The term security token has been appearing more frequently in various crypto-channels. Influential members of the crypto-community promote security tokens as the final step in “tokenizing the world.” Investors are taking notice as they pump millions of dollars into projects that support the sale and exchange of security tokens.

The amount of interest is understandable considering the size of the market security tokens is targeting. Security tokens aim to tokenize the ownership of all assets, whether they are public & private equities, real estate, or precious metals. For context, the global commercial real estate market alone is worth ~$4T.

Where are the points of entry for Security Tokens?

To understand the growing interest in security tokens we explore the issues with traditional securities markets.

• Intermediaries & Fees: In traditional securities markets there are a complex web of intermediaries. For issuers to get their shares into the hands of investors, they must go through investment bankers, brokers, transfer agents, and clearinghouses. These intermediaries often charge high fees for their services. According to PwC, on average, companies planning to public pay underwriters more than $4.2M to complete an IPO.
• Centralization: It is a misconception that investors truly own their shares. What is actually true is the shares held by an investor represent an entitlement to the shares held by their broker. Those shares then represent an entitlement to the shares held by Cede & Co. which is a subsidiary of DTCC. DTCC is a securities clearinghouse that processes the vast majority of global securities transactions. In 2015 globally, DTCC processed $1.6 quadrillion worth of securities transactions, making it the highest financial value processor in the world. (To comprehend this number, it’s approximately 20 times the sum of the world’s GDP figures, making “Gross World Product a bit under $80T.) This centralization places the global liquidity market at risk. If DTCC’s servers go down or get hacked, it could quite literally bring securities markets to a halt.
• Illiquidity Discount: Because of their structure, there are many assets in the market that are illiquid — they are not easy to buy or sell like a share in Amazon. Real estate, private equity, collectibles, et al. fall into that group. Because of their illiquidity, these assets often are discounted — selling for less than actual worth. Some researchers estimate that illiquid assets, on average, receive a 20–25% discount on their value.

So how do security tokens solve these issues?

Making it possible to buy and sell interest in these illiquid assets and positive things should happen not only to their value, but also to access. Let’s break down how:

• Intermediaries & Fees → Limited Intermediaries & Limited Fees: Instead of requiring multiple different intermediaries to issue, transfer, and settle assets, security tokens add simplicity into the markets. With tokens, issuers offer shares directly to investors on a blockchain. All activity typically done by intermediaries in the traditional system can, in theory, be replaced by a blockchain. Issuance, transactions, and settlement can be performed by miners and nodes of a blockchain, limiting the need for additional intermediaries¹.
• Centralization → Decentralization: Instead of a single institution controlling shares and settling transactions, security tokens are built on blockchains operated by distributed miners and nodes (servers). If a miner or node cease operating, the blockchain will continue to run as usual. The lack of centralization makes the settlement and transfer of securities more reliable. No more risk of a catastrophic failure at DTCC.
• Illiquidity Discount → Liquidity Premium: Because security tokens enable the tokenization of any asset. Illiquid assets can benefit from increased liquidity. For real estate, property owners can tokenize shares of their building and issue it to multiple investors. (Today, this can be done only by incurring the complexity of building limited partnerships or real-estate investment trusts (REITs). Instead of a property owned by a single entity, there can be multiple entities owning fractional shares of a real estate property. The ability to distribute small amount of shares — down to fractions of a percent — increases the potential number of members in the liquidity pool . Your average investor may not be able to afford to invest $100M in “Property A,” but they could likely afford to buy “Property A Token” that represents one-millionth of a right to the property for $100. With an increase in potential investors, assets will increase their liquidity, and in turn, benefit from a liquidity premium.

What are the barriers to entry?

While tokenizing the world sounds like next big step for the crypto-ecosystem, there are many disadvantages and risk in the near term for security tokens.

