An Intro to Security Token Offerings (STOs)

As someone who first entered the blockchain space in 2014, I have seen the industry go through numerous changes. From the rise of cryptocurrencies to the recent ICO phenomenon and so called “utility tokens”.

It is hard to argue that the ICO crowd-sale wave of 2016–2017 is losing momentum and transforming into more complicated legal and financial structures around digital assets.

As a Founding Partner at TMT Blockchain Fund, I am often asked about the prospects of security tokens — essentially smart contract representations of equities and other financial or real assets. This happens to be a topic of personal interest to me, since it bridges together my prior career as a corporate attorney with my recent focus on investing in digital assets.

The security token boom has not started yet, but I believe that it is destined to happen over the next three to five years. The key market players are certainly getting ready and the more sophisticated investors are harvesting information about what the future security token markets may look like.

I plan to use this series of posts to share my thoughts on STOs (“security token offerings”) and point out major developments and key players in this field.

What is a “security token” — what is an “asset backed token” — and why it matters?

Based on the latest guidance from the SEC (Securities and Exchange Commission) and the top securities attorneys active in the blockchain space, a security token broadly speaking is any digital token that is offered for sale to US purchasers before it can be functionally used on the platform for which it is issued. For example, even if the token is a piece of functional software code that is a “utility token” once the platform is up and running, it is nevertheless a security for SEC purposes if sold before the platform is operational.

An asset backed token is a digital representation of some specific asset. Almost without exception, all asset backed tokens are typically securities for SEC purposes. For example, a token representing ownership of one share in a private company is legally considered the same way as the underlying share of stock. A token representing ownership of an ounce of gold is likewise an asset backed token.

There can be multiple arguments for why trading and holding asset backed tokens is cheaper, quicker and more advantageous then trading and holding the underlying assets. While many such trades are made electronically already without use of blockchain tokens, the introduction of tokenization carries additional advantages of decentralized record keeping, theoretically lower transaction costs, and immutability.

Right now the entire cryptocurrencies market capitalization is only a fraction of the overall global financial market. In fact, it less than half the market capitalization of a single large tech company — Google. If additional asset classes are traded via tokens, this will increase the overall volume and market capitalization of the digital assets to a level that will matter to the global investor community, as opposed to just early crypto adapters.

Why investors in U.S. are not rushing with STOs?

Currently investors in the US are not rushing to purchase security tokens or asset backed tokens. There are a number of reasons for this:

1) General lack of familiarity with digital assets;

2) Perceived negative opinion of digital assets as highly speculative and volatile;

3) Lack of appropriate infrastructure : compliant exchanges listing security and asset backed tokens, no third party custodians, limited market makers, and lack of retail customers willing to purchase such assets;

4) Lack of regulatory clarity — many of the traditional institutional investors driving overall investment climate (pension funds, large hedge funds, insurance companies, etc) lack legal ability to own digital assets — their charters were written in an era when cryptocurrencies did not exist.

What is a current state of a regulatory market?

Regulatory agencies such as SEC and CFTC have made tremendous progress since the early days of 2016. There is a lot more guidance in the US and globally with respect to legal treatment of security tokens. The overall takeaway is that security and asset backed tokens should be treated the same way as regular securities or underlying assets.

For example, security tokens cannot be sold in the US without either registration with the SEC or an available exemption from registration. Some typical exemptions from registration are Regulation D (sale only to accredited investors in the US) or Regulation S (sale only to non-US investors without a subsequent resale into the US).

Some of the major players in this field today are:

1) Advisory firms and broker dealers specializing in digital assets, such as: Argon Group, Element Group, Satis, Jaguar Capital, Polymath, Securitize, Harbor, and others;

2) Custodians such as Noble Capital, Ledger, Xapo, and Gemini;

3) Crypto Exchanges that have applied for the ATS (Alternative Trading System) license to list security tokens and asset backed tokens (most notably tZero, Templum, CoinList, Coinbase, Binance and Poloniex (owned by Circle))

4) Investment funds investing in security and asset backed tokens — this is the weakest link of the chain right now, together with lack of compliant crypto exchanges — biggest obstacles to rise of transactions in this asset class.

For any investment related enquiries or general questions, please email me at julian@tmtblockchainfund.com.

In my next emails, I plan to tell you more about current STOs and which prominent security token issuances happened already.

• The above does not constitue legal advice and/or an offer or solicitation to provide legal services.