Recently, we have heard that, despite the success observed in 2017–2018, the initial coin offering (ICO) as a mechanism for attracting funds has exhausted itself and should be transformed into a more complex investment instrument. Many believe that the so-called “security token offering” (STO) may be the next step in this evolution.
If during an ICO, participants are usually offered “utility tokens”, then in the case of an STO, tokens that have features of securities are issued. Security tokens are usually backed by assets or the right to receive part of the profits of the issuing company. They can be an investment, a debt instrument, a derivative or a digital share of an asset and, as the name implies, are usually recognised as securities.
In contrast to utility tokens, investors view security tokens as a more reliable investment instrument, since they are generally secured with specific assets; in addition, securities laws provide investors with additional guarantees.
The absolute advantage of token securitisation — and tokenisation in general — is the ability to divide the underlying asset into smaller units, which makes it more liquid and accessible for investors. This is often described as fractional ownership. For example, instead of investing in the purchase of an apartment for subsequent lease, the investor can buy a token representing a share in this flat, and that entitles the investor to receive a pro-rata portion of the income from its rent. Moreover, despite the low liquidity of real estate as an underlying asset, the token itself will have higher liquidity and can be easily resold.
In addition, the use of blockchain technology should provide fast, reliable, and transparent transactions with security tokens, eliminate unnecessary intermediaries, reduce commissions, and lower overall transaction costs.
It would seem that some of the benefits of security tokens are visible. But why are we still not seeing the STO boom? There are several reasons for this, which we will discuss below, but first, let’s take a closer look at the term “security token”. For the purposes of this article, all security tokens can be divided into three groups.
First, I must note that I agree with those of my colleagues who argue that the roots of the term “security token” are to be found in the “DAO case” of the US Securities and Exchange Commission (SEC). Thus, in its report in July 2017, the SEC stated that DAO tokens contain signs of securities since DAO investors invested money for profit. Subsequently, this approach of the commission was repeated several times and was detailed, in particular, in the SEC statements and the investigation report regarding the Munchee project, when the commission concluded that even if the token is not secured by an asset, and only performs the function or gives the right to receive services on the platform, it may still have signs of a security if, due to the manner of its sale, investors who acquire such tokens have reasonable expectations of a return on investment or profit. It is necessary to note that the position above is only the approach of the US Securities Exchange Commission.
In a recent survey of January 9, 2019, the European regulator ESMA reported that the national regulators of all Commonwealth countries in their practise do not classify utility tokens as securities.
Therefore, the first group of security tokens are tokens that perform some useful function in a product or on a platform but are not backed by assets or shares in a company and do not qualify for profit or management, but because of the way they are promoted and offered to investors, they have features of securities. This group includes the offering of tokens of the GRAM project TON (Telegram Open Network).
The second group is tokens, which, in fact, are securities in our usual sense. In other words, they represent the right to share in the company, give the right to participate in profit distribution, are a debt instrument, and so on.
Finally, the last group consists of tokenised assets. In this case, the token is a right to an asset or part of it, for example, precious metals, paintings, real estate or any other property. An example would be the tokenisation of a fashionable hotel in the U.S., St. Regis Aspen Resort.
In this article, we will talk about the offering of security tokens of the second and third groups.
So, when it comes to STOs, what is the complexity, and what must be considered when conducting one?
1. International aspects
In recent years, we have become accustomed to the fact that the token generation event (TGE) is an international event in which investors from all over the world participate and which is accompanied by a public marketing campaign.
In our practise, we must observe that agencies that previously specialised in supporting ICOs try to apply the same approaches to STOs, limiting themselves in legal structuring by “choosing the right jurisdiction” for the tokeniser company (issuer). We at AURUM consider such an approach to be erroneous.
A special feature of the STO is that the project team must fulfil the requirements of legislation on securities circulation not only in the jurisdiction where the issuer will be located (the tokeniser company) but also in each jurisdiction where tokens will be offered to investors.
For example, a project from Singapore, which, under the framework of offering for qualified investors, also intends to offer its tokens to investors from the U.S. and the EU countries, in addition to the requirements of Singapore law, will have to comply with the requirements of Regulation D and S in the U.S., and requirements under Prospectus Directive and Prospectus Regulation in the EU.
