The cryptocurrency industry is moving at such breakneck speed, that’s it hard to keep up with all its developments.
Here’s one you’re probably not too familiar with: security token offerings (STOs). If it sounds something like initial coin offerings (ICO), you’re right, but it’s different, as this token offering is supposed to follow securities regulations.
It may sound ridiculous for ICOs to be going out the window considering they were all the rave just last year. But STOs are shaping up to be the industry standard for cryptocurrency, and there are several potential reasons why this is so.
STO vs ICO
The true difference between ICOs and STOs revolves around their regulation status. ICOs are unregulated funds raised for a new cryptocurrency venture. Most of the ICOs to date have been promoted as using Utility Tokens (vs. Security Tokens) - that the token had an intrinsic role in the function of the (proposed) product. This was to avoid them being treated as a security. However, securities regulators in many jurisdictions have taken the position that majority of these ICOs and the tokens used were indeed securities.
Enter STOs, which claim to follow securities regulations. And this difference is what has brought STOs to the forefront of the crypto world.
One of the biggest dilemmas and criticisms of ICOs are their unregulated nature, and the risks it poses to investors. Numerous scams have taken place concerning ICOs and some companies, with “pump and dump” schemes, where ICO issuers have taken the funds and disappeared. In some cases, such as Tezos, founders found themselves in dispute, backlash of the crypto community due to problems and issues with regulators.
The North American Securities Administrators Association (NASAA) has recently cracked down a series of cryptocurrency scams by means of their “Operation Crypto-Sweep”. The probe revealed close to 70 inquiries and investigations, and 35 pending or completed actions by means of enforcement. A Wall Street Journal analysis of 1,450 cryptocurrency offerings also revealed plenty of scams, with 271 presenting “red flags” of some sort.
It’s prompted countries like China and South Korea to ban ICOs completely. And companies such as Facebook have banned all cryptocurrency marketing because so many involved with it engaged in fraudulent practices.
Security tokens, however, have the potential to address both the volatility and fraudulence that affects ICOs. Since STOs are tied to something publicly visible, such as a company’s shares, the chances of fraud are significantly lower. Also, STOs mimic regular shares, and for a business to successfully adopt STOs, they must comply with the registration process of a traditional IPO.
While STOs are used where either security Offer Memorandum or a security Prospectus exists, this alone may not satisfy all regulations. Regulators want to make sure they know who is investing and where the funds are coming from and going. As such, they ask that Anti-Money Laundering (AML) and Know Your Customer (KYC) compliance is met.
One of the challenges the regulators have with the use of ERC-20 tokens in ICOs (BTW, these can also be used for STOs so the issue isn’t solved by just calling an ICO, “STO”), is that tokens can be forwarded to others without restrictions. This is part and parcel of the design of a peer-to-peer system of blockchain.
What this means is that an investor who complies with AML/KYC regulation and invests in a registered security token that uses ERC-20 (the most popular token standard) tokens, can sell their tokens to anyone in the world through secondary markets or privately, without going through AML/KYC.
To address this, several regulated stock exchanges including those in the US and Canada are looking to support a blockchain enabled security token offer through use of schemes such as “surrogate tokens” to stop secondary market trading of tokens for AML/KYC compliance. The recent announcement from the Swiss stock exchange (SIX) is to start with tokenizing bankable assets before opening up to non-bankable assets.
Opportunities of an STO
With an STO ecosystem in place, there will be an opportunity for seasoned (accredited) investors to take part in the offerings. The gold standard for falling into this category means either earning an annual income of $200,000+, having net assets of $1 million, an institution with over $5 million in assets or an entity consisting entirely of accredited investors.
The most important benefit of an STO is the fact that it merges the best of both the new-age cryptocurrency world and old-school investment standards. This gives organizations access to decentralized nature of blockchain, but with the added security of an IPO which the space lacks. Institutions, organizations and other parties will recognize this as a tangible asset, a real investment.
With these new measures in place, that means regulatory organizations will notice “blackhat” blockchain and crypto platforms faster and ban them sooner. After all, it’s far easier to find the bad apples when a standard of rules come into play - those bad apples’ behaviour will show face.
One of the best aspects of security token offerings is their application to fundraising for entrepreneurs. As we mentioned above, many startups have received funding from unregulated ICOs with risky propositions.
With an STO ecosystem, startup founders can tokenize the equity in their company through blockchain, which can bring liquidity to venture capitalists and angel investors. Ultimately, both investors and entrepreneurs will be in compliance with regulatory bodies.
Challenges of STOs
Security token offerings will take some getting used to of course. Part of the appeal of cryptocurrency ICOs is the low barrier of entry, and the ease at which people can establish themselves within the space. This is partly due to the lack of regulations. But once STOs come into the mix, it’s possible some companies may be threatened if secure tokens replace ICOs as the standard means for using cryptocurrency.
Another potential issue is this: STOs will weed out the fraudulent companies, but they may also deter legitimate ones who could offer valuable services. How so? The registration process. Unlike current ICOs, an STO-focused company would have to undergo more strict and thorough procedures before they could launch themselves as a regulated organization. This removes the low barrier of entry that makes it easy for companies to enter the cryptocurrency and blockchain space in the first place.
The other concern is that firms can offer legitimate “STO,” but then possibly become non-complaint with securities regulations at some time in the future. This can be as a result of offering a securities compliant Offer Memorandum or Prospectus-based security offering to accredited and AML/KYC compliant participants, via use of ERC-20 tokens that can be openly traded with non-AML/KYC compliant or unaccredited investors as part of the design of ERC-20.
There are also other concerns.
Needless to say, it’s important to understand and seek professional guidance on these matters before proceeding.
Key Players in the STO Market
Security token offerings haven’t become a household name yet, but there already some companies who are shaping up to be key players in this market. One such company is The Elephant, which serves as a pre-IPO equity provider using blockchain. In other words, they provide a platform that allows companies to invest in shares which are represented in the form of digital tokens.
There’s also Funderbeam, similar to The Elephant, which has helped over 100 pre-IPO startups raise over $5.8 million in funding. Also in the space is Causam Exchange, which uses a similar concept with its Blockchain Instrument for Transferable Equity (BITE).
And then there is Polymath. This company has received a significant amount of buzz due to their approach to securities. Their vision? To put the stock market on blockchain, an undoubtedly ambitious yet promising goal.
These companies are early adopters of the STO concept, and are already demonstrating that it can bridge both traditional markets and cryptocurrency space together.
What Tokenized Regulation Means For You
You can look at the idea of merging traditional investments with cryptocurrency trading as a “sweetspot” of sorts. Perhaps, you were one of the many who resisted (and maybe now regret) a pre-2017 bitcoin investment since it didn’t seem stable. In the near future, cryptocurrencies based on tangible assets will give you more confidence to put money towards digital ones.