First, what is a security token?

There’s more and more buzz around Security Token Offerings (STOs), security tokens, and the potential of tokenized assets. But why? And what are they?

Many people are saying the STO will be the next Initial Coin Offering (ICO), and there are a number of reasons for this. One is all of the new regulations and laws evolving around digital asset ownership and issuance; and then you have crypto-related startups attempting to get out of the legal grey zones and comply with existing regulations.

Launching an ICO has become a risky venture, and more startup companies are looking for ways to raise funds without the fear of the SEC later telling them their token was a security, and that they had participated in an illegal offering all along.

Enter security tokens, a form of investment contract. These are not like utility tokens that offer access to a finished good, service, or dApp (decentralized application) on the blockchain.

Security tokens represent equity in a company, profit sharing, or even voting rights.

These tokens are governed by securities laws, so there are a lot of legal requirements in place for issuance. This is why many companies today still offer utility tokens despite the risk of impending regulatory framework, or later having their utility token defined as a security by the SEC (something no blockchain-related startup wants to happen).

In general, there are 3 types of security tokens.

Keep in mind, just because a company decides to call their token a “utility token”, it does not mean that token is in fact a utility token.

Moreover, if a company calls their token a “security token”, it may not really be a security.

This is what everybody new to these tokens needs to understand. Some utility tokens are actually securities. Other utility tokens may later be deemed as securities, and the issuers will have to deal with securities laws and possible penalties for illegal offerings.

And then you have some companies offering tokens as security tokens, but they are really little more than utility tokens that have gone through legal and regulatory compliance procedures.

Along this backdrop, a token’s legal status will depend on future regulatory rulings and classification, and the investment characteristics of the token itself. It will also be dependent on how the SEC and global regulators legally define “utility tokens” versus “security tokens,” and how they intend to move forward with regulations.

That said, let’s look at the three most common classifications of security tokens.

  1. ICO tokens that were explicitly sold as securities with an expectation of price appreciation. This is a token not intended for usage or utility value, but rather as equity in a company, profit sharing, or even providing voting rights to holders. Due to securities regulations, most of these cannot be found on major exchanges, especially those centralized and based in the US.
  2. Utility tokens that were offered by ICOs but were later deemed backed securities. (And this is the type of security token no company wants to have.) In the SEC’s famous DAO Report, they said that ICO tokens needed to go through the Howey Test to determine whether or not they would be considered securities. The SEC also said that “nearly all ICOs they looked at were actually securities,” leading to a lot of uncertainty regarding their legality, future regulations and penalties, as well as causing concern for startups who had already taken the ICO approach.
  3. The new security tokens that comply with regulations and are issued as official security tokens. These STOs embrace the security status rather than running from it. Issuers treat their tokens as a security for the purposes of fundraising, and in this way they do not have to worry about the SEC coming back later to tell the company their token was a security all along. Fundraising via STO is complaint with US laws, meaning crypto companies are now allowed to sell security tokens to institutional players -- something that was unheard of before.

What’s the difference between STOs and Initial Coin Offerings (ICOs)?

Both the ICO and the STO issue either coins or tokens to raise funding for the development of a startup company.

The STO, however, while similar to the ICO, requires far more legal assistance and advisors, as well as time, to be compliant with securities laws.

The main differences can be seen in the benefits of the STO model over the ICO.

  • STOs are compliant with existing securities regulations. This means they have more legal and compliant access to crowdfunding for investors.
  • There is less investor risk with STOs. There are laws that enforce company transparency, equity ownership, and more.
  • Security tokens can be backed by real-world assets, making their true value easier to assess.
  • You can even trade unique assets with security tokens, like real estate, art, agriculture, and others.
  • STOs allow the tokenization of these assets as well as fractional ownership, leading to more overall liquidity in secondary trading markets.

Because STOs are compliant with existing securities laws, launching an STO is a much more time-consuming process for companies choosing this approach.

Compare that to the ICO, which more often only requires a team, an idea, and a whitepaper (although not always necessary) before they begin raising funds.

This is not the case for STOs. The process for launching an STO is more similar to the process of launching an Initial Public Offering (IPO).

So it’s more like an Initial Public Offering (IPO)?

In many ways, yes.

Image alt textSTOs are regulated public offerings, just like the IPO. This means STOs must comply with all of the legal framework for launching a public offering.

The procedures for licensing and compliance require time and capital. Compared to the ICO model, the barrier of entry for STOs and IPOs is higher, and this makes everything slower.

