Diving into security tokens

Let’s try to alleviate some of the confusion around Security Token Offerings (STOs) and the difference between security tokens and utility tokens.

To really get a grasp on this emerging crowdfunding model, you need to look at existing regulatory frameworks around the world, the rules for compliance, and what security tokens can potentially offer on the market.

Also, this is a follow-up post, so in case you missed it, be sure to read our write-up on "Tokenized Securities and Security Tokens: What is a Security Token Offering (STO)?"

Security tokens vs utility tokens

Utility tokens provide users access to finished goods or services on the blockchain.

These tokens are not meant to offer equity, profit sharing, or voting rights in a company. If a utility token is later deemed a security, this is a major problem for the issuer if they were not a registered STO.

It is possible and becoming more common for startup companies to register their utility token as a security. By treating a token as a security from the very start of an offering, the issuer can avoid future concerns and complications with the SEC.

Security tokens are actual financial securities

Security tokens can be backed by real-world assets.

You can trade both traditional and non-traditional assets with security tokens, allowing the fractional ownership of unique things like real estate, art, agriculture, and much more.

By tokenizing these assets and allowing fractional ownership, security tokens have the potential to create greater liquidity in previously illiquid markets. Moreover, they provide access to a 24/7 market, which was not previously available for these assets.

It can also be easier and less expensive for blockchain-related startups to fundraise this way. And because of the compliance with securities regulations, security token offerings can lead to far less fraudulent and scammy projects for the crypto ecosystem in general.

What’s the issuance process?

With any security token offering, there are complex legal and technological processes companies need to go through before issuance.

These will require extensive time with advisors, lawyers, regulatory authorities, and finally technical platforms to launch a token for trading.

Security tokens also must be compliant with KYC (Know Your Customer) and AML (Anti-Money-Laundering) requirements, as well as complying with securities regulations in whatever district the tokens are bought, sold, or traded.

The key for STOs is embracing the security status.

Rather than trying to avoid the security status at all costs, as many ICOs are currently doing, STOs must embrace it. They must completely comply with all securities laws and regulations in their jurisdictions of operation and trading, as well as with their technical platforms.

Each jurisdiction for launching an STO comes with its advantages and weaknesses, with some regions much more favorable than others. The key for companies is choosing the best country to operate in for them. Each jurisdiction varies in regulation and in accessible investor pools.

For now, many companies are choosing to avoid the US because of tighter regulation and the higher cost and time required for compliance. This is also why a lot of companies do not pitch their products to US-based investors.

Finding the right jurisdiction of operation

There are some countries which already have a full framework in place for STOs, with a significant amount currently launching out of Europe. There is substantial funding opportunity here, as well as lower costs for compliance and a friendlier approach to regulation.

Some of the most sought-after jurisdictions in Europe currently include Lithuania and Switzerland. Lithuania has much more progressive regulation, while at the same time staying within the EU legal framework and granting companies access to investors from around the European Union.

Switzerland, also known as the “crypto valley” for its ability to attract crypto-projects from around the globe, is by far the friendliest and most open when it comes to regulations and blockchain-related projects. Because of this, it’s considered one of the top choices for many crypto-related projects, STOs included. It’s a stable country to launch from, with clear rules and excellent opportunities for funding.

While Lithuania and Switzerland could arguably be the best places for launching an STO, some companies may choose a jurisdiction if it offers a specific advantage over others, or if they have the financial muscle required to register as a security with the SEC.

What are the existing SEC compliance rules?

In order for a company to be deemed a security token, there are 4 categories an STO can choose from for either registration and approval as a security, or exemption from registration.

  1. Regulation D
  2. Regulation S
  3. Regulation A+
  4. Regulation Crowdfund (CF)

These exist to set requirements on who can invest, limits on the amount of money raised, whether you can solicit or advertise your offering, and different things like lock-up periods, audits, and more.

The goal for an STO is to be legally compliant with these federal securities regulations from the first day of the token launch.

Regulation D

Regulation D, also known as “Reg D”, includes two exemptions from having to register with the SEC. Reg D 504 or 506 (C) allows a company access to US investors without SEC registration and approval.

  • Reg D -504 is for companies that intend to raise less than $5 million US over a year period. It frees companies from needing to have only accredited investors, but investors will have to be locked in for the first year.
  • 506 (C) is a simple form that means the company will only deal with SEC accredited investors. These investors are high worth, high net individuals. Basically, somebody with over $1 million to their name. These investors will also be locked in for at least a year.

Regulation S

In short, Regulation S essentially means a company will not deal with Americans. It is designed for companies that operate outside of the US, and therefore will not be subject to registration requirements under section 5 of the 1993 Act.

Due to stringent KYC (Know your customer) regulations, if you file for Regulation S exemption, you need to block any marketing getting to the US. This means companies need IP filtering, and the company will also have to be careful of any Americans trying to get around the system to invest in their offering.

