Can Tokenization Fix the Secondary IPO Market?
April 17, 2020
Every company was once a startup, likely coming from humble beginnings, fueled by the blood, sweat, and tears of its founding members – eventually gaining a stronger foothold through initial investors. The expectation was that these early employees, founders, and investors would all benefit immensely from liquidity when the company had its IPO. However, as the timelines to enter the public marketplace have been drawn out in hopes of creating companies with +$1 billion valuations, historically one of the most attractive investments offered on Wall Street, shares of newly minted companies, are faring worse than they have in decades.
Having realized that they were strapped with illiquid equity in private companies that may not become public for more than a decade, founders and employees both sought a means to generate wealth for themselves which ultimately gave rise to the secondary, pre-IPO market. This secondary market, unfortunately, is costly, highly inefficient, and unregulated, making it potentially dangerous for both buyers and sellers. However, with the rise in blockchain technology, tokenization may offer a means to add liquidity and trust to the secondary marketplace while also affording different types of investors opportunities to buy into private companies early in their respective lifecycles.
This secondary market is comprised of transactions in which employees and founders sell their pre-IPO stock to mutual funds, sovereign wealth funds, family offices, and other investors. These buyers would normally not have had access to the shares in these private startups (The Rise of the pre-IPO Secondary Market); founders and employees, through this market, have found a way to generate wealth for themselves outside of the IPO process. The pre-IPO market, however, is not without its inherent issues and risks. Currently, there is no pre-IPO exchange; sellers must seek out buyers on their own. Additionally, in most cases of private stock sales, the buyer must be an accredited investor (e.g., an individual who has a net worth exceeding $1 million) and, even if a buyer is found, startups often place restrictions on their pre-IPO stock (Hawk). Assuming that a buyer is identified and that a seller is able to sell their pre-IPO stock, there is no defined timeline upon which the private company will IPO, meaning that the buyer’s investment will be tied up until then. Combined with the fact that there is no guarantee that the company will IPO or what the price at IPO will be, to compensate for the risks and lack of market depth, often founders and employees are forced to apply illiquidity discounts to their stock in order to sell them.
Having recognized the pitfalls of independently selling pre-IPO shares, some firms (i.e., NASDAQ Private Market, SharesPost Inc., Forge Global, etc.) have made attempts to facilitate trades and, ultimately, add liquidity and value back to this market by making it easier to match buyers with sellers. This method is also not without its issues, the key one being that pre-IPO brokers operate independently of one another, which has served only to decentralize the market, further compounding the issue of matching buyers with sellers (Hawk). Additionally, brokers in this space typically charge significant fees to facilitate these types of transactions which doesn’t remedy the issue of creating more value in the market itself.
Being a private market, pre-IPO trading is subject to adverse selection due to information asymmetry issues. As pre-IPO implies, the companies themselves are still private, meaning they are not subject to federal regulations nor required to report their financial information. For a potential buyer, this is an issue as the seller of the pre-IPO stock knows more about the company. To remedy this, sellers keep their “transactions quiet and ensure privacy through non-disclosure agreements (NDAs). This cautiousness greatly slows the rate of private market transactions, as even if buyers sign an NDA, the subsequent due diligence process often takes at least 90 days to complete.” (Hawk)
Blockchain technology, specifically tokenization, may present an opportunity to vitalize the secondary pre-IPO market. While seemingly similar to securitization, tokenization is categorically different. “Securitization” is the process of taking illiquid assets (or groups of assets), often debt, and transforming them into a security that is more liquid. This is done by pooling the various financial assets into one group. Issuers can then sell the group of repackaged assets to investors. For example, banks can use securitization to convert mortgage portfolios into cash. By underwriting mortgages, banks will own the future income paid by the borrowers paying off their loans, creating a balance sheet asset. “Tokenization” is the process of converting an asset into a token which can be moved, recorded, and/or stored on a blockchain system. More so, tokenization converts the value stored in illiquid assets (e.g., expensive art, classic cars, houses, etc.) into a token which can be transacted more easily on the blockchain (Dale).
While similar in their end results, the securitization process has some notable flaws. Firstly, the securitization process itself is extremely costly and time consuming; on average, it takes six months to a year and costs between $500,000 and several million dollars to complete. This is due to the fact that the securitization process requires a detailed audit of both the asset pool and the various party agreements under conditions of asymmetric information (Ho). Additionally, “the lack of full transparency in the various stages of securitization hinders accurate risk assessment and enables fraud (for example, issuing concurrent mortgages on the same asset, or the inclusion of non-existent assets").
