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What are Security Token Offerings or STOs?

by | Nov 30, 2018

2017 was clearly the year of the ICOs. A big contributing factor to the 2017 crypto bubble, was the ICO gold rush. It pushed up prices of altcoins and the total market cap to unsustainable levels while everybody was dreaming of Lambos. After the bubble popped and regulators started to really put a pressure on ICO fundraising, ICOs went largely underground. With ever increasing crackdown via lawsuits and new regulations, ICOs are starting to fall out of favor. Coming to the next phase of crowdfunding in the crypto space are Security Token Offerings (STOs). While for the longest time projects were trying every trick in the book to have their ICO not be deemed a security, the new trend is for projects to explicitly become a security and comply with rules and regulations. So what are Security Tokens and what could be the future of these new digital assets?

Utility Token vs. Security Token

In order to avoid problems with regulators, projects tried to avoid having the characteristics of a security. This is why they all tried to be utility tokens, with the purpose of giving access to a product or service on a (future) platform or dApp. This is opposed to being a security token, which is a form of investment contract that gives equity in a company, pays out a profit share, and may even give voting rights for governance.

3 types of security tokens

Currently, there are 3 different types of security tokens:

  • ICOs that explicitly sell security tokens that have some form of profit sharing, dividends, or explicit expectation of price appreciation. These ICOs generally ban citizens of the US (and other countries, like China) to avoid scrutiny by the SEC. These tokens generally cannot be listed on the larger (or US based) exchanges and are therefore only available on decentralized or smaller/shadier exchanges.
  • ICOs that try to avoid being a security by claiming to be utility tokens, which the SEC still deems to be security tokens after all. After the SEC published the so-called DAO Report, which was the result of an investigation in the hacked DAO ICO, the SEC made it clear that it would apply the Howey Test on ICOs to determine if they are securities or not. ICOs that launched after the DAO report and had characteristics of securities were at risk of persecution by the SEC. The SEC later came with statements saying that practically all ICOs they looked into were in fact securities. Since not a single one had registered, it stands to reason that all of them would be regarded as illegal, unregistered securities. The reasoning of the SEC was that the utility token characterization doesn’t apply in those cases, because even if there is no equity ownership or profit sharing in the company, those utility tokens were still sold to investors in order to raise funds for a common enterprise, where results rely on the effort of others, and with the expectation of price appreciation. Those were 3 other characteristics from the Howey Test, that applied to the vast majority of “utility” tokens and are therefore now at risk of a crackdown by the SEC because of their illegal security classification. Even the founder of decentralized exchange EtherDelta, where many tokens are traded, already had to make a settlement with the SEC over this issue and other ICOs have had similar experiences. At least one project was able to make a stand against the SEC and was able to win their case in court to prevent being labeled as security (read the article here).
  • New STOs: Security Token Offerings where projects comply with security regulations and issue official security tokens. Where first projects did all they could to prevent being a security token, now you see more and more projects specifically seeking to become a security token. In some jurisdictions outside the US, it is already possible to be fully compliant with regulations and offer a security token. These compliant security tokens are of course not available to US citizens yet, but are to a broader international audience of investors.

Benefits of Security tokens:

  • More people can legally participate in crowdfunding. So far most ICO investing has been illegal and investors run the risk to lose their money because of it.
  • Less risk because of legal enforcement of token rights. Legal security tokens are regulatory compliant so the rights of token holders can be enforced by law (equity ownership). Also, usually there are more requirements for financial transparency, so investors are able to better monitor developments in a project.
  • Tokens often represent real world value. As opposed to most “utility” ICO tokens, the underlying value may be backed by real world assets, which means it becomes more practical to assess the true value of a token, rather than just a speculative perceived value.
  • Possibility for easier trading of unusual assets, like real estate, art, etc. These types of investments were not very accessible for most investors. Tokenization and fractional ownership makes them more liquid, which is also an advantage for owners of these types of assets, because they becomes easier to sell.
  • International access to markets due to the global nature of cryptocurrency exchanges and markets
  • 24/7 trading – cryptocurrencies can be traded 24/7 unlike traditional securities
  • Opens up access to global investor audience
  • Easier and less expensive fundraising
  • Less scams. The unregulated ICO wild west has been rampant of scams – an estimate of more than $5 billion has been lost to scams and failed projects. Some regulatory compliance might reduce this greatly, thus increasing investor confidence.

Future of STOs

Regulations in some other countries already facilitate the possibilities of issuing security tokens and allow them to be traded on exchanges. In many countries, regulations are more or less similar, so if a token is compliant in one of the stricter jurisdictions, usually they are deemed legal in other jurisdictions as well. And wherever their token is not compliant, such as the US, they will be excluded from that market. However, within the US, many different regulations already exist that tokens can comply with and that may be utilized more in the near future by token projects.

