Security Tokens Explained: Regulations and STO'S

Rajarshi Mitra

10 months ago
Security Tokens? Offerings and Regulations

“Security Tokens Explained” or “STOs” is the big topic of the week.  There is a chance that they may completely outperform ICOs in the coming year.

Security Tokens Explained: Regulations and STO'S

Regarding the importance of STOs, Overstock CEO, Patrick M. Byrne said,

“The ICO craze of last year created a toxic waste dump of financial assets. To me, that world of ICOs is a Superfund site. What we’re developing is a mechanism so that there will be a legal way to go forward and not create any new toxic waste.”

So, what are STOs and how do they work? Let’s find out more in this article.

The Rise of ICOs

When ICOs first started out, they revolutionized the concept of public funding and crowd sales. Usually, in IPOs or Initial Public Offerings, a company needs to go through a lot of red-tape in order to qualify for a public sale. However, ICOs disrupted this system by allowing developers to collect millions of dollars in exchange for just a white paper.

This is How ICOs Work

ico cycle

Step 1: Generating Hype and White Paper Creation

Firstly, the developers will announce their intention of making the project to generate hype and interest in the project. This step is very important because first impressions are everything.

Then, the developers will create a white paper.

A white paper is a document issued by the developers which highlight their project and the specific features of that project that makes it enticing for the potential investors.

While it is true that white papers are supposed to be a sales and marketing tool, they are nowhere near as flashy and over-the-top as a brochure or a sales letter. Whitepapers are written in an academic manner and the specific purpose is to entice the investors by showing its potential and features. They are meant to be purely informational.

After that, they will run the white paper through prominent members in the blockchain community to get their backing. Getting this backing is critical because this is where they will gain the credibility required to carry forward with the project.

Step 2: Token Generation

Now, they will need to create the tokens which they are going to exchange for Bitcoin or ETH in the token sale. Developers will have to decide the limit to the number of tokens and the amount that they want to charge for each token.

Usually, the price of these tokens is very low at the start of the ICO. Setting a cap on the number of tokens is necessary because having a limited supply of tokens automatically increases their demand (according to the law of supply and demand).

Along with the cap on the number of tokens issued, developers will have to decide a time at which they want to hold their ICO. Selecting the time, and the amount of time it runs for is critical and this will be covered in detail later on. Along with that, they also need to decide on the cap for the amount of money they will be taking in.

Once all these are decided, the developers choose a platform where they can advertise their ICO.

Step 3: The Sale

ICO

The sale is a pretty simple one.

If someone wants to buy the tokens they send a particular amount of ether to the crowd sale address. When the contract acknowledges that this transaction is done, they receive a corresponding amount of tokens. Since everything is decentralized, an ICO is considered a success if it is properly well-distributed and a majority of its chunk is not owned by one entity.

In 2017, ICOs raised $5.6 billion while in 2018, they raised >$20 billion.

The Problem with ICOs

Where there is smoke, there is fire.

ICOs have raised so much money that they have invariably attracted tons of scammers as well. In fact, the number of scammy and bogus ICOs has increased so much that it has affected the overall value of the global ICO market.

Since the actual requirements of creating ICOs are so non-existent, it is very easy for literally anyone to create an alluring white paper and raise millions of dollars with little-to-no accountability.

Most of these scams fall under the following categories:

  • Ponzi Schemes: Remember Bitconnect? Bitconnect was one of the most infamous Ponzi schemes of all time. A Ponzi scheme is similar to a pyramid scheme where it generates returns for older investors, provided they acquire new investors. It promises a high rate of returns with little to no risk.
    If you think that this is a little too good to be true, well then, that’s because it is.
    The Ponzi scheme is one of the oldest scamming methods known to us, however, investors continue to fall prey to them.
    Many scammers have taken advantage of this gullibility to leverage Ponzi schemes in their favor.
  • Front Running: In this case, a company or individual buys a large chunk of the tokens before any other investor even gets the chance to do so. The moment the price of the tokens goes up, they immediately sell everything.
  • Pump and dump: This happens when a group of traders colludes beforehand to buy a bunch of tokens and drive their price up high before selling them all in exchanges. This is one of the most common scams in the crypto world. This is called a “pump and dump”.
  • Washed Trades: In this case, a group of investors just keep trading tokens between them in order to create an illusion of asset liquidity.

All in all, the ICO world has been something akin to the “wild west”. With the lack of regulations and red tape, we have had amazing success stories, such as the Ethereum ICO while we also have had outright scams such as Bitconnect.
However, in order to safeguard the interests of the investors, regulations have entered the market and created a new type of token offering to make the token issuers more accountable for their actions. These offerings are known as security token offerings.

STO: Security Tokens Explained 

STOs, like ICOs, are fundraising tools, however, they have certain regulations that hold the token issuers accountable for their actions. Unlike the regular utility tokens, STOs generate “security tokens” which are real-time digital assets that operate within legal boundaries.

So, to understand STOs, you need to look into what a security token is.

