From Initial Coin Offerings to Tokenised Securities: Far From the End Game

On September 12 this year, a US federal judge issued an order finding that a defendant had promoted digital tokens (RE Coin and Diamond) through initial coin offerings in violation of U.S. securities laws, granting a victory to the US Department of Justice and the SEC until a jury can make a final decision. The promoter of these coins was charged on, essentially, two counts: illegally proceeding with an unregistered offering of securities and making misrepresentations and false claims. For the crypto world, the core issue was whether those coin offerings qualified under US Securities Laws and whether the coins should have been treated as securities. In issuing his order, the judge applied the “Howey Test”, a test arising from US case law and used to determine when an investment offering instrument is a “security”.

“The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.”

Much has been written about the Howey Test and its applicability to ICOs, and the September 12 decision was the second time a federal judge issued a finding to that effect. By now, there is a broad consensus that almost all ICOs done to date are, in fact, unregistered securities offerings, exposing their promoters, enablers, advisers, brokers, underwriters and even lead investors to prosecution and fines, and this is a important factor explaining the slowdown in the market. Few people are willing to go to jail now that the warnings have been made.

The ICO market has clearly cooled down since its May 2018 peak (chart courtesy of

The fear of legal prosecution is only one factor behind the decrease in ICO closings. A more important one is simply that the market has turned and many ICO are under water. This has upset investors, the majority of which were retail individuals and it has led to threats of legal action, open revolt in some telegram chat rooms, class actions and the involvement of regulatory agencies. It has also cast a spotlight on dubious practices including insider trading, outright scams and misrepresentations by ICO promoters, and shed light on some structural issues with ICOs, including the lack of contractual recourse and proper governance and the perverse incentives for entrepreneurs. After all, why not forget about the project and keep the money when the going gets tough?

Yet, for all the negatives, there is no denying the critical innovation of ICOs as a decentralised blockchain-based crowdfunding tool. The number of projects in the pipeline from various industry and countries keeps increasing (, with a total industry wide fundraising in excess of US$8 billion year to date.

And this is where “tokenized securities”, otherwise known as security token offerings or “STO” come into play. What if the industry could collectively re-work how ICOs are structured and make them compliant with securities laws? It’s a very logical idea, one that holds the promise of attracting large and more stable institutional investors and bringing liquidity to many illiquid assets and fundraising capacity to many entrepreneurs.

Many companies have entered the space, from “compliance protocols” to “security tokens exchanges”: “Compliance protocols” purpose is to mimic registered investment banks distributing traditional securities in compliance with regulations, while “security tokens exchange” purpose is to create trading platforms where tokens can be exchanged between qualified buyers and sellers via accredited brokers, in the process addressing some of the concerns expressed by regulators on the lack of proper “know your customer”, “anti money laundering” and “counter terrorism financing” procedures.

Reading from the “evangelical” predictions and statements made by some of these companies, one would be forgiven for thinking STOs will revolutionise capital markets . We doubt that: the public credit markets and the main stocks markets are effective and efficient and they are tested. There is no need nor demand from institutional investors to instead switch to a technology (public blockchain) that is still evolving, does not know yet how to both scale and remain decentralised and that is still prone to security breaches, hacks and market abuse. Instead, the believe the potential market will come from start-ups and young companies struggling to attract capital through traditional means as well as asset-backed tokenization, markets which retail investors can’t easily access.

That most of the ICO/STO activity would occur on Ethereum, a very creative token platform that is struggling to remain decentralised under the weight of its own success is a concern too: if a STO platform is not truly decentralised, then what is the point of using public blockchains?

While we applaud the new wave of entrepreneurs building up the STO infrastructure, we believe the majority of these companies either misunderstand the scope of regulatory challenges or misrepresent their role. Adequate disclosures are seldom found; instead, there is a tendency to narrowly equate lawful offerings and regulatory compliance with a “tick the KYC box” attitude, and there is in our estimation an untested and over-optimistic view about the ability of smart contracts code embedded into protocol tokens to ensure that a crypto asset will never, anywhere, fall into the wrong hands. This is implausible.

Let us explain. A traditional bank such as HSBC spends in excess of US$2 billion per year on compliance alone, with over 6000 employees across the globe whose tasks are: keep up to date with the ever-changing requirements issued by law makers and regulatory bodies in each jurisdictions, maintain active relationships with such regulators, keep track of sanctioned entities and individuals, perform increasingly complex background checks and fraud identifications, and enforce these regulations on their customers and their front offices. And even then, they occasionally get it wrong and get fined.

Here comes a start up focusing on compliance protocol, staffed mostly by IT and computer science entrepreneurs, with little to no financial or capital market background, but a strong belief that encoding rules and regulations in a smart contract will do what HSBC is actually struggling to do. These start-ups have no relationships with mainstream regulators, no enforcement experience and rely instead on snapshots memorandums compiled by law firms with a summary of restrictions on selling restrictions. The memorandums come with pages of qualifications and exclusions. Yet, these snapshots restrictions are then encoded in smart contracts without any concept of minimum denominations, hoping that that will work out over time once the token is issued.

