Will there be adults in the room when tokens disrupt the financial order of venture capitalists and angel investors?
- Blockchain firms from the US and Hong Kong are launching ‘tokenised’ venture capital funds, promising better liquidity and quicker returns for investors
After regulatory action against issuers of initial coin offerings (ICO) seriously dampened investor enthusiasm this year, some blockchain evangelists are gearing up for another offshoot of start-up fundraising, which they believe could even disrupt the traditional venture capital model – security tokens.
Start-ups working on various blockchain projects have in recent years been raising funds through ICOs – mainly bitcoin and ethereum – and in exchange issue investors with utility tokens that give them access to their application or service. But a number of fines imposed by the US Securities and Exchange Commission this year on ICO issuers – including one in which the regulator imposed a lifetime ban on two executives involved in a fraudulent ICO project – has flagged the potential legal pitfalls that could undermine an ICO.
Worse still, a recent study by the consultants EY in October found that 71 per cent of the 141 ICO projects launched in 2017 failed to bring any working products to the market.
But proponents of securities token, such as Ciarán Hynes, managing partner of Boston-based venture capital firm Cosimo Ventures, are gearing up to launch a “tokenised” venture capital fund, initially targeting US$20 million – some of it from Asian investors.
“Blockchain is disrupting and turning venture capital model on its head,” said Hynes. “The liquidity options from a security token venture fund is more attractive than what has been available under the traditional venture capital fund.”
Different from a traditional venture capital fund, Hynes said its security token fund, Cosimo X, will issue security tokens, each representing a US$1 par value in the fund, for investors to subscribe using bitcoin and ether, or US dollars and euros. The Cosimo X fund will be listed on securities token exchanges.
Cosimo Ventures will use the proceeds raised to invest in four to five tech start-ups seeking Pre-series A round financing. Besides blockchain, Cosimo will also invest in those specialising in internet of things, augmented reality and cybersecurity tech.
Hynes said he expects sufficient liquidity in the tokens as they would be listed. Once listed, investors would be free to trade their security tokens if they see that the net asset value of the token appreciates. Additionally, once a portfolio company makes an exit, Cosimo Ventures will allocate up to 50 per cent of the proceeds to investors, while reinvesting the other half back into the fund for making new investments.
The fund will be open-ended, meaning that the manager will continuously issue new security tokens to meet additional demand from investors.
Hynes said he expects the fund would appeal to investors focusing on short term returns and those who want to cash in on their investments readily. It would appeal to high net worth individuals or family office investors, rather than financial institutions such as an endowment or pension funds that are used to the long holding period of this asset class that ranges from eight to 10 years.
“With the popularity of crowdfunding platforms in recent years, which allow investors to pick and choose their own companies and investment horizons, we see a change in mentality among investors. They want to make better return earlier,” said Hynes.
Cosimo Ventures is finalising a partnership arrangement with a licensed manager in Hong Kong to help with the fundraising and distribution.
Listing private equity or venture capital funds is not new. Some industry players estimate that there are close to 100 such funds trading on traditional exchanges globally, although secondary market liquidity has been focused on just about a fifth.
Due to lack of trading interest, it is not uncommon to see many of these listed funds trading at a discount to their net asset value (NAV). A fund’s NAV is the sum of all its assets minus liabilities, and then divided by the number of all outstanding shares.
It therefore remains to be seen what mechanism the manager of these security token funds have in place to address issues like lack of trading interest, or tokens trading at a discount to NAV.
In Hong Kong, Jehan Chu, managing partner of blockchain focused investor Kenetic Capital, which is also gearing up to launch a security token fund in partnership with asset manager Venture Smart Asia early next year, sees them as being able to untangle the “barnacles that have been weighing down the ship of capital market progress”.
He said security tokens can be the future foundation of capital markets as we evolve past “programmable money”, that is bitcoin, into an era of “programmable assets”.
“Imagine a future where your equity not only has increased liquidity, but increased intelligence powered by AI, machine learning, IoT, and more – that’s the true potential of security tokens,” he said.
The Cayman-domiciled Kenetic Opportunities Fund, whose initial size he refused to disclose, will also be an open-ended fund that will invest in both security tokens or related infrastructure, as well as utility tokens that are already trading on crypto-exchanges.
Chu said the fund will targets investment in up to 40 such tokens.
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However, the performance of utility tokens post-ICO has been poor. According to the EY study, nearly 86 per cent of the 141 ICOs surveyed were trading below their listing price in 2018 and 30 per cent have lost substantial value. EY also found high risk of fraud and theft by start-ups seeking funds via ICOs.
“We will help these listed ICO start-ups manage their finances, apply best practices to ensure that they have healthy cash flows,” said Chu.
As utility tokens in an ICO do not confer equity ownership to their holders, this is one reason why many venture capital firms have not invested in ICOs as this goes against their ethos of owning a minority stake in a start-up, and also having a say to shape the business operations.
While Kenetic Capital does not operate as a venture capital manager, Chu described the fund’s investment approach as taking a “venture capital approach” akin to hedge fund-like, stock-picking strategy. Given the poor performance of some of ICO tokens after their listing, Chu said the fund will seek to pick undervalued tokens that are not trading at the right venue and include them in its portfolio for potential price upside.
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In Hong Kong, the Securities and Futures Commission (SFC) in November launched a regulatory sandbox to explore whether to regulate and license cryptocurrency asset trading platforms and exchanges. It will accept eligible exchange and platform operators into the sandbox to jointly explore proposed regulatory requirements in addressing risks and provide investor protection.
Currently cryptocurrency exchanges in Hong Kong, which trade bitcoin, bitcoin cash and ethereum, are not regulated.
The SFC has said they do not fall under its definition of “securities” or “futures contracts”. But this might change if the SFC decides at the end of the sandbox to regulate and license these platforms.
The SFC said in its framework document that if an operator is interested in being licensed by the SFC, it should offer the trading of “at least one or more virtual assets which fall under the definition of ‘securities’ on its platform”, as only then would the platform operator fall within SFC’s jurisdiction and grant it a licence for “regulated activities”.
But industry players say they are unclear if in the future a licensed platform operator or exchange could indeed list and trade a security token in Hong Kong.
In both Hong Kong and US, regulators have said that many digital tokens offered in an ICOs may qualify as “securities”, which would then entail the issuers to be licensed or register their tokens as such with the regulators. But it remains unclear how many security token offerings have been successfully filed and registered in both jurisdictions.
Kevin Loo, co-founder of cryptocurrency fund manager CryptAM, said so far his firm’s funds have not invested in any ICOs or securities tokens. Going forward, if the regulatory environment proves to be favourable for security tokens, he might consider including them.
“While we welcome the introduction of security tokens in the future, bringing further innovation to the fintech scene, we are mindful that the road ahead for regulatory approval for security token offerings is likely some way off into 2019,” said Loo.