One of the major topics of discussion in cryptocurrency at the moment is around the emergence of security tokens. Security tokens are backed by real assets such as an equity, shares of a limited partnership company, or commodities. They are also subject to federal security regulations.
Blockchain Capital conducted one of the first security token offerings last year when it raised capital for its third fund. A new NYC-based venture capital platform announced a tokenized venture fund this week. J.P. Morgan’s co-president Daniel Pinto said, “The tokenization of the economy, for me, is real. Cryptocurrencies are real but not in the current form.”
So what is a security token? How is it different from a utility token? Term Sheet sat down with Josh Stein, the CEO of tokenized securities startup Harbor to discuss. The company recently raised $28 million in funding from investors including Founders Fund, Andreessen Horowitz, Pantera Capital, Craft Ventures, and Signia Venture Partners.
David Sacks, a PayPal co-founder, Yammer CEO, and Zenefits COO, came up with the idea for a security token startup and eventually recruited three former Zenefits executives to run the company. Stein was the former general counsel and chief compliance officer at Zenefits, the company that got into hot water for inadequate compliance procedures. “We didn’t have a chief compliance officer until after everything happened,” Stein said. “That was the problem — the company hadn’t prioritized it.”
Harbor’s co-founders are not only prioritizing compliance, but it’s the foundation of the software. What follows is a Q&A about the nature of security tokens & their role in the regulatory ecosystem.
TERM SHEET: What is a security token?
STEIN: A security token represents traditional, private security interest. It could represent a share in a company, an LP interest in a fund or a trust, a member share in an LLC. Essentially, you’re taking something that today you have on paper and you’re putting an electronic wrapper around it.
The best analogy is the transition from email to snail mail. You can type out a written communication, print it out, put it in an envelope, address it, send it, and wait two to three days. Or you could hit send on an email. The content is the same, but by putting an electronic wrapper around it, you can send it faster, cheaper, and easier.
To put it in context, you could have the same investor agreement or certificate on paper. It’s the same thing, but now it has an electronic wrapper, so now I can issue it and trade orders of magnitude faster, cheaper and easier.
So what role does Harbor play in this process?
STEIN: There’s a little bit of programming in that token, but it calls to Harbor every time that token goes to trade. Harbor is this trade-compliance gatekeeper, and we check if the trade is compliant. We check who the buyer and seller are, what the trade is, and where it occurs. If those are compliant, the trade happens and no one even knows Harbor was involved.
If any of those are not compliant, the trade gets stopped. So it might say, “This buyer is not approved. They haven’t been vetted for “Know Your Customer” (KYC) and “Anti-Money Laundering” (AML).” It might say, “This trade doesn’t conform to the cap table requirements.” In those instances of non-compliant trading, the programming will automatically kick in and not allow the trade to occur. You’re not unwinding trades — they just never happen.
How is a security token different than a utility token?
STEIN: These protocol tokens, utility tokens or ICOs refer to tokens that power a decentralized software. For example, if you’re using decentralized file source — think something like DropBox but done in a decentralized fashion — you’d have a storage coin that would power this system & it would be a payment mechanism for the system. Think of it almost like a pre-paid software license. But the key here is that it’s not a security interest. You do not own anything in the company and there is no real world asset that backs it.
How does your service comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements?
STEIN: We hook into the rest of the blockchain ecosystem, so these tokens can trade on any properly licensed exchange. They can interact with qualified custodians. We control all the compliance-related tokens in the Harbor ecosystem.
The compliance is centralized at Harbor, and that’s a little different than some of the other companies doing this. Some folks are a complete walled garden — they have to issue the tokens, they only trade on their exchange, and you can’t use other players. Other folks are completely decentralized where you find all the players, like law firms and KYC/AML vetters, on the blockchain and somehow deal with people you don’t know and trust. What we do is we centralize the compliance and decentralize everything else.
Theoretically, what assets could be tokenized?