A token is classified as security when there is an expectation of profit from the effort of others. If the ICO doesn’t follow certain regulations, then they could be subject to penalties. However, if all the regulations are properly met, then these tokens have immensely powerful use-cases.

Security Token = Investment Contract

At its very essence, a security token is an investment contract that represents legal ownership of a physical or digital asset like real estate, ETFs etc.. This ownership must be verified within the blockchain.

After the ownership is verified, security token holders can:

  • Trade away their tokens for other assets
  • Use them as collateral for a loan
  • Store them in different wallets

Having said that, the true value in security tokens lies in how they can completely redefine the meaning of “ownership”. They can democratize assets and distribute them among people all over the world. To give a very crude example, instead of owning a gold coin, which may be out of a lot of people’s budget, it is now possible for 100 people to own fractions of that gold coin.

What Regulations Are Security Tokens Subjected to?

Anthony Pompliano does an admirable job of explaining the kind of regulations that security tokens will be subjected to in this article.

According to him, because Security Tokens are subject to federal security regulations, they are compliant from the first day itself. So, in the USA, security tokens need to follow these regulations:

  • Regulation D
  • Regulation A+
  • Regulation S

Regulation D

Regulation D will allow a particular offering to avoid being registered by the SEC provided “Form D” has been filled by the creators after the securities have been sold. The individual who is offering this security may solicit offerings from investors in compliance with Section 506C.

So what does Section 506C require?

It requires verification that the investors are indeed accredited and the information which has been provided during the solicitation is “free from false or misleading statements.

Regulation A+

This exemption will allow the creator to offer SEC-approved security to non-accredited investors through a general solicitation for up to $50 million in investment.

In order for the requirement to register the security, the issuance of Regulation A+ can take a lot more time compared to other options. For the same reason, Regulation A+ issuance will be more expensive than any other option.

Regulation S

This happens when a security offering is executed in a country apart from the US and is therefore not subjected to the registration requirement under section 5 of the 1993 Act. The creators are still required to follow the security regulations of the country where they are supposed to be executed.

NOTE: As Anthony Pompliano notes in his article, the above summaries are merely his interpretation. They should not be construed as legal or investment advice and you should consult a lawyer for any and all questions you have.

If you are interested in diving deeper into the laws and regulations associated with blockchain and STO’s, check out our Blockchain for Law Accelerator Program!

Examples of security tokens are:

  • Sia Funds (Sia has two tokens, Sia coins which is a utility token and Sia Funds)
  • Bcap (Blockchain Capital)
  • Science Blockchain

Utility Tokens vs Security Tokens

Alright, so let’s see how these two tokens do head-to-head.

STOs vs ICOs

Security Tokens Explained: Regulations and STO'S

So, why have STOs garnered so much attention?

If you market your business effectively through an STO platform, then it can be an extremely powerful and effective tool for raising capital.

“But that’s the same for ICOs too!”

Correct, but think about this:

  • Since Security has to go through so many regulations, you know for sure that your investment is in the right hands.
  • An ICO investor gains profits on their investment via the use of the company’s platform or by the appreciation in the value of the token. However, an STO investor’s investment value is directly tied to the value of the company, They gain cash flow in the future and gain potential dividends or any potential right to vote that comes with the security.
  • Since security tokens are backed by external assets, it gives them value as soon as they are issued. Utility tokens, on the other hand, gain value by mere speculation until the platform that it is based on is developed.
  • An ICO is more like a Kickstarter or a “Go fund me” campaign, while securities are more like professional stock options.
  • STOs can seriously improve the crypto market’s image when it comes to crowdfunding. They can create dedicated black and whitelists that help in assisting with the anti-money laundering and know-your-customer regulatory requirements.
  • Security tokens are tied to real securities which mostly represent tokenized assets. As such, they are a lot more stable and credible than ICOs.
  • Since security tokens are already compliant, they don’t need to suffer from government interference in the future.

The Four Layers of STOs

The four layers of STOs are as follows:

Blockchain Protocols

The protocol is the underlying technology on which a particular project is built. Eg. Golem’s protocol is Ethereum. While ethereum still remains the most popular protocol with thousands of developers and contracts running on top of them, there have been many more protocols that have entered this marketplace. We have protocols like EOS which has become extremely popular with gaming and gambling DApps.

Smart Contracts

Smart contracts are automated contracts. They are self-executing with specific instructions written on its code which get executed when certain conditions are made.

Smart contracts are how things get done in the Ethereum ecosystem. When someone wants to get a particular task done in Ethereum they initiate a smart contract with one or more people.

Smart contracts are a series of instructions, written using the programming language “solidity”, which works on the basis of the IFTTT logic aka the IF-THIS-THEN-THAT logic. Basically, if the first set of instructions is done then execute the next function and after that the next and keep on repeating until you reach the end of the contract.

The best way to understand that is by imagining a vending machine. Each and every step that you take acts like a trigger for the next step to execute itself. It is kinda like the domino effect. So, let’s examine the steps that you will take while interacting with the vending machine:

Step 1: You give the vending machine some money.

