What are Security Token Offerings (STOs)?
The launch of the Bitcoin network in January 2009 brought blockchain technology to the world, creating an entirely new industry. Satoshi Nakamoto, the pseudonymous creator of Bitcoin, originally envisioned his elegant solution to the double-spend problem of digital currencies as a method of decentralizing money. The potential use cases of blockchain technology, however, are demonstrably far wider in scope.
It didn’t take long for innovators around the world to realize that virtually anything could be tokenized and decentralized through the application of the distributed ledger technology that drives Bitcoin — including the way in which companies and platforms are created and funded.
Thus, the “initial coin offering,” or ICO was born. Instead of pursuing venture capital funding or launching initial public offerings, blockchain technology enterprises began launching tokenized, crowdfunded ventures that have raised billions of dollars through decentralized capital generation events.
While ICOs have significantly boosted awareness and adoption of blockchain technology and resulted in the launch of hundreds of highly successful platforms, the impact of the initial coin offering on the blockchain ecosystem has not been entirely positive. A total lack of regulatory oversight and a high frequency of ICO scams has catalyzed a regulatory crackdown on ICOs, with many governments around the world banning ICOs outright rather than attempt to incorporate them into existing securities law.
Blockchain technology, however, is highly adaptable. The security token offering, or STO, represents the next step in the evolution of the blockchain industry, focusing on cooperating with existing securities regulation frameworks while retaining the decentralized structure of the ICO model.
The History of STOs
Security token offerings have emerged as a result of the problems created by the initial coin offering industry. ICOs allow blockchain technology platforms to connect directly with potential users of future products, capturing startup capital by offering investors blockchain tokens intended for use on the platform subsequent to launch.
Early examples of highly successful ICOs include NEO, Storj and Ethereum. The rapid expansion of the ICO industry, however, made it almost impossible for regulators to create regulatory frameworks in order to protect investors from fraudsters and exit scams.
Wildly quixotic market sentiment leading up to the late 2017 cryptocurrency bull rub saw initial coin offerings capture over $5.6 billion — statistics generated by TokenData, however, demonstrate 46% of these ICOS have already failed or disappeared. A STATIS Group report commissioned by Bloomberg in July 2018 revealed that over 78% of all initial coin offerings can be classified as scams.
The high prevalence of scams within the ICO ecosystem has resulted in rapid legislative action from regulators, with countries such as China and South Korea banning initial coin offerings altogether. In many cases, the tokens sold by ICOs meet the definition of a security under US securities law, offering investors a guaranteed return on investment.
The US SEC first intervened in the ICO market in December 2017, when it halted the launch of the Munchee ICO, serving company executives with a cease and desist order for the sale of a token that met the US securities law definition of a securities offering. The SEC has taken an increasingly active role in the regulation of the ICO market, with SEC Chairman Jay Clayton stating in April 2018 that virtually every ICO, according to the SEC, is a securities offering.
Increasing regulatory oversight has seen blockchain enterprises place a stronger emphasis on working within securities law, consulting with law firms such as Cooley in order to create the SAFT Project. The SAFT project is the progenitor of the security token offering model and focuses on creating a compliant framework for token sales.
Within the current regulatory environment, initial coin offerings are restricted to offering “utility tokens,” or tokens that will serve a function on a future platform that will be developed by crowdsale operators. The STO model makes it possible for blockchain enterprises to launch crowdfunding ventures that offer tokens that meet the Howey test definition of a security, and hold the potential to dramatically transform the securities market at large.
How STOs Work
At a basic level, a “security” is a financial instrument that is issued by a company in order to raise capital. Investors that purchase securities are provided with specific rights in return for their investment, such as interest generated on a principal in the case of bonds, or partial ownership of a company or dividends in the case of stocks.
STOs offer investors the opportunity to purchase security tokens, which perform the same functions as traditional securities. The most important difference between a security token and a traditional security is the blockchain — security tokens are digitized and exist on distributed ledgers, and thus offer many more features than a stock certificate, for example. Security tokens, like traditional securities, are subject to securities law.
What Problems Do STOs Solve?
While initial coin offerings may be highly popular, investing in an ICO is often not the best position for an individual investor. Retail and individual investors are often the last group to invest in an initial coin offering, following private token sale rounds and pre-sale round investors to purchase tokens at the highest price before ICO conclusion.
Moreover, the lack of transparency within the ICO ecosystem means that individual investors are often unaware of the token price made available to seed investors and venture capital investors, which can result in open crowdsale investors being dumped on by early investors when tokens are listed.
Security tokens, however, eliminate many of the risks presented by the ICO model by protecting investors with the same regulations and policies that govern traditional securities. The benefits of STOs extend beyond the ICO ecosystem, however — bringing securities onto the blockchain also benefits the traditional securities market.
