Understanding Tokenomics and What Security Token Offerings Are
Summary of the most up-to-date knowledge on STO
Background
Let us first begin with the classification of the tokens in the current market. The most prolific kinds of tokens are:
- Utility Tokens
They are made to give access to existing or future digital applications or services developed by the issuer. They may come in the form of an app or user token. They are not created for investment purposes. Possession of these tokens does not equal ownership of the underlying company and there is a lack of earnings potential from holding the tokens alone except the capital gain on the token’s market price.
However, due to the lack of regulations and oversight, recent developments led to the discussion of:
- Security Tokens
They are asset-backed and give ownership rights to real assets such as participation rights to companies, earnings or an entitlement to dividends or interest payments. In terms of their economic function, this kind of token is analogous to equities, bonds or derivatives. They are subject to the laws and regulations of the country in which they are issued. Possession of security tokens may guarantee digital ownership of the underlying company and may have some earnings potential in the form of the same token issued. Any combination of these tokens would become a hybrid token.
In this article, we focus on the features of security tokens and their issuance (STO) as well as how they compare to Initial Coin Offering (ICO) and Initial Public Offering (IPO) or Private Placement (PP).
Security tokens are digital assets subject to governmental and financial regulations of a given country where they are issued or sold. They are designed to represent complete or fractional ownership interests in assets such as having a stake in a company, real estate, or intellectual property. While utility tokens have no limitations on who can send or receive the token, security tokens are subject to many restrictions based on identity, jurisdiction and asset category and may include steps such as registration with regulatory authorities, Know Your Customer (KYC) and Anti-Money-Laundering (AML) checks.
The tokenized security is typically based on the blockchain of Ethereum, although other platforms are available now. It is easy to set up a digital wallet for a token derived from Ethereum, hence, it is trivial to make a new token and issue it to be sold to the public. But to ensure that there is a common framework for issuing security tokens where issuers, investors, KYC providers, exchanges, wallet services, regulators and developers can all work together on common grounds, several standards and protocols are implemented. The two most recent developments of security token frameworks are the following two standards where they include differentiated ownership, error signalling, document references, gatekeeper (operator) access control and issuance/redemption semantics:
Similar to the ERC-20 standard for the issuance of utility tokens, the above two new standards are specifically designed for STOs.
As an example, if a Security Token Offering (STO) happens within the USA, they must be compliant to the Securities Act of 1933 from day one, including but not limited to:
- Regulation D
It relates to SEC Rule 506(c) allowing public sales of Security Tokens to accredited investors without formal registration with the SEC apart from filing an electronic Form D.
- SEC Rule 506(c)
Issuers can offer securities through means of general solicitation, provided that
- all purchasers in the offering are accredited investors,
- the issuer takes reasonable steps to verify their accredited investor status, and,
- certain other conditions in Regulation D are satisfied.
- Regulation A+
This exemption allows an issuer to offer a security qualified with the SEC to non-accredited investors through a general solicitation for up to a total of $50,000,000 in investment. Due to the requirement to register the security, Regulation A+ issuance can take longer compared to other options. Regulation A offerings require qualification of a Form 1-A offering circular, including audited financials. Due to the requirement to qualify the security and complete an audit, Regulation A+ issuance can cost more and take longer compared to other options. Regulation A+ offerings treat all money raised as revenue and tax it as such if the money doesn’t represent equity in the underlying company.
- Regulation S
This is when an offering of securities is deemed to be executed in a country other than the US and therefore not subjected to the registration requirement under section 5 of the 1933 Act. Issuers of the security are still required to abide by the security regulations in each country where they offer their security.
An “accredited investor” includes a natural person who:
- earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or
- has a net worth of over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
An “accredited investor” may also be an entity such as a bank, partnership, corporation, nonprofit or trust, when the entity satisfies certain criteria. The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited investor status of purchasers.
This issuance model is based on the existing model of Private Placement where startup companies raise initial capital on the private primary market asking money from accredited investors, venture capital firms and angel investor firms. The sale proceeds with a placement of a smart contract to the Ethereum blockchain. The smart contract would require the verification of an investor to be an accredited investor by the authority of a third-party platform that complies with the SEC and has the appropriate and adequate license. Once verification is established, the accredited investor may invest directly into the project without a broker. The minimum amount of such a sale is in the range of thousands of USD which is substantially less than that of a typical Private Placement.
Comparison with ICO and IPO/PP
The Security Token Matrix
Compared with ICO and IPO or Private Placement, the security tokens have the following advantages and disadvantages
Markets and Liquidity
Tokenization largely increases liquidity, making the assets less costly to trade, due to investors’ access to exchange markets where they can buy and sell the issued tokens on the secondary market. But tokenization alone is not enough to make liquidity high. It is merely an enabler.
The smart contract for the STO can require the buyers to hold the token for a pre-defined amount of time before they can be sold on the open market. The liquidity of a token based on the Ethereum blockchain may be far bigger and grows faster than that of a Private Placement which usually happens through an exit such as selling the shares to new investors during a future investment round that might or might not happen after many years.
An effect of tokenization is the fact that the platform on which the tokenization happens would be increased in value by the participation of more and more of issuers. If there is a surge of issuers based on the Ethereum platform (ERC-20 compliant tokens), then the value of Ethereum increases which could affect the price of Ether.
Regulatory Challenges
Regulations take usually a long time to develop and mature. The technological development of security tokens, however, is accelerating at an exponential rate. This creates a time gap of regulations to catch up with the technology.
There are also challenges in terms of corporate governance. Separation of control and ownership has to be developed to give a group of individual enough incentive to oversee and run the day to day management of a project.
To address these issues, existing regulatory organisation targeting cryptocurrencies slowly publish their statements on how to regulate that market. Here are some examples of regulatory bodies that would concern the crypto space:
- Swiss Financial Market Supervisory Authority
- SEC
- Financial Industry Regulatory Authority
- Department of Financial Services
- Financial Services Agency
Another example of a progressive move towards crypto regulation is the Delaware Blockchain Initiative. This initiative would change the landscape of the US and the global economy because it permits companies registered in Delaware to use blockchain technology to record, verify and discover smart contracts relating to debt and equity ownership. Since the vast majority of IPO companies in the US chose to register their company in Delaware, this can affect the future state of the US corporate world as well as the crypto space at large.
Online Resources
- Tokenized Security Offerings Offer A New Way To Raise Capital
- Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings
- Definition of an Accredited Investor
- Why The Delaware Blockchain Initiative Matters To All Dealmakers
- The Official Guide To Tokenized Securities
- FINMA publishes ICO guidelines
- Digix, Security Asset for Gold
- Coin Center Regulatory Research
- What does it mean to issue a token “on top of” Ethereum?
- Your Official Guide to the Security Token Ecosystem
- Regulation S for STOs
- Top Security Tokens You Should Watch Out For In 2018
- List of companies supporting the Security Token Standard
Disclaimer
This article including the summaries of US securities law, including Regulations A+, D, and S, listings of third-party companies and organisations for illustrative purposes are merely the personal opinion of the editor/editors of this article. They should not be construed as any legal or investment advice and you should consult a lawyer or a financial advisor before taking on any investment decisions. The content of this article does not represent any opinions expressed by Madginger as a company.
About MadGinger
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