Timing matters: Is it the right time in Germany to do an STO? Issuer-side works, investor-side not existing yet
There are two main reasons why 2019 and early 2020 might be difficult for companies to issue security tokens. We identified various challenges that might make it difficult for German companies doing a security token offering (STO). While it is not impossible to conduct a STO these days, we argue that time has not yet come to ease the life of security token issuers. The key point we make is the following: “supply” of security tokens is now possible in Germany through recent decisions by the German financial market authority BaFin. Also, the technical basis allows the issuance of security tokens. But the “demand” side is the problem. — Authors: Philipp Sandner, Evgeni Kozyr, Kai H. Kuljurgis
The STO market at that point in time simply lacks demand of investors. This is rooted in various reasons which reflect challenges to investors that still have to be overcome in the next years. Without these challenges being addressed, the “demand” side of the STO market — that is breadth and depth of investors — will not develop.
We categorized these challenges as follows: regulatory challenges, and investor challenges.
It is reasonable to argue that within the upcoming years we will witness a broad adoption of security tokens. However, at present there are some significant problems that need to be solved. Time might simply be too early to launch a security token.
What are security tokens?
Security tokens are issued in STOs and are nothing else than securities complying with existing capital market rules but being “packaged” into tokens sitting on blockchain-based systems (e.g. Ethereum, Stellar). With the help of security tokens, existing assets and securities can be “converted” into digital tokens. This process is called “tokenization”.
In this manner, it is possible to transform tradable financial instruments such as stocks or profit-participation rights into digital assets on the blockchain. In the future, this will happen in a dematerialized fashion without a physical certificate (in German: “Urkundenpflicht”) or without commercial register as we know it today.
Upon placement at the primary market, investors can potentially come from anywhere in the world as long as Know-Your-Customer (KYC) and Anti-Money-Laundering (AML) rules are followed. Besides, payments back to security holders such as dividend payments can be automatically processed via underlying smart contracts. In addition to that, there will be automated “fund” smart contracts that invest in portfolios of underlying security tokens, bundle them and issue their “fund tokens” to investors. If investors’ funds and tokens are sitting on one and the same blockchain platform — as is the case with Ether and any ERC20 tokens running on Ethereum — two highly important mechanisms from traditional capital markets will be revolutionized: First, delivery versus payment will happen within (milli)seconds and without siloed IT structures. Second, clearing and settlement will become significantly more efficient.
Thus, security tokens represent an improvement to classical securities such as stocks or profit-participation rights. Consequently, STOs have — for example — the potential to challenge the predominance of traditional issuance processes of equity as known from Initial Public Offerings (IPOs).
This is the vision and the future. But the situation these days shows that this vision has not become reality.
Is 2019 the right time to issue security tokens?
Ever since the Berlin-based blockchain startup Bitbond got the approval from the German Federal Financial Supervisory Authority (BaFin) in early 2019 to conduct a security token offering, many startups and companies in general are looking for funding, examined the potential of STO. By now, two more STOs have been approved by the BaFin which suddenly renders Germany the number one country in Europe concerning the issuance and approval of STOs.
The benefits are clear: International and low-cost transactions that are legally compliant and the option to choose a different structure or participation model, which might contain less influence of investors, results in the same incentive scheme for investors and a cleaner cap table. Moreover, the proof of ownership can be realized by a digital token instead of paper-based certificates. Nevertheless, it is important to analyze, whether the timing for an STO is beneficial and if the instrument is suitable for a given business case. As follows, we will point out different perspectives, that should be considered if a company wants to raise funds through a security token offering.
There are two main reasons why 2019 might be difficult for companies to issue security tokens. First there is “regulatory affairs” which reflects the challenging decision of choosing a complex legal workaround to issue a security token to somehow comply with existing law. Second, there are “investor challenges”, which reflects the difficulties of individuals encountering significant barriers when they seek to invest.
A side remark: Recall that in classical e-commerce practices every single barrier and unnecessary complexity results in a dramatically reduced conversion rate. In the STO area, any barrier or misfit results in significantly reduced raised funds.
If a company wants to issue a security, it needs to follow capital markets regulations. Currently in Germany, “plain vanilla tokenization” is not feasible.
Therefore, companies aiming to issue a security token in Germany need to find legal workaround, as Bitbond in early 2019 did so by structuring its security token as a form of debt financing (in German: “Schuldverschreibung”). However, this can be problematic since debt financing might not be the right fit to the high risk profile of a startup. Because of the danger of a total loss that exists with investments in startups, investors could find this scenario unattractive.
