In part 1 of this series we covered all cryptocurrencies (and/or commodities) and why it makes sense to bring those onchain, the next basket of assets falls under a different regulatory regime. As a result, it has much different regulatory packaging. The challenge with securities is that the rules are set by the issuer, this means every other piece of the stack has to fall in line to the rules set by the issuer. Someone has to part the sea.
Onchain and offchain, it’s a security
Whether the asset is onchain or off chain does not change the rules of the road, a security is a security. We see people issuing with various structure, for example we see the following:
SEC-Registered Offerings — These are registered with the SEC under the Securities Act of 1933, as S-1 or F-1 offerings. These can be sold to the general public which makes them ideal for onchain activities.
Exempt Offerings — These are offerings where, if you follow the SEC guidelines, you’re welcome to offer securities without explicit SEC approval. What you typically see are Regulation D 506(b) and 506(c). If you’ve ever raised using a YC-SAFE, you were most likely falling under 506(b). To qualify for 506(c), you have to verify that all participants are accredited investors or similar.
Regulated Offshore — This is where we see assets issued under ESMA, MiFID II. They may just be issued out of BVI like an ICO token :/
The Right Structure
If you asked me all the way back in 2020, when I launched the first SEC-registered assets natively on Ethereum, what the right way to do it was, I would tell you the following:
You need a scalable pipeline of assets:
This could be a theme such as art, these days it’s stocks
A scalable pipeline provides a story to enable the market
You need to bootstrap the liquidity:
There need to be several DeFi markets stood up at least one for each application of sufficient liquidity to allow the asset to remain pegged to the underlying
They must be DeFi compatible to enable use cases
Use cases including loans, perpetuals, anything!
DeFi compatible means ERC-20
If securities are going to be on the blockchain, there better be a great reason. Generally speaking the blockchain is more complicated to use. What’s possible on the blockchain that’s not possible today? That’s what we should be pursuing.
We were doing better in 2020
In order to reach the ideal structure for securities on the blockchain, we need a couple things. Ideally the assets are freely transferable. There is one model that has been pending effectiveness that allows for permissionless transfers of securities is Permuto Capital Trust, however it is not yet in production. Questions about DeFi fungibility remain.
In 2020, I was able to get the closest to the ideal model through the SEC with an F-1 offering and a ‘40 Act Fund both of which went effective and live with over 9,000 users. This model relied on the ERC-1404 standard and allowed for free transfer across authorized users, with DeFi compatibility. Subsequent attempts that came near were not necessarily defi compatible (meaning on a chain with a vibrant defi ecosystem) such as Franklin Templeton’s BENJI which originated on Stellar or Figure Blockchain Stock which is on the Figure Provenance blockchain.
Wandering in the desert of low liquidity
We’re six years after the first SEC-registered, DeFi-compatible assets and the landscape is not looking good. We don’t need Clarity Act to get these to market, we don’t need new regulations, we just need teams that know how to build into the existing regulations. What we see on the market today is largely not available to US retail investors directly. If you take a look at the terms of service of these financial products or the offering documents, you’ll more than likely have to attest that you are not a general retail US user. When it comes to secondary trading they may be available to purchase permissionlessly however, this is not through a formal offering or secondary process.
Taking a look at the data (see below), we can see that the only asset open to retail investors in the US has 71 holders and is offered through a centralized application. Not exactly liquid, not exactly well distributed. What could be missing from the go-to-market. We can also see that 89% of the liquidity is not available to US retail.
The data shows that launching to US retail is the way. The INX IPO, launched by Tokensoft in 2020 continues to be one of the most decentralized launches in history with over 9,000 individual token holders. The largest security onchain today is Ondo’s Nvidia token with around 6,200 holders,
The Promised Liquidity
If you asked anyone in 2018 why they wanted to put their venture fund or art on the blockchain, they would tell you it was for more liquidity. Once I went down the path of getting these funds on the blockchain, I realized that the same rules that existed on paper had to be replicated on the blockchain, which meant that the better liquidity was not there. In the next installment of this series I’ll cover how we can get there.
Originally published on The Masonic. Subscribe for occasional writing on tokenization, compliance, and what’s actually happening at the frontier of financial technology.