Tokenization offers several advantages over securitization, one of which is the creation of market depth. Fiat currency can only be broken down to two decimal places (i.e., $0.00); most tokens can be broken down to 18 decimal places. By allowing for fractional ownership, the barrier for entry into the market is lowered and, thus, the realization of an asset’s true monetary value is more likely to be reached without the need for an illiquidity discount. Another advantage comes in terms of programmability. Tokenization allows for business logic to be coded into the tokens themselves via smart contracts. This allows tokenized transactions to self-execute based upon the predefined contract criteria which further increases the speed of settlements. Furthermore, blockchain technology is immutable: The ownership history of tokenized assets is recorded and publicly available via the blockchain. This helps to eliminate fraud as ownership of tokenized assets cannot be falsified (Ho). To illustrate an example of how this can occur:
|In Monterey, California in 2018, a Ferrari 250 GTO sold at auction for $48,400,000, shattering the record for most valuable car sold at auction at the time. It was able to achieve such value after a carefully planned auction was put together and global market hype was created by Sotheby’s Auction House over several months. The problem with owning this car is that, while it has immense inherent value, very few people are able afford to purchase a 250 GTO on short notice. In an emergency situation, selling the car wouldn’t be possible unless there was a massive illiquidity discount. If the 250 GTO were to be tokenized, instead of one buyer, ownership could be divided up between, say, 100,000 investors which would lower the barrier for entry and make the car easier to transact (sell) without incurring an illiquidity discount (The Power of Increasing Liquidity). Immutability would serve to assure interested buyers of the car’s authenticity while also tracking ownership history as programmability would assist with increasing the speed of the settlement process itself (i.e., documentation of the transfer of partial ownership of the GTO before partial ownership is actually transferred over).|
The tokenization of illiquid pre-IPO stock would ensure that the seller actually owns stock in the private company as well as facilitate the tracking of trading activity in the market. It would also give small investors an opportunity to access private equity at earlier stages of growth. “By using a blockchain token model, secondary marketplaces can enable users to more easily trade assets and enhance the liquidity of their investments. A token model can also minimize transaction costs and can remove geographical constraints by handling processes through blockchain and the internet.”
What this all translates to is greater market efficiency and liquidity as tokenization would allow for easier market entry and faster transactions without the need for brokers all the while helping to decrease the risk of fraud. As a result, financing structures may adapt accordingly, becoming much more innovative and token centric. Going one step further, tokenizing IPOs themselves may one day allow companies to “raise capital in the public market without the bureaucracy and maturity requirements of an IPO.” (Scheichenost).
Tokenization, however, is still in its infancy and faces many obstacles before mainstream adoption. While many individuals have capabilities to create tokens, tokenization itself is more encompassing than that; it is the creation of a whole ecosystem which takes into account various issues and standards. Another crucial obstacle tokenization faces is “regulatory uncertainty, since the legal framework in most jurisdictions is not yet prepared for transactions that use blockchain. There are no commonly used technical standards for trading platforms that operate with tokens.” (Popov) Regulated markets -- where exchanges would come into play -- would be capable of mitigating the inherent risks and reducing the volatility associated with tokens. In order to be classified as an exchange, a crypto platform would either have to register with the SEC as a regulated national securities exchange or as an Alternative Trading System (ATS). Under the ATS regulation, platforms would need to register as broker-dealers as well as file an initial operation report (i.e. an ATS form) with the SEC to disclose that they would be trading tokenized assets (Nead). Of the current platforms in the crypto space, none have registered with the SEC to become nationally regulated exchanges and only one, Coinbase, is ATS-certified. While Coinbase is ATS-certified, it received its broker-dealer status through the Financial Industry Regulatory Authority (FINRA)-approved acquisition of Keystone Capital in 2018. So though it may be certified to trade securities under the ATS regulation, it hasn’t received SEC approval to trade tokenized assets (Coinbase Says It Never Needed SEC Approval to List Security Tokens). True ATS acceptance from the SEC and FINRA is needed to create a viable secondary market to exchange tokenized securities in the U.S.