Designing the security token as a profit participation right (in German: “Genussrecht”) is not yet possible in Germany. Cashlink provides security tokens in the form of “virtual shares” complying with German law. While this is an interesting structure, it still is a workaround and no straightforward tokenization of equity. This comes with the restriction of being accessible only to semi-/professional investors and a limitation to a maximum number of ca. 150 participants. In general, equity cannot be tokenized directly in Germany.
Hence, issuers and lawyers are struggling to find easy solutions. A company looking for funding wants to comply with as many requirements from different countries as possible in order to extend the number of potential investors. Ideally, the company is able to raise funds among retail investors and professional investors — again with the goal to increase the potential number of investors. Offering a security token in many countries to all investors (including retail investors) is not possible at this point in time.
Divergent regulation increases the legal costs significantly. The upcoming Liechtenstein Blockchain Act will ease some of the difficulties, as it allows the tokenization of any right in a “plain vanilla way” which means that no complex legal workarounds have to be found. Therefore the cost of tokenization would be reduced dramatically.
One of the most important questions that need to be answered is: Who can be attracted by a token issuance?
First, there are institutional investors. One problem for them — from a German perspective — is that there is no secondary market for security tokens. In fact, there are some pioneering exchanges in Europe, but currently they have little to no volume so that a broad adoption has yet to come. A second problem is that, in many cases, security tokens do not ensure the required rights institutional investors might need for an investment. A third problem is that storing the tokens with high-quality custody solutions is still an issue. Custody solutions, which provide a solid infrastructure required for institutional investors are so far not easily accessible.
For the retail investor, in case his or her participation is possible, the biggest hurdle is the entry barrier. The investment as well as the private key storage process are still too complicated if compared to simply purchasing a Daimler stock at traditional online brokerage providers. Although the minimum invest might be small, in the case of Bitbond, a Stellar wallet address is needed. Even though there are custody solutions available, nowadays private key management for retail investors is still a problem. This problem is existing not just for newcomers in the blockchain area but also for existing players who face difficulties when they seek to efficiently store their assets.
At last, there are the crypto investors. Crypto investors mainly believe in crypto currencies such as Bitcoin and Ethereum. This is where they see the upside. They are therefore questioning why they should — as insiders — switch from Bitcoin and Ethereum to an early stage startup issuing security tokens providing a less interesting benefit-risk-ratio. These investors would not switch to Bitbond’s debt instrument with a limited upside when they simply can “HODL” their cryptos.
Security tokens are the future. They will provide an alternative way of financing for startups and contest the regular emission of securities. The possibility to issue any security without the deposit of a paper-based certificate (e.g. in Germany) is groundbreaking. As outlined above there are also a number of other advantages. However, due to the different challenges described above, the maturity of the process will still need some time.
The reason for this is simple: Why there is an increasing “supply” of security tokens in the market, the “demand” for security tokens by investors is still very low and only very slowly increasing. As always, if supply exceeds demand, prices drop. In the case of security tokens, this is reflected in unexpected low fundraising volumes or significantly high market expenses to reach the investors that are — up to now — still quite scarce.
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Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2021, he was ranked among the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. He has been a member of the FinTech Council and the Digital Finance Forum of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of FiveT Fintech Fund, 21e6 Capital and Blockchain Founders Group — companies active in venture capital financing for blockchain startups and crypto asset investment management. The expertise of Prof. Sandner includes crypto assets such as Bitcoin and Ethereum, decentralized finance (DeFi), the digital euro, tokenization of assets, and digital identity. You can contact him via mail (email@example.com) via LinkedIn or follow him on Twitter (@philippsandner).
Evgeni Kozyr was a research fellow of the Frankfurt School Blockchain Center (FSBC). His field of interest is primarily the research of distributed ledger technologies. You can contact him via mail (Evgeni.firstname.lastname@example.org) or via LinkedIn (https://www.linkedin.com/in/ekozyr/).
Kai H. Kuljurgis is the Founder and CEO of coindex®, which is the first German platform for intelligent crypto portfolios. Using coindex® enables retail investors to easily buy, automatically manage and securely store index based crypto portfolios. The portfolios are based on the cdx® — a data-driven crypto index that reflects on average 99% of the global market with just over 1% of total assets. The cdx® is the first German crypto indexwith a WKN / ISIN (SlA6t7 / DE000SLA6T71). The coindex® platform is realised in cooperation with a German bank to ensure full compliance, transparency and security. You can get in touch via mail (email@example.com) or via linkedin (https://www.linkedin.com/in/kaikuljurgis/).