By Ellis Ng

Blockchain technology has emerged as a transformative force in the digital economy, with cryptocurrencies like Bitcoin and Ethereum becoming household names. The past few years have also seen cryptocurrency bubbles burst into a crash, yet many survive and get stronger.

In mid-November, the value of Bitcoin reached record highs of around US$92,000 as part of the latest rally in cryptocurrencies and growing mainstream adoption. The rise comes as major trading platforms report millions of new users and the crypto market value hit a record US$3.2 trillion valuation, though the sector remains volatile and unpredictable.

“Blockchains came to the world as a novel technology and rapidly attracted an industry built around it,” says Li Tianyi, Assistant Professor at the Department of Decisions, Operations and Technology of the Chinese University of Hong Kong (CUHK) Business School. “Emerging technologies hold promises while often undergoing hype cycles of their utility.”

In a recent study titled Development trajectory of blockchain platforms: The role of multirole, Professor Li and the Wei Lun Professor of Business Artificial Intelligence at the same department, Michael Zhang, revealed how blockchain has enabled participants to act simultaneously as users, investors and labours, which engenders complex dynamics of the system that have influenced platform development.

Professor Li and Professor Zhang’s research analysed over 100 blockchain token price series and developed a novel model to explain platform development patterns. It suggested that the success of platforms is dependent on how well these roles of platform participants are balanced, with different roles dominating at different stages of platform development.

The research found that blockchain platforms demonstrate a three-phase development trajectory, characterised by the relative dominance of participants’ different roles. By studying the price data of platform tokens, the researchers created an effective parametric model that could be used to predict and explain how platforms grow.

Their model outperforms traditional scaling models in predicting network growth and is extended to analyse “forking”, those events in which blockchain platforms branch into competing versions. The creation of Bitcoin Cash in 2017 from a hard fork of Bitcoin, as well as Ethereum Classic and Ethereum from a 2016 hard fork, are prominent examples.

Professor Li and Professor Zhang’s findings suggest that the timing of a fork matters more than the size of the split. Counterintuitively, these splits can help the original platform by increasing its visibility in the market.

Moving from chaos to stability

The study shows that the initial phase of a blockchain platform begins with a small, dedicated community of labourers, which refers to participants who contribute to a blockchain ecosystem by performing various digital work, including supporting the blockchain’s operation, maintenance, and development. The second phase marks rapid growth driven by investment activities. A mature blockchain platform will then settle into stable market cycles.

“Blockchains came to the world as a novel technology and rapidly attracted an industry built around it. Emerging technologies hold promises while often undergoing hype cycles of their utility.”

Professor Li Tianyi

“In this trajectory, the beginning stage of the platform is characterised by intense labouring activities within a small participant group, the intermediate stage is characterised by increasing investment activities that rapidly boost the platform’s population base, and the mature stage is characterised by recurrent market oscillations between a high and a low participation mode,” says Professor Li.

Early participants are attracted by high labour rewards. For instance, blockchain miners receive block rewards for successfully mining new blocks, and the increasing value of the platform’s native tokens gains significant returns, among others. However, these rewards often decline quickly as more people enter the network. The platform then enters a stable, predictable development, with user numbers rising and falling in cycles that affect its value and use.

This phase will often set the foundation for later growth to the next phase, as investment takes centre stage. When a platform grows, it creates price differences that traders can profit from, making investment opportunities more attractive and turning many investors into active participants.

User numbers grow in waves, hitting new highs with each cycle, and the increased visibility draws in even more participants who find practical uses for the platform. Eventually, when joining offers fewer benefits, user growth slows down and stops. Rather than reaching higher peaks, user numbers rise and fall in stable patterns.

The study also found that two factors—the time delay in quitting the platform and the holding time of platform tokens—were particularly crucial in differentiating successful platforms from failing ones. A larger time delay indicated higher trust in the platform and higher switching costs, leading to more user “stickiness”, the research noted. Meanwhile, the longer an investor holds a token, the lower its price volatility or transaction velocity, which translates to more investment stability.

Engagement is king

Platforms need to effectively engage all three participation roles — users, who utilise the platform’s services, investors, who create the financial landscape, and labourers, who maintain the network — to achieve sustainable growth, the researchers suggested.

In the early stage, labourers — like miners or validators – are crucial in building the foundation. During the growth phase, investors drive rapid expansion, with regular users keeping the platform stable as it matures.