Additionally, crypto platforms themselves are not without their own issues. As evidenced by Coincheck, Bitfinex, Mt. Gox, and Zaif, crypto exchanges are hackable, which means that as immutable a blockchain ledger may be, the technology itself is not infallible. Additionally, there are issues with the listings themselves as the act of tokenizing assets and listing them for sale does not merely create liquidity; there has to be a supporting user base of individuals who want to trade the tokenized assets. Furthermore, there are issues with fraudulent market activity and data. For instance, in the crypto landscape, there have been several instances where whales back “project[s] just to keep the price up, buying the crypto [asset] whenever the price falls. Other times, clever actors will push up the volume of trades or even generate fake trading data by trading between multiple accounts. This fraudulent activity is known as phantom trading and can give the appearance of liquidity when in fact the activity is held up by a house of cards.” (Lawrence) As previously noted, there is a sizable cost directly attributed to the IPO process. This cost, while creating a higher standard for entry, also ensures market safety and stability for the market securities themselves. If crypto tokens were able to adopt similar market protections, a similar level of stability may be attainable in the future (Lawrence).
In the past, startups worked towards an IPO and used it as a means to grow. Now, IPOs are viewed as a means to achieve profitability. With the advent of the secondary market, founders and employees found a means to profit from their startup equity prior to the IPO events. Yet, the pre-IPO market is not without its pitfalls and inefficiencies. Blockchain technology and tokenization may possess the means to add security and stability as well as enhance the liquidity of this secondary market. However, at this point in time, blockchain technology and tokenization systems are still early in their lifecycles and evidence has yet to be presented to substantiate their theorized efficiency gains and cost savings.
Alternative Trading System ("ATS") List. Fenruary 2020. <https://www.sec.gov/foia/docs/atslist.htm>.
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Coinbase Says It Never Needed SEC Approval to List Security Tokens. 19 07 2018. TheNextWeb.com. <https://thenextweb.com/hardfork/2018/07/19/coinbase-sec-cryptocurrency-securities/>.
Dale, Oliver. What is Tokenization? Democratizing Ownership & Real-World Assets on the Blockchain. 31 07 2018. BLOCKONOMI. <https://blockonomi.com/tokenization-blockchain/>.
Hawk, Rand. Secondary Pre-IPO Markets. 22 01 2020. IPOhub. <https://www.ipohub.org/secondary-pre-ipo-markets/>.
Ho, Albert. How does tokenization work, anyway? 20f 10 2019. freeCodeCamp.org. <https://www.freecodecamp.org/news/how-does-tokenization-work-anyway-afb5fed1ac47/#ccc3>.
Lawrence, Tiana. Does Tokenization Equal Liquidity? Tackling a Commonly Used Dichotomy. 06 02 2020. Coin Central. <https://coincentral.com/does-tokenization-equal-liquidity/>.
Nead, Nate. Alternative Trading Systems and Crypto. 2018. InvetmentBank.com. <https://investmentbank.com/ats-crypto/>.
Popov, Artem. Tokenization: Use Cases Of Blockchain In Finance. 26 November 2019. <https://www.forbes.com/sites/theyec/2019/11/26/tokenization-use-cases-of-blockchain-in-finance/#319c82694c83>.
Scheichenost, Max-F. Cheers to IPO 2.0: Next Generation IPO - Tokenization of Equity. 26 August 2018. <https://entrepreneurship7.com/2018/08/26/cheers-to-ipo-2-0-next-generation-ipo-tokenization-of-equity/>.
The Power of Increasing Liquidity. 17 01 2019. The Tokenizer. <https://thetokenizer.io/2019/01/17/why-increased-liquidity-means-increased-asset-value/>.
The Rise of the pre-IPO Secondary Market. 28 April 2019. <https://thelephant.io/the-rise-of-the-pre-ipo-secondary-market/>.
 Smart Contract: a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution, and transactions are trackable and irreversible.
 Alternative Trading System (ATS): An ATS is a trading system that meets the definition of “exchange” under federal securities laws but is not required to register as a national securities exchange if the ATS operates under the exemption provided under Exchange Act Rule 3a1-1(a). To operate under this exemption, an ATS must comply with the requirements set forth in Rules 300-303 of Regulation ATS.
 On August 02, 2019, the Hong Kong-based Bitfinex exchange reported that it suffered a security breach which resulted in 119,756 bitcoin being stolen, equating to roughly $65 million at the time of the hack.
 On February 28, 2014, the Tokyo, Japan-based Mt. Gox filed for bankruptcy. Discovered through a leaked document, it was revealed that the exchange had 744,408 bitcoins stolen equaling $460 million at the time of the hack.
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