By Alexander Labowitz, General Counsel, Cadre
Here we go again! Last year, I had some fun blogging my top 5 takeaways from FINRA’s blockchain symposium. So I couldn’t resist the opportunity to use the now tried-and-true “Five Takeaway” format again. This time, I’m writing about the first-ever Security Token Summit held June 11, 2018 at the Conrad Hotel in lower Manhattan.
Introduction
A note for the uninitiated about security tokens. There are some great blog posts and white papers about security tokens, but a simple explanation is that security tokens are securities issued on a decentralized ledger distributed across blockchain. For example, a small cap operating company could forego the typical way of evidencing ownership, namely either issuing stock certificates or using a centralized shareholder ledger, and could instead choose to issue its shareholders “security tokens” evidencing their ownership share that would be held in each shareholder’s “blockchain wallet”.
Security tokens have recently become the proverbial Belle of the blockchain ball, with some saying that asset tokenization is the most important evolution in blockchain since Bitcoin. Security tokens show immediate promise in the area of private capital raising, such as start-up capital, crowdfunding, and real estate investment. Modern regulations like the Jobs Act have brought private capital raising into the technology age and put previously inaccessible opportunities within reach for millions. Security tokens meet this kind of tech-enabled capital raising head-on.
Cadre is an investment platform that provides investors access to a curated set of institutional quality commercial real estate opportunities. Could we use security tokens on our platform? Sure we could — we are a target customer for this product. But should we use security tokens on our platform? That is what I intended to find out at the Security Token Summit. As Cadre’s General Counsel, I was looking to be “wowed” not by style but by substance. After all, Cadre is a FINRA-registered broker-dealer and SEC-registered investment adviser, so our clients expect us to extensively diligence any new product before introducing it to them.
And now for my takeaways — Enjoy!
5. Crypto = Corporate?
I was surprised at how few crypto-nerds attended this conference. Almost every attendee was on the corporate side of the business and came dressed in business attire. This was a group of lawyers, cybersecurity pros, bankers, and operations professionals.
The panels and discussions reflected the corporate atmosphere. Outside of a few moments, the entire event was about traditional non-tech topics such as legal, compliance, operations, cybersecurity, identity verification, and the overall regulatory environment. Only cursory homage was paid to the counterculture “cypherpunk” origins of blockchain and there was no discussion whatsoever about the technology behind blockchain or security tokens.
Turned out that FINRA and the SEC were the real stars of the Summit. Panelists were consistently trying to one-up each other on how closely they work with regulators. As a lawyer and compliance professional, I view this focus as a really positive development. But I also believe that corporate guys like me would benefit greatly by hearing some more about the underlying technology and its full capabilities (and any shortcomings).
4. Much Still Unsettled
Unsurprisingly for a brand new product, much is still unsettled, which led to some contentious moments during the Summit when panelists debated unsettled points. Some examples: Can a security evolve to no longer be a security at some point later in its lifecycle? (Interestingly, an SEC employee recently weighed in on this question at the Yahoo! Crypto Summit.)
Can white-listing of blockchain wallet addresses suffice for KYC / AML / OFAC compliance? (Regulators are just now starting to provide some guidance on these topics.) How can custody be addressed in a reasonable way, e.g., what happens if I lose my private key? Are utility tokens securities or not?
These and other open points will have to be addressed in the near term so that consumers and investors can participate with certainty.
3. Huge Opportunity, Bigger Competition
There was a palpable sense at the Summit that we are in the very early stages of what could be a huge commercial and social opportunity. Attendees were told to remember what the Internet was like in 1993 and apply that thinking to security tokens in 2018 (there was the obligatory rocket launch promo video to hammer the point home).
Because of the potential size of this opportunity, this relatively nascent industry already feels pretty crowded (one person I spoke with called it a “Cambrian explosion”). The various platforms and protocols all seem to be vying (sometimes as panelists sitting uncomfortably on the same panel as their competitors) for the coveted space at the top of what I call the “interoperability food chain”.
What is the “interoperability food chain”? Tokenization allows for interoperability, whereby assets can be traded for each other across platforms and asset types. So imagine your wallet held a tokenized share in a hedge fund, but you wanted to exit that position and buy some tokenized real estate. In an interoperable system, you don’t need to exit the system by “selling” the hedge fund shares (taking out cash) and “buying” the real estate position (wiring cash). Your security token wallet can do that all for you through tokenized trading. Interoperability is, theoretically, very powerful. And the top of the “interoperability food chain” is a lucrative place to be because interoperable networks such as these tend to end up with just one or two very big winners.
2. Great Tech Still Needs Great Assets.
A lot of the discussion at the Summit was about tokenization of real estate assets, the area I am most interested in given Cadre operates a real estate platform. The application of security tokens to real estate does feel promising (faster, safer transactions; removal of certain operational barriers to liquidity).
However, conference attendees without a real estate background might have left with some misconceptions about the asset class. One example was when a panelist described the risk / reward ratio of real estate backed tokens versus utility tokens and said “Utility tokens can become worthless, but real estate can’t go down to zero.” I thought this was a little confusing because most real estate deals involve significant debt leverage, meaning that the equity (or tokenized) portion of any real estate deal is most certainly at risk of being completely wiped out (happens all the time when a downturn hits).
I know how hard it is to find great real estate deals. Cadre’s investments team (over 20 investment professionals) reviews hundreds of deals a year and only about 1–2% make it through diligence, underwriting, and investment committee review and onto our platform. A bad real estate deal in token form is still just a bad real estate deal — even though trading the bad deal is operationally simpler and you’ve opened greater access to it.
1. “Final Take” — When Will the Hype Be Met?
Most panelists sounded convinced that security tokens are poised to change the industry over the next 18–24 months (panelist quote — “A complete paradigm shift”). Panelists predicted billions, even trillions, of dollars in tokenized asset transactions occurring during that time (panelist quote — “Market will easily be in the trillions”). Others predicted that most of the key challenges facing the security token industry will be solved in the near term (panelist quote — “Issues such as custody and assurance will be settled”).
My feeling is that the time horizon will be a bit longer, and the road a bit bumpier, than those predictions made at the Summit. Maybe I know too much. I know how hard it is to digitize assets (we do this at Cadre). I know how hard it is to meet broker-dealer obligations when running an ATS (again, we do this at Cadre). I know how hard it is to find great assets, with the right operations team and business plan, at the right price (yes, we do this too).
I left the Summit hopeful and excited about the direction and long term potential of the security token industry. As a potential user, Cadre and I will closely monitor the industry’s progress and would be delighted to participate in the ongoing substantive conversations to ensure the business hype is met with legal and regulatory clarity and certainty.
Note: If you missed the event, you can purchase video recordings from the Security Token Academy.
Important Disclaimer
The views expressed above are presented only for informational and educational purposes and are not necessarily the views of Cadre or any of its affiliates. Cadre makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. This post is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. Additionally, this post is not an offer to sell or the solicitation of an offer to buy any securities or other instruments.