The research also showed that platforms supporting all three roles were resilient and showed better development trajectories than those focused on fewer roles. When one role becomes less active, others can help maintain a platform momentum.

“We hope that this study can bring some utility to different stakeholders interested in blockchains,” says Professor Li. One concrete application of this model could be in decision-support simulations to assist blockchain entrepreneurs with platform design and early-warning detection. The model can also aid in strategic investment analysis and regulatory policymaking, according to Professor Li and Professor Zhangy.

As blockchain technology continues to evolve and new platforms emerge, Professor Li hopes these findings will help stakeholders better understand and manage platform development.

“This model provides a ground for analysing the profitability of participants’ activities on tokenised platforms, [meaning] platforms with blockchain implementation, through their token investment and crypto labouring,” Professor Li says. Furthermore, he and Professor Zhang plan to extend the model to discuss the earnings on the platform and people’s strategic participation that maximises the earnings.

The post Critical paths to sustain blockchain growth first appeared on China Business Knowledge.

By Pete Sabine

Decentralised finance, or DeFi, emerged more than a decade ago alongside the rapid growth of cryptocurrencies as alternative investments. With no central authority, DeFi disrupts traditional financial systems and is a conduit for innovation. At the core of its disruptive power lie smart contracts on self-executing blockchains.

Similar to other financial products, DeFi is not immune to theft, which is caused by programming errors and incomplete contracts. In April 2023, for example, blockchain-based lending protocol 0VIX lost approximately US$2 million after hackers exploited technical faults to manipulate its token prices. To mitigate this risk, smart contract audits became popular.

Unlike standard financial audits for public firms, smart contract audits focus on the integrity and completeness of a piece of computer code as opposed to financial statements. A new study by Janja Brendel, Assistant Professor of the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School, found that the smart contract audit market is thriving.

The study titled Decentralised finance (DeFi) asssurance: Early evidence, which was conducted in collaboration with Professor Thomas Bourveau at Columbia University and Professor Jordan Schoenfeld at the University of Utah, provides valuable insights into the smart contract audit market and the role of auditors in ensuring the security and reliability of DeFi ecosystems.

“We provide some of the first evidence showing that these audits are pervasive, with the audit firm market composed of new technical audit firms. The scope of these audits can span a variety of contract features, and the audit inputs and outputs differ substantively from those of conventional financial audits,” says Professor Brendel. “The market reacts positively to the release of these audit reports, suggesting that these reports are value-relevant.”

DeFi making deft inroads

For this seminal study, Professor Brendel and the team gathered a comprehensive sample of smart contract reports from January 2017 to the end of June 2023 from a smart contract scanner, De.Fi. The data showed that new blockchain assurance services have become a force to reckon with in the market in the past few years, as can be seen in the table. The “full sample” consists of 8,531 unique audit reports that delve into specific details. The “market sample” comprises 303 audit-venture events focusing on each DeFi project.

The audit market for smart contracts is composed of many new entrants. TechRate, the largest audit firm established in 2017, accounts for around 20 percent of the market share, followed by InterFi, founded in 2021, with more than 11 per cent and Certik, which was set up in 2018, with six per cent.

In terms of cost, the audit fee mostly depends on the length and complexity of the code. Audit firms with more expertise and experience can also charge more. TechRate and InterFi are widely considered to be low-cost, charging from US$250 and US$300 respectively, for a standard audit. As a comparison, Quantstamp, OpenZeppelin, and Trail of Bits label their services from US$5,000, and Hacken starts its fee at US$9,000.

These prices are justified for various reasons. The largest audit firms have conducted audits for more than thousands of projects with household names in the crypto world. Top-quality audit firms are found to provide more detailed reports, comprising team size, methods used, and days spent on the audit. These firms are also more likely to deploy audit teams of five or fewer, use a combination of manual and automatic processes about 88 per cent of the time, and conduct longer audits, as measured in days.

While these audits can identify vulnerabilities, programming errors, and deviations, audit firms do not provide a guarantee against data breaches, thefts, and hacks. Many smart contract audit firms even put legal disclaimers in their reports and advise clients to obtain third-party opinions, leaving some space for insurance to grow. For instance, Certik introduced a plan in 2023 to compensate its clients for any hack-related losses incurred after one of its audits, up to US$2 million.