• Regulation: Security tokens are by definition securities and are regulated under the same laws as traditional securities. As such, regulations can severely limit the advantages of security tokens. One example: Security regulations that apply to one country may not apply to another. If an issuer issues security tokens in Country A, regulators in Country B may restrict investors from investing in these tokens — thus limiting the liquidity.
• Ownership rights: There is a reason why our current system is centralized. Centralization enables efficiency. The majority of issued securities in traditional markets are registered instruments, that is, ownership of the security is recorded. When Person A transfers their registered shares to Person B, the change in ownership is also recorded. On the other hand, security tokens are quasi-bearer instruments, where token ownership is recorded on the blockchain but not necessarily property ownership. In this case, the ownership of an asset would logically belong to the owner of a token. Following this logic, if a hacker steals a property token, does the hacker now own the right to that property? If not, how do you enforce the right to the property? Do you go full circle and have an intermediary record asset ownership transfers? (There are ways to revoke and reissue tokens to handle thefts and hacking, but these also add complexity at nearly every point in the process.)

Securities laws and markets are extremely byzantine. For security tokens, too, there are many unanswered items because we have yet to see the application of them at scale. These tokens can quite literally change how the current financial system operates, or they could as just as easily be another footnote in the new edition of a business textbook.

¹ This argument is a lot more complex. Just because you removed the intermediaries does not mean you remove the need for their services. Removing intermediaries means the issuer will often take on the job of intermediaries.

While members of the crypto community continue to recite the phrase “not your keys, not your bitcoin,” realistically the general population will need custody solutions. In fact, legally, institutional investors are required to secure their clients’ assets with qualified custodians.

Part of the beauty of bitcoin is that it gives you the option of securing your own money. Those that want to become monetary sovereign individuals have that choice. Those that don’t will also have that choice. Of course, in a perfect world of sovereign individuals, everyone would properly secure their own money. In the real world, however, humans aren’t very good at securing their money.

It is understandable that experienced members of the crypto community do not want to risk their wealth by trusting a third party. There are obvious concerns when letting a third party manage your private keys. When you give another entity full control over your private keys, your wealth is dependent on their trustworthiness. Who is to say Coinbase’s security team will not conspire to steal your private keys? Nevertheless, as Bitcoin adoption continues to scale, one can’t assume that every novice investor could adequately manage their private keys.

In the short term, custodial services offered by companies like Coinbase and Xapo will be crucial for newcomers. Many are not yet comfortable managing their own money yet wish to explore bitcoin and cryptocurrencies. In the long term, as these new folks educate themselves on the importance of private key control, we will see a shift to semi-custodial services offered by the likes of Casa and self-custody via hardware wallets.

All in all, custodial services are a net positive for the community. It will take time to educate all users on the importance of private key management, and custodial services are a good compromise until we get there.

It is hard, however, to blame entrepreneurs in this space. When your competitors are raising, via ICOs, what amounts to Series D rounds for back-of-a-napkin products you can’t help but to take a seat on that same rocket ship. Ultimately, ICOs have done a disservice to entrepreneurs: ICO wealth has blinded many who now believe that successful dApps need native tokens. This is not true.

Tokenless dApps like OpenBazaar and Mastodon have succeeded not because have they raised millions of dollar through ICOs (they haven’t) but because they are building products in spaces where needs are unmet. Additionally, instead of making their dApps challenging to use — by incorporating “tokenomics” wherever possible — these dApps prioritize easy-to-use interfaces and the frictionless onboarding of users. If you force users to use your native tokens to access your dApps, in hopes of creating utility for your token, users are not going to use your products.

In the last 24 hours, OpenBazaar added 373 new nodes onto its platform. This number, alone, is enough to place OpenBazaar as the 5th most actively used dApp — assuming each node represents a new user. To clarify, this is the number of new nodes that OpenBazaar has added and not the total number of OpenBazaar nodes — which is approximately 75K. Just think, a dApp without a native token has added more users in a day than the daily-active-users for a majority of dApps with native tokens.

Now the point is not that dApps do not need native tokens (though they really don’t). It is to show entrepreneurs that they can build successful dApps without them. Just take a look at Mastodon: The founder did not seek funding or launch a native token. Instead, he built a great product that people needed and has 1.5 million users. That’s more rewarding than a token no one wants — or needs.

As often as members in the crypto-community tout “decentralization,” there is still one truth: centralized cryptocurrency exchanges are kingmakers in this ecosystem.

