Tokenized Securities and Security Tokens: What is a Security Token Offering (STO)?

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.

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.

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.

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.

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).

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.

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.

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.

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.