What is an STO & How is it Different from an ICO?

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aelf

7 min readFeb 1, 2019

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).

In the two years leading up to December 31, 2018, more than 1,500 ICOs raised a combined total of over $28 billion. However, the vast majority of funds, around 85%, were allocated before the second half of 2018. So, what happened?

The demise of the ICO was a confluence of different events that took place throughout 2018. First of all, the value of Bitcoin dipped several times over the year, falling from over $17k in January to under $4k by year end. As the crypto markets tend to follow BTC, it became clear that ICO investing was not necessarily a route to quick riches.

As was bound to happen in an unregulated and seemingly unstoppable market, scam artists entered the scene. One study estimated that 80% of ICOs conducted in 2017 were scams. Founders would simply wait until the funds started rolling in and then disappear.

Finally – and also inevitably once the scammers showed up — regulators around the world started to take notice of the growing trend for ICOs as a means of raising startup capital. In the US, the Chief of the Securities and Exchange Commission (SEC) made it clear that regulators would take legal action against ICOs selling unregulated securities. Chinese authorities even went to the extent of a blanket ban of all commercial activities related to cryptocurrencies.

These three factors combined led to a sharp decline in the number of ICOs. However, this isn’t necessarily bad news for the blockchain community. It’s now leading into the next evolution of blockchain crowdfunding — the Security Token Offering (STO).

Regulatory Pressure

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.

Most, if not all, ICOs don’t pass this test. ICO investors were buying tokens with the full expectation that they would see future returns on their investment. Any expected returns would be based on the efforts of the project founders, not the token holders themselves.

For a time, some projects tried to style it out that their token offerings were pure utility tokens with no offering of returns. However, the fact that people were buying into an ICO with the expectation of future profits ultimately means that an ICO fails to pass the Howey Test or similar regulatory tests in other countries.

While being clear that ICOs will be regulated as securities offerings, the US SEC hasn’t yet issued any formal guidance regarding the offering of digital tokens. However, some other regulatory authorities such as Singapore and Switzerland have been more forthcoming.

Criteria of an STO

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.

Launching an STO

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.

“For a startup founder or company that wishes to launch an STO, then legal compliance is the most critical consideration.”

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.

At aelf, we have been very focused and visionary in regards to some of the complications that might arise about compliant fund-raising for future DAPPS, by joining forces with Republic. Republic is an SEC-licensed, FINRA-regulated investment platform that lets anyone, anywhere invest in promising startups. Republic, the first fully compliant fund raising platform in US, will extend investment counsel to projects under the Innovation Alliance and provide enterprises and new blockchain projects within the alliance the opportunity to host compliant token presales on its platform.

In addition to Republic, aelf has joint forces with other regulated parties in crucial markets around the world, including Singapore, UAE and the U.S. Our approach is to partner with lawyers, auditors and security brokers to create the best platform for security token offering.

Some countries will be easier to navigate than others. For instance, the UAE has recently established a framework for STOs which should help founders understand what they need to do to remain compliant. Aelf is working with Dubai-based consulting firm CGS to keep an open dialogue with the local businesses and authorities, enabling aelf to support many companies in adopting Blockchain solutions and potentially operate as a compliant platform for STOs in the future.

The Future of Token Offerings

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.