Security Token Offerings — What is an STO?
Much like Initial Coin Offerings (ICOs), Security Token Offerings (STOs) provide enterprises with a blockchain-powered funding mechanism and investors with an opportunity to gain exposure to a company. Yet there are key differences in the crypto investment landscape that have led STOs to be described as “the next big thing in blockchain” and “the end of blockchain’s Wild West.”
What is a Security Token?
A Security Token is a digital, tokenized representation of an underlying investment asset, be it bonds, stocks, or real-estate investment. As a security is the financial instrument that holds monetary value, a security token is the ownership information of the aforementioned security stored on the blockchain.
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How do ICOs differ from STOs?
An ICO makes coins available to participants who then in turn become invested in the success of the coin. STOs on the other hand, offer securities. This essentially turns buyers into minority business partners and interest holders.
STOs are said to hold intrinsic value, they can guarantee interest, profit sharing, dividends, voting rights, and more.
Are ICO’s considered securities too?
ICOs are investments in common enterprises with the expectation of profit, leading many to naturally classify them as a form of security. However, many ICO teams reject or attempt to reject the security-classification. Not least so that they can avoid the need to fulfil a sizeable list of requirements imposed by the Securities and Exchange Commission (SEC).
The primary tool for determining whether ICOs should be considered securities is known as the Howey Test — an assessment that judges whether something is a security even if it goes by a different name. Performing the Howey Test entails asking whether profits are expected to come solely from the work of others (the enterprise invested in).
In an ICO, the success and profits of the coins is not only dependent on the issuer, but on market sentiment and the behaviour of the buyers. Thus, many ICO advocates have a strong argument to say that ICOs should not be classified as securities.
Why choose an STO over an ICO?
If there is an argument for ICOs legitimately avoiding SEC constraints, why would an enterprise opt for an investment mechanism that must comply to so many extra rules? The answer, at least for many STO proponents, is the very fact that they do follow these regulations.
Over the last two years, the complete lack of regulatory oversight has had detrimental effects for the blockchain-powered funding industry, with multiple ICO scams delegitimizing the entire market. STOs embrace SEC requirements and regulatory oversight — acknowledging that they are there to protect investors against scams and bad investments.
Following legal requirements provides enterprises with legitimacy and investors with comfort.
SEC Regulations for STOs
STOs commonly fit into three regulatory categories based on the level of oversight: Regulation D, Regulation A+, and Regulation CF.
Regulation D, commonly known as Reg D, is a SEC regulation governing private placement exemptions. Smaller companies use it to accumulate capital without the cost and hassle of an Initial Public Offering. The enterprise must provide proper framework and disclosure documentation, including names and addresses of executives, and details of the offering.
Furthermore, under Reg D, the issuer of the securities must disclose any prior “bad actor” events. Reg D guidelines strongly favour accredited investors over unaccredited ones, raising the barrier to entry. To mitigate that, Reg D is sometimes used in conjunction with Reg S so as to allow international investors to participate.
Regulation A+, the second category, is often referred to as the best pathway for STOs. It allows enterprises to sell up to $50 million of securities to the general public. Reg A+ is regarded as less strict than Reg D although issuers must submit audited financial statements and file reports with the SEC on an ongoing basis.
The third regulation, Reg CF, gets its name from Crowdfunding. It covers exemptions for crowd-funders up to $1,070,000. Importantly, for Reg CF exemptions, the auction must take place online through an SEC-registered intermediary such as a broker-dealer or a funding portal.
What are the advantages of STOs?
Prominent players in the blockchain industry seem to be edging closer towards STO-based solutions. In June 2018, Coinbase, the largest Bitcoin exchange in the U.S, acquired the financial services firm Keystone Capital, turning it into a fully regulated broker-dealer.
STOs are increasing in popularity. It is safe to say that they will be significantly more regulated than ICOs, a fact that should make them safer. Rather than being contrary to the principles of blockchain, this regulation arguably increases the democratization of the investment process by removing gatekeepers who prevent low-tier investors from participating in the market.
Blockchain-based securities can hold all of the relevant asset-information, including capitalization tables, voting rights, dividend payments, or liquidation preferences. At any time, participants will have secure and immutable access to their stake’s information. In addition, smart contracts could potentially help automate the necessary parameters like stock-restriction.
The liquidity of security tokens is also very attractive. Unlike the 5–10 year exit period one would usually expect when investing in a startup, security tokens promise near-term liquidity on exchanges that will trade tokens 24–7 with a global pool of investors. The possibility of infinite asset divisibility could open opportunities for a new class of trust funds and asset portfolios.
What are the disadvantages of STOs?
STOs are a new asset class, something that entails risk as well as opportunity. There are concerns about secondary markets for security tokens and/or a new wave of bad actors exploiting the STO hype. While many exchange platforms are looking to expand their operations by including security tokens, as of early 2019, no mainstream platform has done so.
A truly decentralized stock exchange that operates across borders would require both issuers and purchasing parties to comply with international regulations. Complying with each country’s individual exchange laws would be a gargantuan and costly task — rendering “universal” security tokens extremely unlikely. It’s probable that there may never be a single exchange that services clients on a global scale in the STO market.
The biggest concern of the crypto community is of a different nature. They fear that added regulation and reliance on the mechanisms of traditional finance reopens the door to the organisations that have always controlled finance; that increased regulatory oversight will counteract the decentralization and democratization of the market.
The world of Security Token Offerings is very much in its infancy; the coming months will reveal a lot about its future. Though as things stand, there are plenty of reasons to be cautiously optimistic.
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Disclaimer: This content does not represent financial, legal, or tax advice; nor is it supposed to be understood or interpreted as solicitation to buy or sell any securities, tokens, or coins.