At the same time, however, this approach (if done correctly) provides the much-needed certainty and quality you can find in the IPO markets, which has been clearly lacking in the ICOs.

Because of this, a company wishing to launch an STO will need lawyers, advisors, certified accountants, underwriters, and Securities and Exchange Commission (SEC) experts, just like an IPO.

But there are some noteworthy differences

Many industry insiders believe the coming STO model will disrupt the IPO markets, and perhaps rightly so. Compared to the IPO, the process for launching an STO is not as complex, nor as expensive. And there are other differences as well. Let’s dive in.

Cost and investment differs.

Initial and post-offering administration often costs much less with an STO. What is more, STOs can potentially provide more direct and transparent access to the investor-base, as well as lower brokerage fees when compared to traditional investment banks.

Investment in IPOs is limited by jurisdiction. STO investment is not.

And this is a major advantage for companies launching an STO. If you want to invest in an IPO, you often need an investment account with a broker bank in the country where the IPO is conducted.

With an STO, there is no such limitation - you only need an account on the STO platform to participate. This does not necessarily mean STOs are automatically global offerings, like the ICO, but it does provide STOs with much greater reach than IPOs.

STO issuers can set their own restrictions.

This is also a massive benefit to companies looking to increase their investor pool. STO issuers are able to set their own restrictions to the offering. They may limit investment to regions where the STO is registered and compliant (like in the European Union, for example).

Compliance is programmable and enforced by code.

This is what makes the offering and post-offering administration less expensive for companies. Transfer restrictions, geographical boundaries, investment lock-up periods and more can all be programmed into the security token itself, eliminating the need for various intermediaries.

It’s a novel concept and appealing to a wider range of investors.

Crypto-assets and ICOs swept like a storm over the financial markets, introducing investing to a completely new community of investors. This community realized a great deal of profit, but, unfortunately, also a lot of loss -- especially with ICOs.

Owing to this, there’s a new community of investors looking for better and safer investment opportunities. These investors may have different investor profiles (STO vs ICO investor), but with considerable interest growing around the STO, the door is wide open for newcomers.

Some of these people have never invested in traditional markets, and it’s likely they never will. The younger generation especially may be more interested in token investment rather than opening investment accounts with traditional banks.

Fractional ownership makes investment more accessible to a wider audience.

Tokenizing assets allows for fractional ownership of securities and assets that previously had much higher barriers of entry. One thing this does is make investing on a limited budget more feasible, with securities/assets being fractionalized into smaller amounts.

What is more, fractional ownership can have an impact on liquidity discounts. Liquidity discounts are often applied to illiquid shares. And because of the fact that a lack of liquidity can increase Volatility of the Share price, investors will discount an illiquid investment at a higher rate than an illiquid one when selling.

With fractional ownership, these assets may achieve greater liquidity, potentially eliminating the need to discount when selling, and naturally increasing the value of previously illiquid assets.

The interoperability provided by tokenization of an asset can represent a significant advantage over the current system.

Traditional exchanges have to deal with limited trading hours, different time-zones and national holidays. Around-the-clock standards of blockchain exchanges and their global reach eliminates these issues.

Blockchain technology can provide a framework for interoperability in the sense of the unrestricted sharing of resources between different systems. Globally accepted standards (e.g. ERC-20) enables investors to hold ownership claims to assets from different classes (real estate, equity or shares) on the same platform.

This would unlock unforeseen potential for decentralized finance, in which different asset classes can further reference each other in financial contracts, interact in an automated way within a smart contracts and enable frictional movements of value in and out of the diversified portfolio.

Key takeaways

One of the most exciting things about security tokens is their ability to tokenize existing real world assets. If they succeed in this venture, they have the potential to truly revolutionize traditional and non-traditional markets.

Taking it one step further, the STO could be the next big method for financing startups and crowdfunding in general. While it is more difficult to launch an STO than an ICO, it is not as complicated as registering an Initial Public Offering. And it does provide many of the benefits and protections for investors typical of IPOs, something that has been clearly lacking in ICO markets.

What do you think? Will the STO be the next big thing? Did we miss anything in this article? Is there something more you’d like to know about? Write us and let us know! And look for our follow-up article on the differences between security tokens and utility tokens, existing regulatory framework around the world, and the challenges going forward.

And in case you missed it...

This article is a follow-up to: ‘After the Initial Coin Offering: ICO 2.0 or Security Token Offerings (STOS). Read the post in the link below:

And for further reading, please be sure to check out our latest eBook, “Rebalancing a Cryptocurrency Portfolio: How to Intelligently Invest in a Highly Volatile Market”.

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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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