-effective, and transparent fundraising process. Embracing these technologies can significantly enhance access to global capital markets, reduce operational costs, and improve overall investment efficiency, making them a pivotal part of the future of finance.

About Raze Fintech, Inc.

Raze is a disruptive operating system that significantly reduces the cost of raising capital acquisition for startups while substantially increasing transparency, access, automated compliance, and efficiency for investors. Startups and existing businesses can design, set up, and deploy their raise using equity, debt, and revenue financing to qualified investors.

For more information, please visit: raze.finance