Hitchhiker’s guide to STO & Security Tokens

Cryptocurrency related activities are now starting to operate according to a few regulations that are meant to make the online trade much safer and more lucrative to new and existing investors.

The initial idea behind cryptos was to allow the trade to be frictionless, but as time went by, various stakeholders are beginning to come to terms with the fact that we may, after all, need some form of formal structures to guide certain aspects of crypto projects.

Despite security regulations not being new to the investment space, securities tied to crypto assets are.

When did Security Tokens first appear?

The argument over the distinction between utility and security tokens was first settled by the S.E.C. in mid 2017 when they were put in the position to judge the DAO incident.

The DAO tokens gave holders the power to vote on new projects and were used to determine how the profits would be distributed. During their ICO they have raised $150 mln, but a bug in their smart contract has led to $60 mln being siphoned away.

Due to the huge prejudice created, the SEC was forced to intervene and find a resolution for the investors. In order to evaluate the risk of the ICO, they applied the Howey Test which led to the conclusion that DAO tokens created expectations of profits, therefore they fall under the federal securities laws.

The incident has forced cryptocurrency issuers to register with the commission or to qualify for an exemption from the registration requirements of the federal securities laws. Shortly after ruling the case, SEC issued a report which was met with mixed responses from the crypto community at that time:

Brad Garlinghouse (Ripple CEO) said,

“Regulators aren’t going away — and shouldn’t. For generations, they have protected from fraud (some is happening w/ the ICO market).”

Roger Ver, Bitcoin.com CEO, however, disagreed with the decision,

“Call this what it is: A bunch of strangers in a far-off land threatening peaceful people all over the world with violence if they don’t obey.”
Like the number of projects who were offering security tokens disguised as utilities grew, the number of SEC reports grew as well.
“How many roads must a man walk down?” 🌀

All Aboard!

As security tokens are investment contracts that are being sold with the anticipation of future returns, their nature implies analyzing them through the lenses of international securities laws, consumer & investor protection laws, and AML regulatory frameworks.

🇺🇸 United States

In the US, a security token offering falls under Federal Securities Law and would likely make use of one of the following regulations: Regulation D, Regulation S, or Regulation A+

Regulation D will allow a particular offering to avoid being registered by the SEC provided “Form D” has been filled by the creators after the securities have been sold. The STO is required to verify that the investors are indeed accredited and the information which has been providing during the solicitation is “free from false or misleading statements”.

Regulation S applies to companies based outside of the US who are, therefore, not subject to the registration requirement under the Securities Act of 1933. These companies still need to abide by securities laws in their own jurisdiction as well as each country in which they are offering their security.

On Dec. 19, 2018, the Securities and Exchange Commission adopted final measures allowing public reporting companies to use the “Regulation A+” exemption for security offerings of $50 million over a 12-month period.

Companies are already filing under Reg. A+, which means that non-accredited investors will be able to participate as well.

🇪🇺 European Union

Similarly to the US, Europe has taken the approach that if a newly issued digital token has the features of a security, then the token sale will fall under the EU’s pan-European securities laws, as laid out in the prospectus directive and the prospectus regulation.

Security token issuers need to draft a prospectus and receive approval from their country’s financial regulator.

🇨🇭 Switzerland

According to the Swiss financial regulator — FINMA — digital tokens that promise a claim on a company’s assets, future income or future cash flows will be classified as securities under Swiss law. This includes tokens that represent a share in a company, a bond or another type of non-derivative financial security.

Asia

While token sales are currently banned in 🇨🇳 China and 🇰🇷 South Korea (with the latter expected to reverse this decision soon), most financial regulators in Asia have taken a similar stance towards security token issuance as their counterparts in the US and Europe.

In 🇸🇬 Singapore, security token offerings fall under local securities laws as set out by the Securities and Futures Act (SFA) and would be subject to applicable rules and regulations.

Interestingly, no security token offering has reportedly yet been approved by the country’s financial regulator, the Monetary Authority of Singapore (MAS).

The same goes for 🇭🇰 Hong Kong. According to the Securities and Futures Commission (SFC), digital tokens that function like shares, debentures or pay interest are regarded as securities and thus fall under “regulated activity.” “Parties engaging in a “regulated activity” are required to be licensed by or registered with the SFC irrespective of whether the parties involved are located in Hong Kong, so long as such business activities target the Hong Kong public,” the SFC announced in a statement.

While the legal situation for security tokens is reasonably clear in the main jurisdiction where token sales are being launched, the wider token sale market — which includes the sale of utility tokens, currency tokens, rewards token, etc — is still challenged by the lack of a clear regulatory framework.

STO Platforms — How are tokens created?

Security token platforms simplify the process of issuance of security tokens. These platforms will not only issue a security token for you but some of them will also help you go through all the needed paperwork and legal procedures to be fully compliant with the securities’ regulations of the jurisdiction where you choose to issue your token in.

The security token platforms available currently include Polymath, tZero, Swarm, Harbor, Securrency, and Securitize.

Polymath

Polymath has developed the ST20 token standard, which aims to become the “ERC20 for security tokens”. The platform provides all the required legal and technical solutions to tokenize stock, bonds, or any other asset on the blockchain. POLY, the Polymath native token is used as a currency for all economic operations taking place on Polymath’s platform.

Polymath is considered a leader in the security token exchange market sector and has established a partnership with tZero, a security token exchange which will promote the liquidity of security tokens issued on Polymath’s blockchain.

Conclusion

It remains to be seen how each country will choose to regulate tokenized securities. Whether it involves a more permissive attitude or restrictive laws, the traditional sector and the blockchain industry are working together to close the gaps and offer a viable solution.

One critical aspect will be how authorities will react to the multitude of solutions developed in the blockchain space.

Coinhatch is a state of the art token sale investor dashboard, whose goal is to make sure your investors benefit from a fully compliant solution that just works, with battle-tested security and uncompromising flexibility.

We post thoughtful pieces each month about the most interesting aspects of ICOs, token sales and blockchain startups.

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