“Smart contract audit reports are used by DeFi service providers primarily to build trust with existing and prospective users of and investors in their services.”

Professor Brendel Janja

Users can look at several factors to assess how good an audit firm’s reputation is. This includes checking portfolios and tracking records. If they have worked on large and high-profile projects that have not been compromised, it is a sign of reliability. Those seeking a smart contract audit should look at the firm’s previous projects with specific blockchains, as they may be more relevant to the project they are currently pursuing. The smart contract audit firm’s previous reports can also be examined for their level of detail or comprehensiveness.

Keeping on the right track

“Smart contracts play an increasingly important role in structuring and executing common DeFi financial transactions, such as loans and venture capital funding, with more than US$200 billion now locked in such contracts,” Professor Brendel explains. “Smart contract audit reports are used by DeFi service providers primarily to build trust with existing and prospective users of and investors in their services.”

Such assurance is important, perhaps due to its decentralised nature, which means smart contract audits are not mandated by legislation. Besides, blockchain projects have a chequered history, so it is inevitable that investors need reassurance that the security protocols are up to scratch and that the underlying code works. This allows investors to assess the overall trustworthiness of blockchain projects while mitigating the risks that cause loss of income and irreversible damage.

Smart contracts that are audited are often audited again when there is a significant update to the contract, not periodically every fiscal year like financial audits. There is no formal education or certification required to be an auditor, and the audits also do not need to follow a universal standard or guideline, which means that the audit process and output can differ significantly based on the auditors’ approach and methodologies in ways that financial auditors typically cannot.

In general, smart contract auditors normally apply automated bug detection software to scan smart contracts for potential vulnerabilities, then augment the procedures with line-by-line manual code review to ensure a thorough assessment. Furthermore, stress testing is also conducted to emulate different attacks that could threaten the system.

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Blockchain and crypto companies can decide whether to release the audit result after weighing the costs and benefits. However, the release of a smart contract audit report is found to result in a positive and statistically significant market-adjusted return of about a 10 per cent increase within the two days after the release. This is consistent with the longstanding proposition in accounting that audits serve as a mechanism to reduce information asymmetry and improve the functioning of capital markets.

With the proliferation of DeFi, assurance services within these new fields are becoming crucial to all fields of business for a number of reasons. Auditing is essential for adding credibility to information that is disclosed, which in turn helps increase trust with users and investors and ultimately helps to raise the number of transactions.

The post A deep look into burgeoning blockchain audit first appeared on China Business Knowledge.

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

Amid the predominantly controversial news surrounding cryptocurrency and peer-to-peer (P2P) lending in the past few years, many still believe that technology will redefine the financial landscape. As concerns regarding volatility, security, and illicit activities have dominated the headlines, regulators are actively considering new laws to safeguard the public interest.

Financial technology, or fintech in general, is expected to experience significant growth in the coming years, with cryptocurrency and P2P platforms potentially gaining more reach among unbanked or underbanked populations. Therefore, gaining insight into the dynamic relationship between the two is crucial for uncovering opportunities for businesses and individuals.

To investigate these effects in-depth, a new study examined how the rise of cryptocurrency markets has influenced the makeup and behaviour of borrowers and investors in P2P lending. The results suggest that active cryptocurrency markets bring economic gains to the P2P lending market. The transfer of funds from P2P lending to cryptocurrency markets, particularly by highly creditworthy and tech-savvy investors, also provokes increased inequality in access to P2P lending markets.

“Contrary to their original intent and purpose, technology-enabled fintech markets may penalise, rather than benefit, many people and firms who are at a disadvantage in accessing financial resources,” says Kim Keongtae, Associate Professor in the Department of Decisions, Operations and Technology at The Chinese University of Hong Kong (CUHK) Business School.

“Understanding the interdependence of fintech platforms is important to assess the implications of their expansion and sustainability.”

Crypto and P2P lending interactions

In the research paper, Interdependence between online peer-to-peer lending and cryptocurrency markets and its effects on financial inclusion, Professor Kim along with Professor Chung Sunghun of George Washington University and in collaboration with Professor Oh Wonseok and Professor Lee Chul Ho of the Korea Advanced Institute of Science and Technology, shows that growth in cryptocurrency markets is associated with increased loan requests and larger loan amounts in P2P markets.