STEIN: Real estate is one. Another is fine art. We’ve talked to a few high-end art dealers with their own inventory and access to institutional inventory. What if you tokenized the work by Monet? Not many people can stroke a check for $20 million. But if you owned a fraction of a Monet, lots of people would like to stroke a check for $200,000. What if you tokenize a bunch of works by Monet and then you create a fund that owns 10% of each tokenized work? Now, I own a Monet fund or a Monet ETF.
With the tokenization technology, you could create leveraged longs and leveraged shorts. You can go long French impressionists and short modern art. You can do the same with real estate — I tear off a 10% strip of all my Class A in Midtown and create a Midtown fund. Class A in Upper East Side, Downtown, Brooklyn, Jersey. I can go long Manhattan, I can go short Brooklyn.
Yes, there will be some gambling going on, but what’s interesting is that if I’m a property developer and I just put a huge amount of capital into Manhattan, I could effectively hedge my position very cheaply and efficiently.
How would a venture capital firm tokenize their fund?
STEIN: Today, there are three reasons why there is illiquidity in traditional private securities: The buyer & seller can’t find each other, you have to re-paper the transaction, and you have to enforce compliance. The result is there’s always very tight transfer restrictions. In other words, transfer is prohibited and you have to go to the GP in a fund, the manager in a REIT, and you have to ask them for permission. They then have to go find someone on the other side of the trade. It takes weeks or months to do it, it takes a lot of hassle and elbow grease, it costs $10,000 to $20,000 to paper the transaction, and you take a big hit on the valuation.
The liquidity benefits investors and hence it benefits people raising capital. On the highest level, we’re attempting to take the liquidity of public markets and bring it to private securities.
Why should people in VC or PE care about this?
STEIN: It’s a good way for them to invest in things that are more liquid. Some crypto-focused VC funds and hedge funds are already tokenizing [TS Note: Firms who have tokenized their funds include Blockchain Capital and Spice VC]. As LPs get used to the liquidity, they’re going to start to demand it.
If you’re a traditional VC fund or hedge fund, and you have no problem getting capital, you shouldn’t tokenize today. You should keep your eye on it in case you may need to down the road. If you want to tap into a new investor base that’s worldwide, and if you want to get lower cost of capital, it’s something to consider.
What are the risks and disadvantages associated with security tokens?
STEIN: The risks are not security risks. We have the ability to freeze trading on behalf of the issuers. Let’s say you want to move back to paper — we’d freeze trading and re-issue paper. Your hassle is some reputation exposure, some administrative expense, and some dashed investor expectation as to liquidity, but none of those are catastrophic. This is not like cryptocurrencies such as Bitcoin or Ether where if you lose control of them, you have lost that asset.
This is a real world asset that only has a cryptographic representation. The asset is still there. You still have a real-world cap table.
And of course, at the end of the day, the investment’s got to be good. If you take a bad investment and you tokenize it, you have a highly liquid bad investment. So we’re being very cautious with our clients in the first year or two. We want to deal with investments that will be successful with reputable owners of capital and who are doing things the right way.
What’s an example of a good investment that you’re looking at tokenizing right now?
STEIN: We’ve talked to multiple property owners primarily in the hospitality and office spaces. Think marquee, classic commercial real estate in major metropolitan areas. Some of them are looking to raise hundreds of millions of dollars, and we’re talking to them about starting off smaller — about $50 to $100 million.
So you haven’t tokenized anything yet?
STEIN: We’ll conduct our first issuance this summer.
What is the current regulatory environment as it relates to security tokens?
STEIN: There’s a misconception that there’s a regulatory problem or that somehow the regulations need to change. They don’t. You need to comply with rules around the world. If the compliance doesn’t work, nothing else can happen.
We have talked with a number of regulators in the U.S. and around the world. No one has given us negative feedback and no one has signed off on it, but our fundamental opinion is that we’re complying with the rules.
How big of a business could this be?
STEIN: Very large. Private commercial real estate in the U.S. is $17 trillion. That’s just one asset class in the U.S.