During 2017 and the earlier part of 2018, the hype around Bitcoin and cryptocurrencies grew to epic proportions. Alongside this, a whole new breed of tech entrepreneurs entered the market, attracting vast investments into the hottest new means of crowdfunding a project – the Initial Coin Offering (ICO).
The main reason that ICOs fell afoul of regulators was the question of whether or not an ICO investor is buying a security. If they were deemed a security then they would entitle the investor the protection from buying a security. In addition to this, should they be classed as a security then this will inevitably restrict those who can issue one. In the US, the Howey Test determines whether or not a particular transaction is a security, by asking if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” If the answer is yes, then the sale is classed as a security and is subject to securities legislation.
STO stands for security token offering. It is a process similar to an ICO where an investor exchanges money for coins or tokens representing their investment. However, unlike ICOs, STO’s take it a step further and distribute tokens that fall under the status of securities. They are linked to an underlying investment asset in a way like stocks, bonds, real estate investment trusts (REIT) or other funds.
As such, security token offerings distribute securities. These are tokens that are fungible, negotiable financial instruments with attached monetary value, like a part of property or company.
Security tokens are not traded on regular token exchanges. Exchanges that want to offer security token trading need to fully comply with regulations, including extensive investigations into token listings, data sharing, and investor onboarding procedures. Thus, security tokens trade on specialized exchanges.
During the 2017-2018 ICO mania, many token issuers have sold investors bags of tokens without any economic rights, value or regard for existing securities laws.
Security token offerings are meant to be a regulatory compliant alternative to regular token sales. They aim to correct perceived inequalities on the investor side, such as granting security token holders rights to dividends or other predefined revenue streams.
STO tokens are beneficial to the issuers, too. There is no need to proclaim tokens as being without any intrinsic economic value, and they typically have clearly defined stakeholder obligations regarding the token distribution, issuance procedure, and secondary trades.
Other advantages that come with security tokens are:
Most importantly, security tokens and STOs allow companies to create a new set of stakeholders with novel permutations of debt, equity or contributor roles.
As such, security tokens are generally considered an improvement over ICOs. They address the fundamental flaws surrounding utility token sales and have the potential to improve traditional securities.
The STO is an attempt by founders to issue a token offering that remains compliant with legislation, depending on the specific geographies from which it is taking investment. This may mean registering the STO with local regulators as a securities offering.
In contrast with an ICO, an STO investor is assured that they are buying equity, debt, derivative, certificate of interest or a participation of any profit-sharing organisation. While this is no guarantee of profit by itself, it’s comparable to buying stock in a publicly traded company. If the project returns a profit, the investor has a legitimate claim on their share of those returns.
An STO isn’t necessarily just for a startup either. An already-established company could use an STO to issue digital tokens against existing equity instruments, for example, to raise funding for a new product or business line.
Whereas the secondary markets for ICO tokens are largely unregulated cryptocurrency exchanges, STO tokens are traded on fully regulated trading platforms. Security tokens are a very new concept, so many of these platforms are still yet to launch. Coinbase has already confirmed it will soon support security token trading. Switzerland’s SIX Stock Exchange is also building a fully regulated digital asset trading platform.
For a startup founder or company that wishes to launch an STO, then legal compliance is the most critical consideration. Of course, this assumes there’s already a clear business plan for adopting blockchain.
Firstly, consider from which jurisdictions you’ll be attracting investors. If you’re aiming for US investors, you’ll need to perform a regulatory filing with the SEC. For other jurisdictions, there may be different requirements. For this reason, it makes sense to take formal legal advice on the STO launch from each jurisdiction to remain compliant with regulators.
Following this, you will need to select the platform to run your STO, although there are a few out there that claim to provide for STO’s, at aelf we are showing clear direction and action towards becoming a platform that can support STOs, both physically and legally. There are a number of steps that can be taken to ensure projects running on the platform will be both secure and compliant with regulatory standards across multiple regions. This is being addressed both from a project view as well as an investor view.
Mistaking security tokens for tokenized securities is easy.
The critical difference between the two is that security tokens are newly issued securities that function on distributed ledger while tokenized securities are just token representations of already existing financial products. Basically, if you issued a new financial product with security features, it is a security token. If you take an existing asset and wrap it in a token, it is a tokenized security.
Despite a similar appearance and terminology, issuing security tokens has nothing to do with tokenized securities.
Given the regulatory challenges now faced by ICOs and the work being done to develop secure and compliant trading platforms for securities tokens, it’s inevitable that the STO is the future of token offerings. Although there is strong momentum now, it is yet unclear how relevant they will be in the near future. The blockchain industry is at an interesting stage right now, with further exciting developments and launches in the pipeline for 2019 and beyond.