The researchers matched data from California-based peer-to-peer lending platform, Prosper, with aggregate data from a price-tracking website for crypto assets, CoinMarketCap, from January 2017 to February 2019. They also investigated positive and negative market shocks in cryptocurrency markets that affect borrowers’ incentives for using P2P lending markets.

The positive shocks were Goldman Sachs’ announcement on 2 May 2018 to open a Bitcoin trading operation and the International Monetary Fund’s statement on 2 October 2017 that cryptocurrency could be the future, which led to sudden and huge increases in Bitcoin prices. Two negative shocks occurred on 13 September 2017, when JPMorgan’s CEO warned that Bitcoin is a fraud, and on 15 January 2018, when China escalated cracking down on cryptocurrency.

During the sample period, the researchers found that high-creditworthy borrowers increased their demands in bullish markets, while low-creditworthy borrowers changed insignificantly. This influx came mostly from borrowers with good credit ratings and high-skilled occupations seeking loans related to cryptocurrency.

“High-creditworthy and tech-savvy borrowers increased their demands in P2P lending when the cryptocurrency market was in a good situation.”

Professor Kim Keongtae

The researchers then examined whether credit rating and occupation affected borrower responses to positive shocks and found that high-creditworthy borrowers largely drove increases in loan amounts. High-creditworthy borrowers increased the requested amount of loans by about US$930 after the positive shock from Goldman Sachs, which corresponds to 7.01 per cent of the average loan amount during the 10-day window.

In contrast, low-creditworthy borrowers generally responded negatively to positive shocks. This implies that growth in the cryptocurrency market induced high-creditworthy borrowers to use P2P borrowing more aggressively. The increase was more positive for borrowers in occupations like investors, computer programmers, executives, professionals, and analysts, who are likely to have more familiarity with and have better access to the cryptocurrency market.

“High-creditworthy and tech-savvy borrowers increased their demands for P2P lending when the cryptocurrency market was in a good situation,” says Professor Kim. “In contrast, low-creditworthy and low-skilled borrowers showed the opposite behaviours, although statistically weaker.”

Identifying the main opportunistic actors

Additional analyses showed that in the following week after the positive shocks, the borrowing and the daily unique number on the P2P lending platform increased, implying that hot cryptocurrency markets attract new borrowers. Economically, for a per cent increase in the market capitalisation of the cryptocurrency market, a daily listing amount on the P2P lending market increases on average by 0.12 per cent.

After breaking down the type of borrowers, the analyses showed that hot cryptocurrency markets are more positively associated with high-credit and tech-savvy borrowers, but had no significant association with low-credit borrowers. “High-credit and tech-savvy borrowers were more responsive to hot cryptocurrency markets,” says Professor Kim.

Given their advantageous condition traditionally in terms of access to credit, high-credit and tech-savvy borrowers are more likely to apply for loans through P2P lending to seize new investment opportunities.

In terms of risk, the study found that better cryptocurrency market conditions are associated with lower default rates and lower interest rates in the P2P lending market. On average, a per cent increase in capitalisation of the cryptocurrency market is associated with a 0.003 per cent decrease in borrower interest rates and a 3.03 per cent decrease in default rates, indicating that as the cryptocurrency market became hot, this led to lower default rates and borrower interest rates at the market level. “This result should not be surprising because hot cryptocurrency markets attracted proportionally more high-credit borrowers,” says Professor Kim.

Consideration for fintech platforms

Overall, the research findings suggest that hot cryptocurrency markets motivate creditworthy and tech-savvy borrowers to borrow more actively and in large amounts. This further implies that financially disadvantaged borrowers have difficulty accessing fintech markets, thereby diminishing financial inclusion, at least in the short run.

“Despite the possible short-term gains derived from the influx of additional loan requests from high-quality borrowers, the increased inequality in access to fintech platforms originating from service to certain groups may hurt the long-term sustainability of P2P lending,” says Professor Kim.

As creditworthy and tech-savvy investors are more inclined to use P2P lending to invest in cryptocurrency, the study suggests that fintech strategies should focus on protecting the investors while ensuring financial inclusion. On the other hand, policymakers should consider the potential impact of cryptocurrency markets on P2P lending and financial inclusion when developing regulations related to fintech.

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This double-edged sword of fintech platforms should be approached with caution, especially for individuals with limited credit scores and technological proficiency, to maintain sustainable practices. For instance, policymakers can offer relevant technological training to individuals and businesses with poor credit ratings and limited technological understanding to bolster financial inclusion.