Centralized crypto-exchanges hold tremendous power, choosing to be the picks and shovels in a space where everyone is looking for gold (or fools gold). And with this choice, they are generously rewarded. Recent estimates show that centralized crypto-exchanges generate millions of dollars in revenue through exchange trading fees. Furthermore, these exchanges often change ICO project listing fees that can reach $1M per token.

Unsurprisingly, the control of these exchanges has stimulated the development of decentralized alternatives in the form of decentralized exchanges (DEX). In fact, there are close to 250 projects attempting to build DEXs.

Where are the points of entry for DEXs?

To understand the rise in the development of DEXs we must examine the core issues with centralized exchanges.

• Central points of failure: One of the most serious issues with centralized exchanges is custody risk. When investors trade on centralized exchanges, they give over full control of their funds. The accumulation of funds on centralized exchanges turn them into honeypots for hackers. Just this year, one of the largest cryptocurrency exchange hacks led to investors losing $533M. In 2018 alone, investors lost over $800M to cryptocurrency exchange hacks. When investors use centralized exchanges, they have to trust a third party to secure and protect their funds.
• Censorship: Centralized exchanges can censor their users. That comes in various forms: preventing users from withdrawing or depositing funds or directly banning them for using the platform. Additionally, because centralized exchanges are inherently easier to target, governments can ban exchanges from operating in their country — as shown by China’s 2017 exchange ban.
• High Fees: As we’ve mentioned prior, because of the power imbalance between exchanges and users/projects, centralized exchange often leverages their power to charge obscene fees. Trading fees on some exchanges can go as high as 1.49% (Coinbase) while listing fees can reach as high as $2.6M (Binance).
• KYC: Many major countries require financial institutions (cryptocurrency exchanges included) to follow Know Your Customer (KYC) rules for verifying their users. For exchange users, these rules are a no-go for privacy-conscious investors. Furthermore, KYC rules also prevent some 1.1N people — mostly in developing countries — that do not have official identity documents from accessing exchanges.

With the problems facing centralized exchanges, how do DEXs solve them?

• Central points of failure → Decentralized network: Unlike centralized exchanges where a single party manages trades, DEXs facilitate trades through peer-to-peer networks. And because DEXs run on a decentralized network of servers, there are no single points of attacks from hackers.
• Censorship → Uncensorable: Unlike centralized exchanges where private keys are managed by the exchanges, on DEXs users have full control over their private keys and how their funds are used, secured, and transferred. DEXs, by their very nature, can prevent users from accessing their platform. Moreover, because no single entity has control over DEXs, DEXs cannot be pressured by regulators and governments to shut down or censor specific trades.
• High Fees → Lower fees¹: Because they typically lack large operation cost (hiring customer service agents, lawyers, C-suite executives, etc.) DEXs often charge negligible fees or in some cases offer fee-less trades. Trades on DEXs often happen through smart contract executions, and traders only pay transaction fees for miners of a blockchain.
• KYC → No KYC: Because DEXs are not single entities it is difficult for regulators to require KYC verification processes. As such, currently, DEXs do not require users to go through a KYC verification process to begin trading.

What are the barriers to entry?

While many entrepreneurs are building DEXs, early stats show that is still a lack of activity on these exchanges. According to DappRadar, over a span of 24 hours, the top 5 DEXs on Ethereum processed ~6,877.54ETH in volume — roughly $1.9M. In comparison, the 24-hour trading volume of centralized exchanges is over $2.9B. In other words, the top five DEX’s have 0.0641% the trading volume that the top five centralized exchanges have.

There can be a number of reasons for this lack of use:

• Functionality: Compared to centralized exchanges, DEXs have limited features. For example, DEXs rarely have different order types (stop losses, limit orders, etc.). Additionally, the user-experience of DEXs are often unfriendly for the average user.
• Speed: By their very nature blockchains are slow databases. This leads to slow trades (transactions) on DEXs as all transactions have to be processed by miners on the blockchain.
• Lack of liquidity: Exchanges are marketplaces, and marketplaces need network effects to operate. Because DEXs are relatively new to the cryptocurrency exchange space they fall into the chicken and egg problem — traders join highly liquid exchanges but for exchanges to be liquid they need traders to join.

