Jesus Rodriguez is Chief Scientist and Managing Partner at Invector Labs. In a recent article, he outlined a major barrier for the institutional adoption of security tokens: information asymmetry. We can overcome this obstacle, he says, through a decentralized mechanism that ensures information disclosure.
How Information Disclosure Impacts Security Tokens
According to Rodriguez, information disclosure is a foundational building block which the next phase of security token development requires.
In fact, he says that the lack of information disclosure “is arguably the biggest roadblock in the evolution of crypto-securities and one that can make the difference between an efficient or an inefficient market”.
Stephen McKeon, Professor of Finance at the University of Oregon, talks about the ‘disclosure marketplace’ as the aspect of security tokens which should result in the transparency of public material information related to a security token.
Yet it goes even further, says Rodriguez.
“If we don’t have access to relevant information about a crypto-security, how can we know whether we are paying a fair price for it or not?”
Utility tokens feature a price dictated by two primary factors: the general utility of the token and trading momentum. Yet with security tokens, price is typically ruled by information about the tokenized asset. Unreliable or inaccurate information produce the phenomenon of information asymmetry: situations where one entity involved in a trade has certain information that no other entities know or are aware of.
Rodriguez went on to highlight the negative potential that information asymmetry could bring to security tokens:
“Markets in which asymmetric information prevail are conducive to bad behaviors such as insider trading or market manipulation in which a small subset of the population with a disproportional access to information take advantage of retail investors. Furthermore, together with exchanges/liquidity pools and liquidity protocols, disclosure is one of the key pillars that will influence the price of crypto-securities.”
The concept of disclosure seems simple, but when it comes to a decentralized system, simplicity isn’t the first word that comes to mind.
A Potential Solution: How a Decentralized EDGAR could Help Security Tokens
In 1984, the SEC developed a program to counter the problem of information asymmetry. The program is called the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). Its primary purpose entails the collecting of information related to public securities investments.
EDGAR is a centralized program— it functions under the oversight and ultimate control of the SEC. The rule of law, along with its stringent penalties and costly fines, is how EDGAR incentivizes companies to maintain information honesty.
Rodriguez has proposed the need for a decentralized EDGAR: a ‘DEDGAR’.
With the current state of security tokens, all disclosures are processed through token issuance platforms in a centralized format. The structure has an inherent risk, says Rodriguez. It requires all users to trust that the token issuance platform properly validated and verified the depth and accuracy of information provided by the token issuing entity— a nearly impossible task.
With security tokens however, come an important feature: programmability. This new feature can allow for decentralized mechanisms and tools to trustlessly provide information to all entities of a security token market.
According to Rodriguez, there are three relevant parties which can be utilized to ensure proper information disclosure throughout the lifecycle of a security token: publishers (including token issuers), consumers (token holders, exchanges, etc.), and validators.
Following this three-party scheme, Rodriguez says an effective disclosure protocol can be established for security tokens.
“The security token smart contract itself will include mechanics for publishing and validating disclosure documents. Exchanges, security token issuance platforms and other entities can act as validators of that information. The disclosure dynamics can be seen as an extension of tokenization protocols such as Securitize’s DS Protocol and, maybe, there is an opportunity for even tokenizing those interactions to incorporate the right incentives.”
The image below illustrates Rodriguez’s scheme.
Rodriguez is undoubtedly correct to assert both the early-stage yet quickly developing status of the security token industry. With recent SEC activity targeting ICOs and the regulatory ambiguous ‘utility token’, some companies are already diverting from ICOs and turning to Security Token Offerings (STOs) as a viable alternative.
Yet before the STO takes full flight, Rodriguez is firm that an effective solution for information disclosure must be established:
“In a nascent market such as security tokens, disclosures are one of the elements required to legitimize the space in the eyes of large investors. I feel that the nature and importance of disclosures will challenge some of the centralized models in the current generation of security token platforms. Hopefully some of the ideas in this article will help to imagine a better path.”
What do you think of Jesus Rodriguez’s remarks on the need for information disclosure with security tokens? Do you agree that a decentralized mechanism is the most effective route? Let us know what you think in the comments below.
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