From an individual standpoint, people need to embrace rapidly evolving financial technologies and actively seek potential opportunities within fintech platforms while possessing a comprehensive understanding of these modern technologies.

The post Can crypto spring reshape social lending? first appeared on China Business Knowledge.

By Jaymee Ng, Principal Writer, China Business Knowledge@CUHK

The rapid development of financial technology, also known as FinTech, in recent years has transformed how people use financial services. On the one hand, the increasing use of automation in banking services has brought with it greater convenience for consumers. On the flip side, the advent of new technological developments such as cryptocurrency, high frequency and algorithmic trading, the rise of the digital wallet or peer-to-peer (P2P) lending, are all examples of FinTech that have brought new challenges to traditional financial service providers to some extent. Given the disruptive influence of FinTech, it was only natural that a group of researchers sought to closely examine its effects on the stability of traditional financial institutions. What they found was that the result very much depended on the market.

The stability of financial institutions usually refers to the ability of these institutions, such as banks, brokerage firms or credit unions, in performing their roles in financial transactions or other intermediation functions without assistance from external forces such as the government. The promise behind FinTech is that it would help financial institutions to enhance transparency, efficiency and make its services more convenient for users. For example, mobile banking has allowed consumers to conduct their daily financial activities, such as transferring funds or paying bills, without the need to talk to a teller or visit a bank branch.

“Regulators should give up on the idea of a one-size-fits-all regulation for FinTech.”

Prof. Jason Yeh

On the downside, Fintech could amplify volatility in financial markets and make the financial system more vulnerable. For instance, the speed and ease of moving cash between banks in response to financial market performance enabled by FinTech can increase volatility. The heavy reliance on third-party service providers for the FinTech activities could also pose a systemic risk to financial institutions. Finally, online lending platforms often fail to conduct effective credit checks on borrowers, which can lead to higher default risk.

For example, China’s P2P lending industry, once the world’s biggest, has completely collapsed in just a few years. Many Chinese P2P lending platforms were plagued by fraud, defaults and even alleged Ponzi schemes, which eventually led to a government crackdown. The Deputy Governor at People’s Bank of China Chen Yulu announced in January that it had eliminated all P2P lending platforms in the country, however more than 800 billion Chinese yuan in debt is still left unpaid, state media Xinhua News reported.

More recently, two of China’s homegrown fintech champions, Ant Group and Tencent, are coming under intense regulatory scrutiny by domestic regulators over business models that some worry will lead to a dangerous accumulation of systemic financial risk.

Yin Versus Yang

“Where there is light there must also be shadow,” says Jason Yeh, Associate Professor in the Department of Finance at The Chinese University of Hong Kong (CUHK) Business School, and one of the authors of a new study. “Given the disruptive nature of technology, the rise of FinTech is bound to have an impact on traditional financial institutions. So it’s kind of fitting that we find that the bright and dark sides of FinTech seem to offset each other and the promotion of FinTech doesn’t necessarily make financial institutions more vulnerable.”

Titled Friend or Foe: The Divergent Effects of FinTech on Financial Stability, the study was co-conducted by Prof. Yeh with Profs. Derrick Fung, Wing Yan Lee and Fei Lung Yuen at The Hang Seng University of Hong Kong.

To examine the impact of the rise of FinTech on the stability of financial institutions, the researchers looked at the introduction of FinTech regulatory sandboxes. A FinTech regulatory sandbox is a way for a financial regulator to allow companies to try out new business models, products or services (under a controlled and supervised environment) that are not covered or permitted by existing legislation. The first such sandbox was introduced in the U.K. in 2016. Since then, 73 similar initiatives have been set up in 57 countries around the world, according to the World Bank.

The team sampled all listed banks worldwide that were active on the Thomson Reuters Datastream platform between 2010 and 2017. Their final sample included 1,375 banks from 84 countries. Using a common measurement of bank stability, the research team found that the introduction of sandboxes did not have a statistically significant impact on the financial stability of the institutions in the same jurisdiction.

They found that the positive and negative effects of these FinTech sandboxes on financial stability tended to offset each other after discounting for the characteristics of individual firms or markets, or macroeconomic and other bank-specific factors. In general, they also found that FinTech increases the stability of financial institutions in emerging financial markets and decreases it in developed financial markets.

