We have seen some good quality developments within the past year in the blockchain space. Hype, a lot of hype, yes, but also concrete developments, as well as some initial use cases towards a more decentralized financial system. One clear trend that emerged has been the tokenization of tangible and intangible assets using blockchain solutions. With this has come the emerging of security token offerings (STOs) as a new financing method for companies of any scale, making it one of the most promising blockchain applications.
In order to discuss STOs, one needs to understand the nature of Initial Coin Offerings (ICOs). If you are in the fintech or finance spheres, unless you haven’t lived on the moon in the past two years, you have certainly heard of it. ICOs provided a new way of fundraising and generating capital consisting of issuing a new cryptocurrency in the form of digital token. In the past 18/24 months, we have seen ICOs taking the funding market by storm, with a spectacular growth followed by an equally sensational fall.
This was caused by a combination of factors including:
- The extreme volatility of the cryptocurrencies value linked to tokens (eg. Ethereum) of the Initial Coin Offerings, and the substantial decrease in the price registered over the last year;
- The rising number of fraudulent offerings;
- The increased regulatory scrutiny by the SEC (the Security Exchange Commission in the US), as well as from other financial regulators from around the world.
The SEC made clear to consider most of the tokens issued through ICOs as securities. “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security”, said the SEC Chairman, Jay Clayton, who later added: “I want to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.”
Okay, good, but what is a Security Token Offering (STO)?
As accurately defined in a white paper published by Node Blockchain (available here), a Security Token Offering (STO) is “a financial security issued in the form of a digital asset; which typically represent ownership rights in an underlying company and/or its assets. This is distinctly different than the aforementioned ICOs, which were “Utility Tokens” or digital tokens that provided access to a project’s future product/service with no tangible claim to an asset or equity ownership.”
So, whilst with ICOs the discussion is about utility tokens, which in several cases have no real utility, with STOs we are talking about tokens that give ownership in the company or the project, that represent an investment and that is subject to securities regulations.
But, practically speaking, how are these security tokens regulated?
That’s a complicated question which requires advice from a lawyer in the country where you intend to operate your platform. However here there’s a simplified recap about the regulations in the US, in order to give you an overview of the whole picture.
Security tokens issuers can apply for different exemptions represented by Regulation D, CF and A+:
- Under Regulation D, the offering should be in compliance with Section 506C. Which basically means this ends up to be a public offering of securities to accredited investors, where the issuer should verify the investors’ accreditation status. At the moment this seems the most popular option when issuing STOs.
- Under Regulation CF, which was initially created specifically for crowdfunding, is possible to get money from the general public (unaccredited investors) as well, yet there is a cap of $1.07M, representing the maximum amount that can be raised through an STO in any calendar year.
- Under Regulation A+, is possible to raise money from both accredited and unaccredited investors, with a total annual cap raised to $50M. The issue here is that the offering should be qualified by the SEC, something not needed under the other exemptions and which makes things more complicated.
Important to note as well that STOs issuers need to have KYC/AML checks on all the crypto wallets during the issuance of the tokens and on secondary trading.
What are the benefits of security tokens?
Security token offerings are somewhere in the middle among ICOs and Initial Public Offerings (IPOs). This position gives them the advantage of more credibility and safety for the investors than ICOs and substantially cheaper and faster to launch than traditional IPOs. STOs offer global trading capability, as security tokens can potentially be bought/sold/traded from anywhere in the world, 24/7.
Another key characteristic is that the security tokens are programmable. Compliance could be substantially simplified and automated. Furthermore, there are all a series of things connected to the issued securities that can be programmed, like for example the release of dividends to shareholders, as well as voting and governance rights and other special privileges.
“It’s inevitable that security tokens will transform equity […] because they afford the owner a direct, liquid economic interest and the expedited delivery of proceeds. Every type of ownership can be tokenized, which is a massive multi-trillion dollar addressable market.” said SPiCE VC’s founder Carlos Domingo who also highlighted two major points related to tokenization:
- Tokens potentially reduce trading frictions and add liquidity to categories of assets and investments that are otherwise difficult to be monetized;
- The total addressable market (TAM) is really huge.
If you are in interested in understanding STOs or related themes in further details with us, you can start by checking this page on tokenization and blockchain. If you see something that you like or want to discuss further, don’t hesitate to send us a brief message and start the conversation.
Alessandro is Co-founder & CMO of Difitek. He has worked in the fintech industry, with marketplace investing and lending, since 2011. Has built and managed digital companies with distributed teams and international partners, gaining experience with both startups and large corporations.
Alessandro grew up in Italy, where he graduated with a B.A. in Economics at University of Parma, before to obtain a M.S. in Finance at Regent’s University London. He is writing on multiple startups publications and is an expert evaluator with the European Commission, for the SME Instrument programme, part of Horizon 2020. Genuinely passionate about financial technology and innovation, he loves to spend his spare time traveling and discovering new cultures.