Innovation Via Adoption of Security Tokens Creates Market Access for Everyday Investors

By Jay Fraser, Director of Strategy at BSTX

The United States' booming capital markets boast of being the deepest and most liquid globally. Over the past decade, the total U.S. equity market value of public U.S. companies increased by 241% through 2021. Rather than what we might expect in light of the explosive growth of capital in public markets, the number of publicly traded companies has been steadily dwindling over the same period. The question is, why are smaller companies eschewing the stock market and choosing to raise money privately when there is more public money available than ever?

According to the latest data from the World Bank, in 2001, there were over 6,000 domestic publicly traded companies listed in the U.S., but by 2019 only 4,266 companies remained. At the same time, the number of Unicorn IPOs (companies worth at least a billion dollars when they go public) has exploded, increasing from 6 in 2016 to over 120 in 2021. Smaller companies are choosing to raise funds privately through venture capital firms (VCs) and accredited investors, making these early stage and potentially highly profitable opportunities less accessible to everyday investors. 

The importance of publicly listed companies

When companies go public, they enable everyone—from the teacher with some extra cash to the hedge fund manager putting millions of dollars to work— to purchase the stock. If they remain private, funds can only be raised from an elite few, which locks out other market participants from earning returns from innovative technology and emerging markets. Part of the outsized growth in value and returns of venture capital firms (VCs) and wealthy investors is due to their unfair access and resulting domination of the private rounds that fund early stage companies. VCs provided $26 billion in funding in 2001, but by 2021, VC funding had risen to over $671 billion, a 25x increase. It’s an age-old story of an uneven playing field, but what can we do about it?

Streamlining the process of going public

Perhaps the most important question to ask is why companies are choosing to remain private. In fact, there are a few reasons. An IPO is difficult, risky, time consuming, and expensive. The Sarbanes-Oxley Act (SOX), passed in 2002, mandated public companies go through rigorous audits, complicated compliance obligations, and other byzantine disclosure requirements. Smaller companies simply do not have the resources to handle these onerous demands, unlike establishment enterprises that can afford to hire full-time counsel to navigate the IPO process and ensure compliance with the U.S. Securities and Exchange Commission. In addition, banks charge higher IPO fees to smaller companies — a $100 million IPO typically bears a 6.5 - 7% fee, which is dropped to only 3% for companies valued at over a billion dollars.

Many small and mid-sized companies decide that an IPO is not worth it and end up turning to other alternatives. Some decide to issue over-the-counter (OTC) stocks, which allows them to issue company equity without partnering with an exchange. However, OTC securities are significantly less regulated and have garnered an unfavorable reputation thanks to several past off-exchange issuance scandals. Another option, especially popular for Web3 companies, is to execute an Initial Coin Offering (ICO). Unfortunately, ICOs largely resemble high-tech versions of OTC stocks, and are plagued by similar issues. For companies that want the legitimacy of a regulated venue, but can’t IPO, raising private money from VCs and angel investors is the most obvious option. 

A better solution through tokenized securities

While blockchain’s underlying technology is complex, it offers a simplified solution to the challenges of the current IPO and stock trading process. Tokenized securities, tokens that represent an ownership stake in a specific venture, empower companies to issue equity through a blockchain in the form of tokens instead of traditional stock issuance. Unlike many crypto assets, these tokens are considered securities under U.S. law based on an analysis under the ‘Howey Test,’ are regulated by the SEC, and include the same investor protections as traditional certificated securities. Blockchain technology also offers increased transparency and decreased settlement times that are not possible with certificated securities. 

In this way, security tokens can serve as a bridge to connect traditional capital markets to the increasingly digital world, a process that would otherwise be as expensive and time consuming as it is antiquated. Companies that issue security tokens can use smart contracts to automate compliance processes, the enforcement of ownership conditions, and other once tedious processes. This high level of automation reduces the burden of the SOX act and other regulations on public companies and dramatically lowers the cost of trading. 

Security tokens are traded on blockchain-based exchanges, which function similarly to their traditional exchange counterparts. Exchanges have the responsibility to provide oversight, maintain orderly markets, and perform due diligence on the companies that are listed. However, these platforms do not charge the same high registration fees as traditional exchanges, largely thanks to their more modern technology which allows them to function more efficiently. This offers smaller companies a cheaper and more streamlined path to public money, while still granting investors the same protections as the most costly incumbents.

Built for the future

Currently, there are more than 19,000 cryptocurrencies in existence and dozens of Layer-1 blockchain platforms. This is a direct benefit to those seeking to access financial markets, as platforms provide a frictionless way for tokenized financial instruments to replicate the features of certificated securities. Security tokens offer benefits beyond what is currently possible due to the underlying blockchain technology. For example, unlike traditional equities which trade in complete shares, tokenized securities can be fractionalized into the tiniest increments opening the prospect of ownership to more people with less money and giving issuers more flexibility by eliminating the need for burdensome stock splits. Additionally, security tokens can be fully executed in a matter of minutes, allowing zero day (T+0) settlement times instead of the traditional two days (T+2). Lastly, transaction records are recorded and secured on an immutable distributed ledger, providing market transparency and open price discovery. 

Blockchain technology has faced many similar growing pains to other nascent industries. The collapse of several high profile crypto lending firms and stablecoins have dominated the headlines in recent weeks, but it’s important to keep these failures in perspective. The risky borrowing and lending strategies that led to these collapses will continue to draw legislative and regulatory attention, which will lead to greater oversight and clearer guidelines for these firms to follow. 

Now is not the time for regulation to knee-cap the DeFi industry, it’s the time to support it. It would be unreasonable to limit the massive upsides of transparency and financial inclusion that the industry has to offer because there have been a few bad actors. We have seen bad actors in traditional finance, and those acting unfavorably will continue to be pushed out through meaningful legislation and regulatory clarity that offers both comprehensive protection for investors and allows for innovation in the industry. 

Security tokens stand ready to increase the efficiency of financial markets, bringing them up to date with modern technology. There is a long way to go in educating the public and growing institutional support and adoption, but security tokens are shaping up to be the fluid path to public money that smaller companies have been clamoring for.

Jay Fraser is the Director of Strategy at BSTX. Prior to joining BSTX, Jay was the Head of Business Development and Listings at IEX Group, a national securities exchange, and Head of Deutsche Bank’s Autobahn Americas, the first ‘app-based’ electronic distribution system in the financial services industry. A graduate of Emory University, Jay began his career in equity trading at Lehman Brothers before holding roles at ITG and Citadel Investment Group.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.