Creators are still obligated to follow the securities regulations and laws of the country which the issuance is executed.

Regulation A+

This is a long procedure, and allows investment up to $50 million dollars. It’s much more complicated, a bit more like the IPO, but not completely so - it is a lot easier comparatively.

Companies need to produce IPO 2-year CPA audited accounts. You can currently go up to $50 million, but soon this may go up to $75 million. With this exemption, the creator is allowed to offer SEC-approved securities to both accredited and non-accredited investors.

Compliance with Regulation A+ can be a lot more time-consuming than with Reg D and Reg S, and issuance is likewise more expensive than any other option.

Regulation Crowdfund (C.F.)

The American JOBS (Jumpstart Our Business Startups) Act recently added a new exemption to the Securities Act of 1993. Under Section 4(a)(6), companies are now permitted to do securities crowdfunding without SEC registration.

In order to comply with Regulation C.F., the company is not allowed to exceed $1 million dollars in investment in any 12-month period.

The JOBS Act, which is the language of the statute, suggests that offerings made under other exemptions (like Reg D, for instance) can potentially count towards this $1 million limit. The view of the SEC, however, is that this limit will only apply to sales under Section 4(a)(6), and that amounts sold under other exemptions will not affect this limit.

This means that the SEC will currently permit crowdfunding offerings to be made alongside other exempt offerings, effectively permitting unlimited sizes of offerings to be launched without registration.

What are the challenges going forward?

With more regulation and less risk, this means investors won’t see the same type of gains or price volatility they saw with ICOs.

While this provides more protection for investment, some traders simply won’t be as interested in accumulating these assets in a portfolio, possibly hindering adoption for security tokens in general.

There will be more limitations on security tokens compared to ICO tokens. This is due to compliance with regulations, meaning there will be defined hard caps, limits on who can participate, how much can be invested into a project, and more.

You’ll also need processes for custodianship, tracking ownership, exchange approval, and meeting KYC and AML requirements. These all need to be in place to create a safe, well-defined and regulatory environment for security tokens.

Another major question is, can this be done on public blockchains? And if so, which ones? If they are allowed on public blockchains, there may be security concerns, like the 51% attack and hard forks, among others.

With STOs facing strict regulations and being tied to specific companies, you may not see security tokens on decentralized blockchains. Rather, security tokens may need to live on centralized, private ledgers. This is especially true in the US, where regulators like the SEC are much more strict.

What’s in store for the future?

First and foremost, STOs must comply with US regulations. The SEC is one of the greatest challenges going forward.

If STOs can meet their strict requirements, however, they will have access to one of the biggest — if not the biggest — sources of venture capital.

Legal status could even mean the tokenization of existing companies, like tokenized assets in Google or Amazon, alongside the tokenization of traditional and alternative assets.

The STO has the potential to completely reinvent how people invest and how companies raise early capital for a project, similar to what many hoped the ICO model would provide.

Whether or not this will be the case is yet to be seen.

STOs need time to not only meet regulatory requirements but also to be tested on the market. Will investors be interested? Only the market can decide.

Final thoughts

The advent of the STO is extremely promising. It has the potential to revolutionize traditional and non-traditional markets.

One thing to keep in mind, however, is that when these security tokens represent existing assets (like stocks, bonds, commodities, etc), you can’t expect high volatility or the chances for massive gains like what was seen with investing in ICOs in their golden days.

But it could be a safer playground for investors.

When you have stricter requirements in place, you can expect more quality projects and less scams in general.

It’s also exciting because the underlying technology powering bitcoin and other blockchain networks could see much higher levels of adoption, giving a needed boost to the crypto ecosystem.

And in case you missed it...

This post is part of a longer series on security token offerings. Make sure you've caught the first two in the series:

And if you haven't already, download our eBook, "Intro to Investing in Cryptocurrencies: A Concise Guide for New Investors."

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Finally, over to you: what do you think think?

Will security tokens be the next big thing? Is the STO the way forward for companies and startups following an ICO-like model? Is there anything more you'd be interesting in reading on this topic?

Let us know your thoughts, and, as always, thanks for reading!

Disclaimer

The articles provided by IT Alpha d/b/a Intelligent Trading Foundation (“ITF”) are provided for informational purposes only. This post does not constitute investment advice, financial advice, or trading advice. ITF does not recommend that any specific cryptocurrency should be bought, sold, or held. Digital assets exist in a volatile and high-risk market, and their value can change frequently and without notice. ITF takes no liability for any decision(s) made or action(s) taken by any of our readers. Our articles are not meant to replace independent financial advice, and ITF strongly recommends any purchaser of digital assets, even if such user is experienced and affluent, seek independent financial advice in the content of their own unique circumstances.

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