Step 2: You punch in the button corresponding to the item that you want.

Step 3: The item comes out and you collect it.

Now look at all those steps and think about it. Will any of the steps work if the previous one wasn’t executed? Each and every one of those steps is directly related to the previous step. There is one more factor to think about, and it is an integral part of smart contracts. You see, in your entire interaction with the vending machine, you (the requestor) were solely working with the machine (the provider). There were absolutely no third parties involved.

In a more technical sense, they are code created on the protocol which serves as a blueprint for the decentralized application.

Issuance Platforms

The issuance platforms are responsible for having compliant, regulated smart contracts for the token issuance. Examples of these platforms are as follows:

#1 Polymath

Security Tokens Explained: Regulations and STO'S

Polymath is a blockchain protocol that helps in the issuance and distribution of legally compliant token-based securities. It helps in streamlining the process of launching financial products on the blockchain by making sure that the new security tokens are financially secure.

On the Polymat platform, you will be able to trade security tokens, authenticate investors, connect with legal delegates and access a developers’ marketplace. The native token Poly helps fuel this system.

#2 Harbor

Security Tokens? Offerings and Regulations

Harbor is an open-source platform that helps in the seamless migration from traditional investment classes onto the blockchain. They provide for a Reg D-compliant private sale which integrates KYC/AML, tax rules, reporting information, and accreditation status into each new token formulated through the system.

#3 Securitize

Security Tokens Explained: Regulations and STO'S
Securitize is a regulatory compliant cloud service solution for the tokenization of securities. The services provided by the platform include:

Establishing the legal and regulatory readiness of the issuers and their legal team, streamlining investor registration in compliance with KYC/AML accreditation or other legal requirements, customizing smart contracts to match issuers’ unique requirements and security token data throughout the lifetime of the security.

Exchanges

The exchange serves as one of the most critical functions in the crypto ecosystem. It basically acts as a portal between the Fiat world and the crypto world. There are usually two types of exchanges:

  • Fiat to Crypto
  • Crypto to Crypto

Fiat to Crypto

Fiat to Crypto exchanges helps you buy Cryptocurrencies in exchange for Fiat money. Coinbase is a perfect example of this kind of exchange. Coinbase helps you buy BTC, BCH, LTC, and ETH in exchange for Fiat currency.

Crypto to Crypto

Then we have the Crypto to Crypto exchanges. These exchanges help you exchange certain cryptos like BTC, ETH, BCH etc. for other cryptocurrencies. Binance is a fine example of a crypto-to-crypto exchange.

Essential STO Stats

Before we go any further, we need to give a shoutout to this article for all the stats. (Note: The graphs were calculated till October 2018).

An increasing number of STOs

Security Tokens? Offerings and Regulations

In the graph above, from Jan 2018 to October 2018, the number of STOs per month has pretty much steadily grown from month-to-month. As the crackdown on ICOs has increased, the shift from ICOs to STOs has been pretty noticeable.

STOs by Industry

Security Tokens? Offerings and Regulations

The industry with the most STO is “Investments and Trading” with over 20% of the total market. Following this are “Technology” and “Financial Services”. Funnily enough, financial services led the pack in ICO numbers.

STO Token Standard

Unsurprisingly, ERC20 leads this with a comfortable 68%.

Security Tokens Explained: Regulations and STO'S

Success Rate

Security Tokens? Offerings and Regulations

Until October 2018, 99% of the STOs were successfully completed.

Benefits Provided by STOs

Alright, so now that we have all the stats and details, let’s look into the benefits provided by STOs. There are three main advantages as follows:

  • Superior liquidity options
  • Reduced cost against IPOs
  • Segmented ownership

Superior Liquidity Options

Fully licensed exchange platforms will now soon be available for security token trading. This will significantly increase trading confidence because of added credibility. Since a real-world asset can be represented via security tokens, it will enable investors to liquidate security tokens against any product.

Reduced Costs Against IPOs

In the non-crypto world, only a handful of companies go public because that transition requires a lot of money in the first place. As such, investors have the option of buying the shares of a very few companies.

However, STOs, on the other hand, can be started right away since they are a lot cheaper than public companies. They reduce costs by completely removing all the middlemen. Also, having more STOs will allow more people to invest in the shares of more companies.

Segmented Ownership

Like we have mentioned before, security tokens will make high-priced assets a lot more accessible for the common man. Security tokens can easily segment an asset into smaller sub-divisions making it possible for an investor to own a fraction of the asset instead of the complete product.

Conclusion: Security Tokens Explained 

As you can see, STOs may become the preferred mode of crowd-funding in the near future. They are a lot more regulated and secure than ICOs while being a lot cheaper than IPOs. STOs also has the potential of opening up asset-ownership to a wide variety of people. Keeping all these things in mind, you can see why STOs have garnered so much hype?

Can they live up to it?

Well, we will need to wait and watch.

Want to learn more about Blockchain  Law’s and Regulation?

Check out the Blockchain Law Accelerator 

Here’s a rundown of the program:

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