Executive Summary
Security token offering (STO) is the new buzzword in the digital asset ecosystem, and its promoters assure that, this time, they have found the killer app that will revolutionize financial asset ownership and trading. There are clearly a number of benefits to tokenizing existing assets via STO. Beyond complying with the existing securities regulatory framework, tokenization permits fractionalization of ownership rights, transfer of paper-based property rights into the digital world, emergence of a secondary market supported by the blockchain infrastructure, and access to a more global investor base. A closer look at the variety of assets that are currently being considered for tokenization—ranging from company shares to diamonds and fine art—reveals, however, that we again find ourselves in a “hammer-looking-for-a-nail” situation. The challenges when trading many of these assets is not the lack of proper infrastructure, but the expertise required to operate in these markets and the resources needed to ensure proper maintenance of these assets in the physical world. In addition, there is potentially a clear legal distinction between different types of assets. In certain cases, the token can be the asset itself (e.g., corporate securities), but for tangible assets, it can only represent a contractual right, as the asset itself cannot be digitalized. Hence, we expect numerous initiatives to fall short of their initial objective. However, STOs offer some clear potential for companies going through early-stage financing and could significantly improve the efficiency of private markets.
STOs are particularly suited to the private markets for a number of reasons. First, the asset to be tokenized is already a financial one. Secondly, tokens have the capacity to embed shareholder agreements into self-enforcing smart contracts. Thirdly, this is a market that, despite numerous attempts to revamp its infrastructure, is still very paper intensive, requiring significant manual labour in post-deal administrative and accounting tasks. Finally, the time horizon of institutional investors in private markets, which tends to be mid-term, is well suited for the type of trading velocity that can be handled by the blockchain infrastructure.
While adoption of the STO mechanism by issuing companies will be incremental—by our estimates, accounting only for around 4% 1 of early-stage financing deals in 2019—Opimas expects that by 2022 STO market value will reach US$19 billion, which is equivalent to 13% of the funds allocated by venture capital firms in 2019 alone. Post-2022, STO growth is likely to accelerate as the market matures and acceptance expands beyond early adopters.
Figure 1. STOs will jump in market value by 2022
The development of STOs in private markets could eventually pose a threat to the existing capital infrastructure, notably for listed equities, as companies that have issued security tokens are unlikely to conduct a traditional IPO in their bid to become publicly traded. While they will certainly have to register with local regulators and provide the required transparency and financial reporting, there would be no need to change their tokens into shares and transfer them from a blockchain infrastructure to a legacy one, trading them on an exchange or over-the-counter (OTC). Therefore, it is quite probable that eventually STO adoption in private markets will cause the attrition of traditional IPOs and, over the longer term, pose a clear threat to investment banks that usually get 3-7% of the deal size when taking firms public and also to central securities depositories (CSDs).
The development of the STO market represents a clear opportunity for service providers in the digital asset space. Our conservative estimate is that, in 2022, roughly US$250 million in revenues will be generated by token issuance providers. In the same year, digital exchanges and broker/dealers will share close to US$4 billion from STO trading revenues.
The size of the STO market, the threat that it could eventually represent to legacy infrastructure providers, and the significant potential upside are driving a limited number of incumbent players—mostly exchanges—to beef up their offerings and develop partnerships with FinTech providers. But the vast majority are still taking a wait-and-see approach, as numerous factors—e.g., macroeconomic, regulatory, and technological—could tamp down STO enthusiasm. While it’s still early days, tokenization has the potential to dramatically alter the dynamic for a number of asset classes that are ill-served by the existing legacy infrastructure.