Crowdfunding regulations available in the US

  • Regulation D
    • Most regular for startup funding
    • SEC approval is not required
    • Only accredited investors can invest
    • No limitation on the capital that can be raised
    • It is allowed to solicit or advertise, but only to accredited investors.
    • Investors have a 12 month lockup period.
  • Regulation A+
    • Open to non-accredited investors as well
    • SEC approval is required: difficult, slow, expensive process
    • Finances have to be audited
    • Not a high chance to be approved
    • 2 different tiers: $20 million hardcap or $50 million hardcap
    • Public solicitation is allowed
  • Regulation CF
    • Hard cap of approximately $1 million
    • Non-accredited investors are allowed, but their individual hard cap is based on their income
    • Filing at the SEC is required, but the process is easier and less expensive than Reg A+
    • Generally there is a 12 month lockup period applicable as well

Even in the US there are several options available for security tokens to take advantage of in order to operate as legal securities. However, in order for US security tokens and international security tokens to both become accessible for the same audiences, some international harmonizing of US security laws would be necessary.

Other future aspects

Another development that we can expect, besides security tokens for crowdfunding of startups, is the tokenization of existing securities (i.e. Apple or Amazon shares). This could mean that eventually (this will take some time), practically all securities trading will be done based on tokenized securities (on a public or private blockchain).

In the first phase, there might be a lot of speculation because of this new form of investment, which may lead to a lot of hype and volatility. This can be extra profitable for speculators but also leads to increased risk for the average investor. Longer term, when these new markets mature and overcome their initial challenges, trading activity will likely normalize to the usual standards that traditional markets are accustomed to.

Challenges:

  • Less risk + more regulation = less potential profits. For example: a lockup period is required in some cases and this means that the prospects of ICO flipping will likely disappear. Also, once the security token market has stabilized and is mature, the 10x-100x gains that we saw before with ICOs might become less frequent.
  • Limitations that come with regulation as compared to the wild west ICO model – who can participate, hardcaps, etc.
  • Token itself not the only problem but also rules around custodianship, tracking ownership, where and how can it be legally exchanged (type of exchanges/brokers), KYC processes.
  • Which platform (public or private blockchain) will be used? And if it can be a public blockchain: which blockchain? There are many different choices in the public blockchain sphere, each with its own properties and trade offs: Bitcoin, Ethereum, Stellar, ADA, or even EOS. Things that need to be taken into account could be: the network’s track record, technology, ability to implement code for regulatory compliance, and more. But also the security of the network is important: the blockchain may host many assets in the form of security tokens that represent a huge economic value, but what if that specific blockchain fails, suffers a 51% attack, or has to deal with a contentious fork (look at the Bitcoin Cash drama).
  • Because security tokens will operate strictly under regulation and usually be tied to a company, they likely won’t be decentralized, censorship resistant, or permission-less. So with all those features lacking, you could argue that they are not actually part of the real cryptocurrency ecosystem anymore, especially if they are launched on private, centralized, distributed ledgers.

Final thoughts:

  • Security tokens are a very promising development that will open a lot of new opportunities for investors and startups, but will also revolutionize the traditional financial markets.
  • However, I do expect that most of the relevant security tokens will be launched on centrally controlled distributed ledgers, so they won’t really affect the cryptocurrency markets as we know (especially when it comes to US securities). On the other hand, outside the US, we can expect some security tokens to be released on public blockchain networks for non-US citizens.
  • Because of increased regulation for security tokens that choose to be compliant and the fact that these represent assets that already have price discovery (stocks, bonds, real estate, art, etc.), price action for security tokens will probably similar to that of their traditional predecessors. Therefore, crypto investor should not get too excited, because 10x-100x gains from the old ICOs will only sporadically happen in this realm. In fact, even for the public blockchain industry, for the time being, we should not expect too much of an impact, because regulators will probably steer towards private DLT (Distributed Ledger Technology) infrastructures.
  • Despite that security tokens may not have a huge impact in the foreseeable future on the public cryptocurrency markets, the fact that the technology is getting adopted and implemented, is yet another step towards the general acceptance and adoption of the technology that Bitcoin and other blockchain technologies provides. And this is promising and exciting!

For more on security tokens, please watch our video explainer:

Disclaimer:

This article was written to the best of our knowledge with the information available to us. We do not guarantee that every bit of information is completely accurate or up-to-date. Please use this information as a complement to your own research. Nothing we write in any of our articles is intended as investment advice nor as an endorsement to buy/sell/hold anything. Cryptocurrency investments are inherently risky so you should never invest more than you can afford to lose.

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