There are different models that can be used to structure an STO; below are the three most appropriate:
(1) To conduct a registered placement of security tokens. It is analogous to the IPO in the U.S. In the EU it is necessary to prepare a prospectus in accordance with the Prospectus Directive, which will be approved by one of the national regulators; similar rules apply in Switzerland, Liechtenstein, Luxembourg, Singapore, Australia, and other jurisdictions. The clear advantage of this option is the ability to conduct a broad public marketing campaign and offer tokens to all classes of investors, including non-professional ones. However, this path is costly and time-consuming, and besides, the organisers of the STO and the project as a whole will have to comply with higher requirements as to information disclosure and financial audit.
(2) Alternatively, an STO can be structured as an exempt offering, based on exemptions allowing it not to register the issuance of securities (prospectus). For example, in the United States, the most convenient exemptions are Regulations D and S, while in the EU, exemptions are provided by the Prospectus Directive and the Prospectus Regulation. In the case of an exempt offering, tokens are sold primarily to accredited or qualified investors. In the case of private placement, participation of a limited range of retail investors is allowed — no more than 150 persons per state in the EU. Preparation and approval of prospectus in case of exempt offering are not needed, and issuance of tokens can be accompanied by preparation of the information memorandum only.
(3) In some jurisdictions, for example, in the EU and Singapore, the security tokens can be offered to the public (including retail investors) without having prospectus approved, provided that the total amount raised will not exceed a certain amount (a small offering). Depending on the jurisdiction, the threshold is from 1 to 8 million EUR.
It is necessary to add that the requirements of the legislation on securities, which should be the focus of the organisers of the STO, are not limited to the above. It is necessary to take into account the requirements of frameworks for collective investment schemes; alternative investment funds; rules for transparency and disclosure of accurate, complete and timely information about the issuer and business; disqualification rules and ‘bad actor rules’; rules for storing and accounting for property rights to securities; and other requirements of the law.
3. Using blockchain technology to account for property rights
Regulation always fails to keep pace with innovation and technology development. Despite the fairly wide recognition of the advantages of the blockchain technology for maintaining registers, its use, for example, for maintaining the register of shareholders of a company, will be possible only in a few parts of the world so far: Delaware (USA), France, Great Britain, Singapore, etc. The situation with rights to land plots and real property is more complex. To tokenise a real estate project there is a general practice to create a special holding company (SPV), shares of which will be tokenised; the SPV in its turn will hold the rights to the target asset.
4. The technical side of the issue
An STO project must comply with the requirements of the law, not only during the initial offering of security tokens but also all further transactions with such tokens must be compliant with applicable securities legislation. For example, if the initial offering of tokens is structured as an exempt offering of securities to accredited and qualified investors, the smart contract must contain all the limitations provided by the law for the subsequent trading of unregistered securities, including the class of buyers in the secondary market and lock-up period, if applicable. At present, a number of platforms address this question in different ways, and provide users with the functionality to issue tokenised securities, validation, subsequent transactions, interface and functionality for investor relations and corporate events such as redemptions, dividend and profit distribution, voting and so on. For example, such platforms as Tokeny, Polymath, Harbor, Securitize, and Neufand already provide different scopes of services and the necessary functionality.
5. Security of the underlying asset
A separate and rather serious task is to ensure reliable legal connections of the token with the underlying asset and the legal and physical security of the tokenised asset itself. In this regard, cases of tokenisation of movable property — luxury goods, precious metals, paintings, products, etc. — are particularly difficult.
6. Liquidity and secondary market
For the formation of a secondary market of security tokens, on the one hand, there are not enough tokens and interesting projects for trading, and on the other hand, there are not enough platforms that have all the licenses and permits necessary for trading securities. This year, it is expected that the Swiss Stock Exchange (SIX); the Malta Stock Exchange; the Gibraltar Blockchain Exchange (GBX); the Sydney, London and Canadian Stock Exchanges; tZero; Coinbase in the USA; and more will start working fully with tokenised securities. Also, to shape the functioning of the market, not only the technical infrastructure is needed, but a sufficient number of professional participants — lawyers, broker-dealers, investment consultants and intermediaries, etc. — is required as well.
According to some estimates the total amount of publicly traded assets amounted to 116 trillion dollars; the capitalization of derivatives, about 500 trillion dollars; and the total value of all real estate — 217 trillion dollars. It is a more difficult issue to calculate other non-tradable assets, but the overall figure will include twelve zeros.
Tokenisation, as a tool aimed at increasing liquidity, eliminating middlemen, and reducing transaction costs, is expected to be a solution for traditional markets. Therefore, in conclusion, it should be said that, despite the apparent difficulties in implementation, the market for tokenised assets has great potential, and according to various estimates its capitalization could reach 5–10 trillion dollars by 2025. As such, it is likely there may be many more STOs on the way in the future.
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