Traditional securities are governed and exchanged by a complex ecosystem that is home to countless middlemen, fee structures, and bureaucracy. As blockchain tokens, security tokens eliminate the need for middlemen, streamlining the securities market. Security tokens also make traditional securities interoperable with smart contracts, presenting the opportunity to eliminate legal costs, complexity, and paperwork.
STOs vs ICOs
STOs are positioned to deliver the same benefits as those offered by initial coin offerings without the significant risk of fraud. By operating within existing securities law, STOs bring credibility and accountability back to the blockchain enterprise ecosystem.
Security token offerings provide blockchain industry entrepreneurs with the ability to access crowdsourced startup capital and circumvent the restrictive venture capital model while avoiding the increasing regulatory risks of the initial coin offering market.
STOs vs IPOs
While IPOs offer investors protection from bad actors within the securities market, the traditional securities market lacks agility. The decentralized nature of blockchain technology makes it possible to create blockchain-based securities markets that deliver advantages over the traditional IPO model.
The IPO launch process involves lengthy audits and regulatory reviews. Security token offerings allow new enterprises to publish documents required by regulators onto the blockchain, speeding up the auditing process and lowering costs.
IPOs are typically geographically limited — the STO-driven future of blockchain-based crowdfunding presents new enterprises with a global market of potential investors. Bringing securities onto the blockchain also allows for easier secondary trading, making it easier for investors to exit by simply liquidating security tokens, attracting more investors to early-stage enterprises.
Australian Security Token Offering Regulation
The Australian Securities and Investments Commission has published extensive documentation and guidance on initial coin offerings. The ASIC perspective on token offering securities classification is clear — initial coin offerings are assessed on a case-by-case basis and, should they meet specific criteria, are defined accordingly.
Token offerings that meet the definition of a managed investment scheme under Australian securities law, for example, must abandon the ICO model and fulfill product disclosure, licensing and potentially managed investment schemes registration obligations under the Corporations Act.
Token offerings that provide investors with the opportunity to participate in the corporate governance of an enterprise are likely to be defined as “shares” by the ASIC, and thus must issue a prospectus in the same manner as an IPO.
The ASIC has established similar regulatory frameworks for initial coin offerings that resemble derivatives, non-cash payment facilities, financial markets, and complex financial products. Australian securities law is primarily focused on classifying any token offering that offers any token not strictly defined as a utility token within existing securities law, and does not yet offer any specific guidance on security tokens.
Infrastructure for Security Tokens
The security token ecosystem is relatively new, but several platforms focusing on STOs have already emerged. The Polymath project aims to do for securities what Ethereum did for tokens, and functions as an open protocol that facilitates the creation of programmable equity that allows organizations to issue ERC-20 tokens in a diverse STO ecosystem.
Harbor takes the concept of security tokens a step further. The Harbor project aims to create a compliance platform that allows existing organizations to fully tokenize assets as well as facilitate rapid capital formation. Companies that want to launch an STO are able to create “Regulated Tokens,” or R-tokens. Harbor uses smart contracts to autonomously ensure that R-tokens are compliant with securities law in the locations the STO is operating and aims to tokenize assets ranging from real estate to corporate equity.
Interestingly, the ASX is already aware of the implications of blockchain technology and the securities market — in 2017, the ASX announced that it would be replacing the aging CHESS settlement system with a blockchain-based system. While the replacement of CHESS has been delayed, the creation of a blockchain-based ASX clearing layer would essentially tokenize the entire Australian securities market — making every security a security token.
Who can participate as Investors?
In many countries, securities can only be purchased by “accredited investors.” Purchasing securities and, by extension, security tokens in the United States is relatively straightforward. In order to purchase security tokens, American citizens need only to meet the requirements to become an “accredited investor.” Specifically, US-based security token investors must have a net worth of at least $1 million, or have an income of at least $200,000 each year for the last two years.
The Australian regulatory environment is more complex regarding securities purchases. Australian retail investors seeking to purchase securities and financial products must do so through an accredited broker with the protection of a regulated disclosure document. Retail investors in Australia are typically only able to access less complex securities, and cannot access exclusive sharemarket deals that are offered to individuals that meet the requirements to become a “sophisticated investor” under Australian securities law.
In order to become a sophisticated investor, Australian investors must obtain a certificate from a qualified accountant certifying an income of over $250,000 for the last two years or net assets of at least $2.5 million.
The Australian Securities and Investments Commission has not yet clearly defined any requirements that investors must meet before investing in security token offerings. If the ASIC follows the example set by the US SEC, however, it’s possible that only accredited sophisticated investors will be able to purchase security tokens. A more nuanced regulatory approach, however, will likely see STOs available to retail investors via brokers.