One of the most hyped innovations to come out of the crypto space in 2018 was the security token. In the midst of a crashing utility token market caused by overinflated valuations, regulatory issues and (of course) a lack of utility, security tokens emerged with the promise of being a safer, more regulatory compliant and practical investment option.
What Is a Security Token?
Security tokens are investment contracts that represent legal ownership (as recognized by the SEC) of a physical or digital asset such as artwork, real estate, or exchange-traded funds that have been registered and verified on the blockchain.
Using smart contracts, investors can exchange fiat money or cryptocurrencies for security tokens. Security token holders can trade their tokens for other assets, place them as collateral for a loan, or easily transfer ownership to other investors.
Security tokens have attracted so much attention because of their potential to change how we define asset ownership. Assets that have been exclusively owned by wealthy investors can now be made more accessible for everyday people all over the world to invest and profit from.
According to the Wall Street Journal, “At least $2.4 trillion was raised privately in the U. S. last year,” which was $300 billion more than was raised in the public markets. This shows that business funding is coming from private channels, which makes security tokens a perfect tool for both businesses and private investors to leverage.
Company equity, rewards, art, gold, or even personal brands, can be tokenized and sold as securities on the blockchain, making the possibilities for security tokens virtually unlimited.
Investor Accreditation Laws Dampen Optimism
Despite the optimism around this innovation, recent reports from Techcrunch have shown that early results in 2019 have not been very positive for the security token offerings market. The primary reasons have been the fact that many private placement investors still view digital tokens as a technological, regulatory and market risk. The market suffers from the classic chicken and egg problem, where a lack of liquidity is keeping investors away from spending their capital, yet more investors are needed for liquidity to be generated.
The root cause of this liquidity problem has to do with the issue of investor accreditation, and how these old rules restrict the majority of retail investors from investment opportunities, which in turn prevents higher caliber businesses from raising capital via security token offerings.
What Does it Mean to Be Accredited?
One only needs to have access to a digital wallet and an Internet connection to invest in cryptocurrencies and utility tokens. However, when it comes to security tokens, U.S. investors must be certified.
In the United States, accredited investors are defined as those who have a net worth of at least $1,000,000, or have earned an income of at least $200,000 each year for the previous two years. This demographic of investor is granted access to more complex and higher-risk investments such as venture capital, hedge funds, and angel investments.
The criteria for accreditation is based on the assumption that only people with significant amounts of money should be afforded the right to make risky investments, presumably because they can afford to lose the money they invested, and because they are more educated and experienced when it comes to making investment decisions.
This flawed logic is supported by the idea that regulators are protecting the average investor. However, evidence proves the contrary.
High Risk, High Reward
Most investors understand that getting into a stock or cryptocurrency at an early stage is a high risk, high reward decision. If one bet on the right asset when it is cheap, then an investor can make significant gains once the market starts to realize its value and late investors pour in.
The problem with classifying accreditation based on wealth alone is that regulators limit access to the earliest and most potentially profitable investment opportunities only to those who are already wealthy. Only once the value of an investment has risen substantially does it become available to the regular investors.
This means that any gains these regular investors can hope to achieve are much smaller, yet the risk is almost the same, as early investors begin to sell their positions at a profit once later investors buy in. In the end, the rich continue to get richer, while the average to less fortunate investors have little chance of ever catching up.
In the long term, the current investor accreditation rules not only limit the viability of the security token market, but they also perpetuate a cycle of favoritism towards the rich that only helps to expand wealth inequality.
Educated Everyday Investors
The most concerning component about today’s accredited investor rules is that they do not account for how most of today’s investors become knowledgeable about the markets. The Internet provides all kinds of investors with an unprecedented ability to improve their knowledge of financial markets and make smart investing decisions regardless of how much wealth they currently have in their bank accounts.
This reality is even more pronounced in the crypto space, where Twitter and YouTube are primary sources of information. With millennials representing a significant demographic of crypto investors, tech-savvy traders are freely sharing ideas on Twitter, YouTube or Telegram. Thousands of people from online communities help each other identify the best opportunities in the market, while also absorbing information about how to become a smarter, more sophisticated investor.
Therefore it only makes sense that investor accreditation should be judged by the experience and knowledge of the investor, as opposed to how much wealth they have at the moment.
Investment Experience and Market Competence
A preferred method to determine whether investors are accredited would be an evaluation of their knowledge of the markets and their investment experience.
If investors are currently using trading accounts, they could submit their portfolios to show how long they have been investing and how diverse their portfolio is. They could also be required to take a simple test that evaluates their knowledge of whatever markets in which are interested in investing.
Both of these criteria allow anyone to accumulate the experience and knowledge necessary to become accredited. This stands in contrast to the current rules for investor accreditation, as earning a net worth of $1,000,000, or an annual income of $200,000 is far less achievable for the majority of the population (ironically, most people would only ever be capable of achieving such wealth through access to better investing opportunities).
Democratizing Capital Gains
Security tokens generated lots of hype in 2018 because of their potential to provide limitless investment opportunities for everyone in the world regardless of income level or connections.
According to The Washington Post, the single biggest driver of wealth inequality is capital gains. The more money someone has, the easier it is to generate greater wealth through investments.
By requiring security token investors to be accredited (based on the current criteria for accreditation), regulators are ensuring that the playing field for rewarding investment opportunities remains uneven and that the problem of wealth inequality only continues to grow.
Security tokens are technology’s answer to decades of limited fundraising channels for non-traditional businesses, and limited opportunities for the retail market.
Basing investor accreditation on experience and market knowledge would allow regulators to protect retail investors, while lowering the barriers to entry for millions of people to rapidly elevate their socio-economic status through better investment opportunities, ultimately decreasing the rate of wealth inequality in the U.S. and around the world.