Boosting Stability and Profits

Looking at specific market characteristics, the study also found that the promotion of FinTech through the setting up of regulatory financial sandboxes can at the very least enhance the stability of financial institutions if the market has low financial inclusion, with

• A bank branch ratio of less than 11.7 per 100,000 adults;
• A central bank assets to GDP ratio of less than 1.6 percent;
• An industry-wide bank net interest margin of less than 2.4 percent, or
• A provisions to nonperforming loans ratio of less than 44.2 percent.

On the other hand, the launch of financial sandboxes in markets with high financial inclusion can undermine financial stability, the study found.

Moreover, Prof. Yeh says that FinTech can also improve the stability of financial institutions by boosting profitability. According to the study, when a country has fewer bank branches than 11.4 branches per 100,000 people, a central bank assets to GDP ratio of less than 1.7 percent, bank net interest margin of less than 2.2 percent, or a provisions to nonperforming loans ratio of less than 45.6 percent, promoting FinTech by setting up regulatory sandboxes can increase the profitability of financial institutions.

But why does FinTech enhance the profitability of financial institutions in emerging financial markets? The authors speculated this may be due to three reasons. First of all, FinTech has been widely adopted in emerging financial markets and has greatly increased the profitability of the banks that invested in these FinTech start-ups. Second, the operational efficiency of the banks in emerging financial markets improved as a result of collaboration with technology companies. Third, the products provided by FinTech companies are often complementary to the existing services provided by banks. These banks gain more customers as a result, and the complementary effect is greater in emerging financial markets.

“FinTech is disruptive but it is also a force for emancipation. Not only has it democratised the access to financial services for the masses in emerging markets, but it also plays a pivotal role on the road to greater financial inclusion,” Prof. Yeh says.

Policy Implications

As the FinTech industry continues to grow, policy makers and financial institutions are seeking ways to reap the benefits of technology further. Prof. Yeh and his co-authors think that their research findings can help policy makers and regulators to better utilise FinTech in different markets.

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For developed financial markets, the researchers advise regulators to focus on implementing measures that can address the instability caused by FinTech. In contrast, regulators in emerging financial markets should consider designing specific measures to promote FinTech innovations.

“Regulators should give up on the idea of a one-size-fits-all regulation for FinTech,” Prof. Yeh comments. “What they need is to come up with a tailor-made framework that matches the characteristics of their own financial markets.”

The post Fintech: Friend or Foe to Financial Stability? first appeared on China Business Knowledge.

By Mabel Sieh, Managing Editor, China Business Knowledge @ CUHK

After the collapse of bitcoin prices in 2018, the crypto world has quickly adapted and turned to securities token offerings (STOs) from initial coin offerings (ICOs). The reason lies in the differences between the two digital offering, according to Chew Seen-meng, Associate Professor of Practice in Finance from the Department of Finance at The Chinese University of Hong Kong (CUHK) Business School.

“In ICOs, investors are offered ‘utility tokens’. While these ‘utility tokens’ don’t represent any equity interest on the coin issuer, they can be used to exchange for products or services offered by the underlying company,” says Prof. Chew who serves as an Honorary Research Advisor for FinFabrik, a Hong Kong-based financial technology solutions provider that specializes in capital markets.

“In STOs, on the other hand, investors receive ‘security tokens’ similar to stocks or shares in a way that they represent the equity stake of the underlying company and offer investors voting rights and dividends – features that are absent in ICOs. These ‘security tokens’ make use of blockchain technology to digitally record investors’ ownership of assets (e.g., gold or real estate) or economic rights (e.g., a share of profits or revenue),” he adds.

How do security tokens differ from the traditional shares offered in an IPO, as shares are already represented digitally and traded electronically?

“The key difference lies in the fungibility of digital tokens,” says Prof. Chew.

“With traditional shares, one would have to first sell company A’s shares for cash, then use the cash to purchase company B’s shares. In the case of security tokens, there is no need to involve flat currencies, since tokens from company A can be used directly to exchange tokens from company B. This has allowed investors to trade in a more direct and effective manner,” he says.

STO Regulations

These securities-like features of tokens offered via STOs are subject to regulations laid out by the Securities Exchange Commission (SEC) in the United States. Specifically, according to the Securities Act of 1933, only accredited investors can participate in them, as Prof. Chew explains.