While, like many projects in the crypto-space, it is too early to judge the success of DEXs, Coinbase’s acquisition of Paradex and Binance’s development of a DEX show that there is increasing interest in this sector.

*¹ Fees are complex as they typically depend on the structure of DEXs. For example, users of the 0x protocol can, in theory, make free trades but often pay Relayers for the convenience of speedy trade executions. Additionally, miner fees can fluctuate greatly depending on the traffic on a blockchain.

We’ve all seen this before. The Chinese government has shown that it is not a fan of bitcoin or blockchain — precisely because these technologies often nullify the government’s censorship attempts. It was one of the first major countries to ban ICOs and cryptocurrency exchanges, and now it is in the process of removing crypto-related media businesses.

This move is exactly why blockchain is vital. A fully decentralized system enables people to share information without the fear of censorship. When everything lives on one platform, whether it is WeChat or Facebook, the platform controls what information people see. When one platform controls the flow of information, it becomes a honeypot for regulators looking to censor content. We need alternatives: The growth of decentralized content-sharing platforms like Mastodon proves that people are actively seeking for them. For information to truly flow free, the path it travels through must be unobstructed.

At The Block, we believe that everyone should get access to the very best tools to aid their research. Whether you are an investor, journalist, or a crypto enthusiast you should be spending less time looking for tools and more time using them.

To encourage people to do their own research we are opening up our ToolBlock. The ToolBlock is a list of resources/tools we have found valuable in our research process and think you might find valuable, too. It is by no means a complete list of every resource out there in the cryptosphere, but it is a start.

We hope with this list we can inspire a new generation of DYOResearchers. I am excited to see what people can write about and build when they have access to the tools they need.

Link to The ToolBlock:
https://docs.google.com/spreadsheets/d/1YcGKIrltangKlOqcZOhVSTq1jXqEoT8meHxFhq-I9aE/edit?usp=sharing

Opening up our ToolBlock was originally published in The Block on Medium, where people are continuing the conversation by highlighting and responding to this story.

The three largest ICOs in Q3 of 2017 were: Filecoin, Tezos, and Bancor. In total, these projects raised $647m in funding. But a year after their ICOs, these projects have been underwhelming. Let’s take a look.

Filecoin ($262m raised in ICO): Filecoin (a project of Protocol Labs) is built as an incentive mechanism for storing and transferring files on IPFS, the impressively named InterPlanetary File System. Currently, users on IPFS “pin”, or store & serve, files to their computers or centralized cloud servers. Filecoin was created to incentivize the decentralized storage of files on IPFS. However, while projects are building on IPFS, a marketplace for file storage has yet to be seen. This lack of a marketplace is because Filecoin, in its current state, cannot be used on IPFS. And while Protocol Labs has been scouting for early users and miners for Filecoin, the current IPFS network still lacks an incentive mechanism for decentralizing file storage.

Tezos ($232m raised in ICO): Tezos is a decentralized application and smart contracts platform built with on-chain governance. Disputes between executives significantly delayed the project. The Tezos’ management team managed to resolve the disputes in early 2018. Recently, Tezos launched its Betanet enabling transaction to be processed and validated. The project also announced plans for a mainnet launch in Q3 of 2018.

Bancor ($153m raised in ICO): Bancor is a decentralized cryptocurrency exchange and liquidity provider. The project is live on the Ethereum blockchain and has 128 daily active users. From June 2017 to September 2018 Bancor processed ~303k ETH transactions on its network and is now in the process of enabling cross-chain transactions.

While it may be harsh to judge blockchain projects a year after they have launched, the limited progress in their development may explain why we are currently in a bear market. ICO projects opened up to much fanfare in 2017, with each new project promising seamlessly unachievable goals. This euphoria, boosted by the unending media coverage, pushed the price of many of the native tokens of these projects beyond what they could realistically command. When investors finally realize that most projects aren’t shipping actual products, the bears took hold and did not let go.

This note was originally distributed via our newsletter Rad.Crypto. Sign up here! The following analysis is part of our upcoming research on Credit Reporting and Financial Service Providers.