Strikingly, there are no STO specific laws, no clarity, no proper regulatory framework in any major jurisdiction. As far as we can tell, few (if any) of these companies maintain any active supervisory relationship with any mainstream regulator (taking the sandbox concept aside). In fact, It could be the case that the current STO eco-system is not a real improvement on the ICO market: instead of enforcing standards consistently, it creates the impression of legality and legitimacy and may end up unwittingly persuading investors to invest and companies to issue STOs that are, in fact, not much better than ICOs from the standpoint of securities laws and investor protections.

In a number of major jurisdictions, government authorities are taking steps to establish a framework to allow distribution of tokens (in France and UK most notably). The indications are that countries will set up a filing and registration protocol, providing a “safe harbour” to tokens distributed locally. The current proposals in France apply to tokens that have substantial economic links to France: more generally, we believe these framework will make the most sense for regionally focused and distributed transactions, more on this later. The United States is in a more complex situation due to the overlap between federal and state agencies, law makers, justice departments and the number of regulatory bodies involved.

We are aware of a new wave of interesting ideas, involving partial re-centralisation through digital Central Securities Depositories (a digital “Euroclear” for crypto assets). These ideas need more work, and they need substantial involvement from mainstream regulatory bodies such as the European Central Bank or the Financial Conduct Authority. At BlockTrust, we are ourselves focusing on being part of the long term STO infrastructure, focusing on the Middle East, India and South East Asia. To explain our approach and philosophy, here is a comparison with traditional asset backed securities. What happens when a security backed by assets such as leases or real estate mortgages is issued and when the issuer, in effect, goes “public”?

Our key insights are:

  1. All third parties involved in a deal are companies under the oversight and scrutiny of major regulators: structuring bank, trustee & custodian, registrar (CSD), exchanges and brokers
  2. Relationships between parties are contractual and enforceable
  3. A Trustee / Custodian will interface throughout the duration of the deal between investors (which are often scattered) and the company. Trustee can and often do sue the Company or its management when it misbehave. Trustee & Custodian also ensure, along with the Company, compliance with standard listing requirements such as IFRS reporting, filings and corporate disclosures
  4. Rating agencies and research firms usually provide an enhanced degree of scrutiny to the deal
  5. The security must be registered in most jurisdictions where it will be distributed

So, here are a number of interesting ideas:

First, compliance protocol companies and STO exchanges could expand their focus to ensure that issuers / companies fully understand the consequences of going “public”. Whenever there is a security listed on a proper and legitimate US or EU exchange, the company has to report its accounts under IFRS or US GAAP and comply with mandatory disclosures and regular filings. In the process ensuring that these companies do not later get in trouble and aligning the STO market to something closer to Alternext (Euronext for small caps) or AIM (London Stock Exchange equivalent).

In the United States, Regulation D offerings provide a limited exemption to filings and registration requirements. The scope of Regulation D is fairly tight: to qualify, an offering must be and remain at an aggregate of less than US$5 million, or its distribution must be limited to sophisticated investors, along with strict transfer and trading restrictions. We do not believe Regulation D is a viable option for the most part.

Second, Trustees & Custodians. The lack of Trustees, who usually carry a fiduciary duty to investors, is the one single biggest structural weakness in the ICO/STO space, and none of the current compliance protocols will change that. A “Digital Trustee” can front investors and face companies and issuers, there is a proper financing agreement or equity subscription contract with the issuer. It shall have no part in the initial distribution process focusing instead on being a solid and low-volatility player. Think Bank of New York or State Street versus Goldman Sachs. When things go wrong, a Trustee can contractually sue and enforce an actual contract, it has no conflict of interest. Compare this with an ICO: there is no contract, it’s nearly impossible to sue anybody. Trustees provide an enormous degree of investor protection, and, I submit, STO structured with a Digital Trustee will sell faster and at a premium.

Third, regionalisation. Forget about companies issuing STO on a global basis; regionally focused platforms will have a more sustainable business model. An example to illustrate why: take an office building in Dubai; the owner wants to get liquidity against it, which presumably he can’t get at attractive terms from the banks via a lease-back. Such a real estate-backed STO would 99% be distributed to regional Middle East investors familiar with the property or the management company. It would be listed on a regional exchange (such as a “digital” Nasdaq Dubai). Ensuring primary and secondary trading compliance with AML/CTF regulations would be easier as we’d only need to fully understand the rules and regulations in the Middle East. Issuers would only need to understand regional reporting and filing requirements in jurisdictions they already understand. Focused regional platforms stand a much better chance of getting it right consistently in our estimation and not fall foul of the law.

Fourth, the industry and major regulators could agree (in the absence of a clear regulatory regime) minimum disclosures and behavioural criteria for promoters, exchanges and compliance protocols. A recent survey by the New York Attorney General covering crypto currency exchanges contains a number of valid points and ideas along with this interesting observation (verbatim):

“…The OAG could not review the practices and procedures of non-participating platforms (Binance,, Huobi, and Kraken) concerning manipulative or abusive trading. However, the Kraken platform’s public response is alarming. In announcing the company’s decision not to participate in the Initiative, Kraken declared that market manipulation “doesn’t matter to most crypto traders,” even while admitting that “scams are rampant” in the industry….”

We won’t get into the details of that report, but its main conclusions are common sense for experience traders: fair market practices, restrictions on employees and principals, disclosures of conflict of interests, market manipulation policy, disclosure of historical outages, insurance, custody and cybersecurity policy, etc.

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