“In Singapore, the Monetary Authority of Singapore (MAS) issued “A Guide to Digital Token Offerings” in November 2018 to urge token issuers to comply with MAS regulations if the tokens are classified as securities,” he says.

As for Hong Kong, the Securities and Futures Commission (SFC) issued a statement in March 2019, highlighting that tokens issued in STOs are likely to be securities, and thus subject to the securities laws of Hong Kong. “The statement also outlines some warnings of the potential risks involved in virtual assets,” he adds.

Prof. Chew believes that all these regulations towards digital tokens are good for the market and investors.

“This is a positive development because the regulatory shield covering STOs will make them safer for investors, as issuing firms will need to pass several due diligence requirements set by regulators before launching their offerings,” says Prof. Chew. “In addition, the regulation will ensure that STOs are offered to accredited investors who have higher capacity for taking investment risks – unlike ICOs which can be marketed to almost anyone.”

A clear regulatory guidance will also lay the groundwork for securities advisory firms to provide underwriting services to companies that intend to raise funds through STOs.

“In time, this could help expand the use of STOs as a fundraising mechanism, develop tokens as a new asset class and increase the user adoption of digital tokens,” says Prof. Chew.

Implication to Startups

According to Prof. Chew, in order to satisfy regulatory requirements, it is likely that startup companies would only raise funds through STOs at a more mature stage – when their products are proven to be commercially viable and have begun to generate stable streams of revenues.

“ICOs are similar to angel funding in that they are typically issued at the early stage of a startup facing a higher chance of failure. STOs, on the other hand, will come in at a much later stage – probably around the same time when the company is ready to launch an IPO (in the traditional market). Thus, STOs should theoretically have a lower probability of failure, and less likely to cause investment losses, as compared to ICOs.”

Currently, the total cost of a single IPO issuance in Hong Kong is above HK$25 million, and the entire process typically takes six to nine months to complete.

“While it is not immediately clear that the cost and duration of STO is much lower (due to a lack of reference examples and case studies), the automation of some mundane due diligence and know-your-client (KYC) steps through smart contracts should theoretically help to make it more efficient.  Moreover, the digital record of transaction details on the blockchain system could facilitate transparent monitoring of the security tokens in the future,” he says.

“We need more success stories of STOs launch with investors receiving dividends and making good returns in their investments. These precedents will encourage more firms to raise funds through STOs, more people to invest in them, and more trading of the tokens, thus creating a virtuous cycle.”

Prof. Chew Seen-meng

Future of STOs

In 2018, the total amount raised through STOs was around US$ 380 million and the amount continues to increase. “An example of STO is tZero issued by Overstock, which raised US$ 134 million. Overstock is the first major online retailer in the U.S. accepting bitcoin as payment for its goods,” says Prof. Chew who believes these numbers are still small compared to some major IPOs where the amounts raised are easily in the billions. “It is still early to say whether this new type of digital fundraising market can fully take off in the coming years,” he says.

Whether STOs will be the ‘next big thing’ remains unknown but Prof. Chew believes their future adoption depends on two key issues.

The first issue concerns valuation and pricing. “How should traditional financial models be used or adapted to price tokens issued in an STO? This is an easier problem to manage if fiat currencies are used to acquire tokens. However, if cryptocurrencies are used instead, the pricing of tokens becomes tricky since the values of cryptocurrencies are very volatile and arbitrary,” says Prof. Chew.

The second issue pertains to the liquidity of tokens, which is still low.

“Until tokens become widely adopted and a sizeable market is developed for them, the trading and hence the liquidity of tokens will be highly limited. Without a critical mass, it is hard for security tokens to be recognized as a credible asset class,” he says.

“We need more success stories of STOs launch with investors receiving dividends and making good returns in their investments,” says Prof. Chew. “These precedents will encourage more firms to raise funds through STOs, more people to invest in them, and more trading of the tokens, thus creating a virtuous cycle.”

Like any type of investments, investors of STOs are exposed to risks, Prof. Chew warns potential investors.

“There is no guarantee that STOs will generate higher returns than IPOs. It is the responsibility of the investors to conduct proper due diligence and to fully understand the issuer’s business and industry before they invest in anything,” he says.

The post Securities Token Offerings: The Next Big Thing? first appeared on China Business Knowledge.