The 2008 financial crisis effectively destroyed consumer confidence in financial service providers. Despite the U.S.’s economic bounce back, consumer confidence remains low and is actually dropping. A 2016 study by NARPP showed that 8% of consumers trust financial service providers — down from 13% in 2015. Also in 2016, Gallup reported that 27% of Americans had confidence in banks. To put it simply, a majority of consumers do not trust financial service providers.

It’s no surprise as to why consumers distrust financial service providers. Their primary role is to protect the data and financial assets of their customers. Yet, many fail to do just that. Take the credit reporting industry. In 2017, hackers stole the consumer credit data of close to 145 million consumers from Equifax — that’s over half the number of U.S. citizens over the age of 18.

As with many industries, disappointment and displeasure breed innovation. What came out of the 2008 financial crisis was Bitcoin. What followed Bitcoin was a Cambrian Explosion of decentralized networks, each seemingly a reaction to the failings of the old industry guards. When Equifax got hacked in 2017, Bloom — a decentralized credit scoring platform — entered the scene with consumers signing up to the platform in record numbers. Will decentralization be the answer to the financial industry’s woes? Has decentralization brought forth a financial revolution or will just it just become a tool that improves — rather than disrupts — the status quo? Let’s explore.

A financial revolution?

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” - Henry Ford

A typical consumer does not understand the inner workings of the centralized financial industry much less a decentralized one. In order to understand the benefits of decentralization, we must understand the issues of centralization. Specifically, we will focus on the credit reporting sector.

• Central Points of Failure: Central institutions are prone to hacks which could cause great personal harm. The Facebook-Cambridge Analytica data breach may not necessarily put any person’s livelihood at risk; however, the Equifax hack exposed the names, Social Security numbers, credit card numbers, and personal documents of more than half of all U.S. adults. One hack of one institution exposed the data for nearly 150 million — when the honeypot is filled with honey the hackers come out to eat.
• Censorship and Forced Engagement: Centralized financial service providers are gatekeepers. They can shut down the account of any individual just as easily as they opened it. This issue becomes glaringly obvious when taken to the extremes. China’s recent experiment with a national credit score shows the full force of how centralized institutions could financially censor consumers. Under its national credit score, Chinese citizens with low credit scores can be banned from getting jobs and are at risk of being denied housing loans.
• Opacity: Like many centralized and therefore “closed” industries, financial service providers tend to avoid transparency. Credit reporting agencies have a history of being opaque in their reporting process. Credit reporting agencies have lied to consumers about what credit scores are being sold and have made countless errors when creating reports. This process has left “tens of millions” of Americans without credit in addition to millions more with scores low enough to hinder them from access to financial services.
• Rent Collection: While the financial service industry is competitive, there are different branches of the industry, such as credit reporting, that are oligopolistic. An oligopoly gives credit reporting agencies close to full control over what they do with an individual’s data, disincentivizing them from providing value to consumers. In fact, because credit reporting agencies generate a majority of their revenue from selling a consumer’s data, they are not obligated to protect the data of consumers. If consumers attempt to limit access to their data from third-party providers by freezing their credit scores, they are forced by agencies to pay an annual fee.

How can decentralization help?

“It will take time for the idea of decentralized trust through computation to become a part of mainstream consciousness, and until then, the idea creates cognitive dissonance for those accustomed to centralized trust systems.” - Andreas Antonopoulos, author of Mastering Bitcoin and The Internet of Money

It’s obvious that centralized financial services have problems, but how do decentralized services solve them?

• Central Points of Failure → Distributed Nodes: Instead of centralizing a database of financial information and data, decentralized platforms have no single access point. A hacker can not target Bloom in search of data because there are no single points of entry. This is because data on Bloom is cryptographically secured across a decentralized network of servers.
• Censorship → Uncensorable: Open decentralized platforms are by their very nature uncensorable and open to adoption. On Bloom, anyone can join the platform despite a lack of financial history data. Bloom instead enables individuals to vouch on the creditworthiness of their peers by staking Bloom’s native crypto asset — letting people to put their money where their mouth is.
• Opacity → Transparency: In theory, decentralized platforms are developed in a way that provides full transparency into their inner workings. For example, Bloom, a decentralized credit reporting platform, has fully written out the formulas for calculating credit scores on its platform in its white paper. Transparent scoring in turn enables users to better manage and track their profiles, ensuring that no mistakes are made that could damage their credit.
• Rent Collection → Fee distribution: Decentralized platforms do not need to look after their bottom line because there are no for-profit entities that require revenue. Credit Reporters on Bloom, or “Attesters”, have to actively compete for the business of users on the platform. Attesters are “hired” by lenders on Bloom to evaluate the credit risk of borrowers. Because Attesters can be easily replaced if they perform poorly or charge too much, fees are kept at competitive rates that reflect the value of the service provided.

Are decentralized platforms really replacing centralized financial services?

Decentralization will not replace centralization overnight nor is it a sure bet to replace centralization. We’re already seeing the latter with two major platforms in the space. Both Bloom and OmiseGo — a decentralized banking platform — rely heavily on traditional financial partners to launch their platforms. In Bloom’s whitepaper, it states:

“Private companies like credit bureaus and governments currently hold the majority of identity data that exists in the world. These organizations play a critical role in helping onboard users onto the BloomID system by attesting to the authenticity of user-submitted data.”

Or take OmiseGo –its roadmap has shown that it is actively attempting to grow the OmiseGO network through “community engagement and… strategic partnerships with global finance players…”

With this reliance on the old gatekeepers to help jump-start decentralized networks, it makes one wonder if it is possible to completely detach ourselves from an industry as old as money itself.

When credit reporting meets decentralization — is it time for the people to take control of their… was originally published in Radicle on Medium, where people are continuing the conversation by highlighting and responding to this story.

Customer Development

Product development should be thought of as a spectrum, where you are starting out and trying to find a problem to address. You will need someone in tuned with the product-problem space, how the messaging can be framed with the customer, continue to refine the message, and prove the fact someone will pay money in exchange for the product. Often entrepreneurs ‘bake’ products that they think will solve a problem and then immediately hand the product over to VP of Sales who will try to sell to a market that will not be receptive. The notion of founder led selling is that the founder will bridge a gap, so you get to a point where you have a ‘bench-scaled’ repeatable sales process that can be handed to a sales professional to scale out.

Right Commercial Argument and Sales Messaging

The right commercial argument will articulate the pain of the customers, show them a solution, and explain the commercial value of using the product. The founder should continue to run iterations on this process after the first 10, 20, 30 customers, only then can you find someone who does this at the same level of efficacy you can. Customer development proposes to you the features you should build, the solution you should build, and your narrative will make the argument on behalf of the product to the market. In order to have recipients for this product they will need to have this pain that you are trying to solve.

Your Ideal Customer Profile

You really need to consider if your prospect has the pain point that you will solve and have them in such high intensity and quantity that they will care about your solution consistently and will be willing to pay you for this solution. You will need to see this pattern in your prospects and when you do, develop your ideal customer profile (ICP). You need to have discipline on the requirements to use your product. Startups from portfolio networks (accelerators) have problems with this because they are insulated from the feedback loop, which forestalls the moment where they will have a real talk with their customers. In TalentBin’s case their prospects need to have at least 5 open software engineering hires, as well as have in house recruiters to use their products. You need to cling to your ICP otherwise your users will not have success with the product which will hurt the “word of mouth” process, as the product will not meet their needs.

Prospect and Build List

After you have created your ICP, you will begin prospecting and building your list of future users. This list can come from customer development interviews; from which you will develop features for the diversity of problems of your prospects. Pete sees this process as ‘baton passing’, each prior step will inform the next step. If you did great customer development you will have a great prospect list from which you can engage prospects with the solutions that will fit their pains. If you did not do great customer development, then you need to identify, using sites such as Datanyze or Crunchbase, those who have pains and care about your solution to build your list.

Presentations That Leads to a Close

When presenting a demo, the goal at the beginning is to validate to pain. You can have a discovery call ahead of time to make sure you are not wasting time for both the prospect and yourself, they either have the problem or not. A demo is a manifestation of your commercial argument. You need to make sure that each feature exists because it solves a pain point discussed with your prospect. Tease out the problem to get prospect to explain how they deal with it. By forming a full commercial argument and making sure you and your prospects are lined up, you are setting yourself up for success. The best sales process is almost like a ‘therapy section’.

For more information check out the podcast with Pete.