In contrast to the tokens launched in an ICO (Initial Coin Offering) which do not offer any obligations and right, security token offering are financial securities backed by tangible assets, revenues of the company or profits. ICOs provide access to a specific platform, service or network, whereas Security token offering (s) offer legal rights like revenue distribution or voting. The role of a security token is similar to that of conventional security, except that it verifies ownership through blockchain and make fractional ownership possible.
Subjected to federal laws for governing securities, security tokens protect investors without the involvement of a third party using smart contracts.
Whether you an entrepreneur or innovator, this article will help you to understand the advanced concepts of STO and what benefits it can offer you and the investors.
What is Security Token Offering?
To understand Security Token Offering, you should first know what is security.
In finance terms, security is a certification that has some intrinsic monetary value. It can either be traded by exchanges who brokers the transaction or traded directly from peer-to-peer.
The securities are mainly classified into two main categories:
Companies utilize these methods to raise capital from investors, to fund some parts of businesses like expansion plans. The financiers are offered to make a profit through means like interest rates, share on the company profits or dividends.
Security tokens are cryptographic tokens that can be paid to the owner as dividends, a share of profits, interest amount or can be used to invest into other security tokens.
There are certain prerequisites to consider a crypto token as a security token. The crypto tokens should subject to federal laws and legal regulations.
For example, to launch an STO in the United States, it must pass the Howey Test and follow some specific regulations.
Security Tokens – Promising a new world of finance
Keeping the benefits of security tokens in mind, many corporate giants have built platforms to trade security tokens and provide institutional investors with an easy and secure way to start investing in blockchain technology.
NY Stock Exchange’s founder recently announced a new venture, Bakkt, a platform that allows buying, selling and storing of digital assets. Also, the Swiss Exchange Platform has planned to develop a regulated exchange for tokenized securities.
Security tokens have the potential to offer investors the security of a regulated instrument combining agility and the speed of blockchain.
Let’s take an example of corporate equity. No doubt that the companies share have been available for purchase since the ancient times of Rome, but the most advanced exchanges around the world need two days to clear settlements. With the implementation of the blockchain, the time could be reduced to a few minutes.
This transformation will not be that easier. Security tokens are far complex than ICOs or cryptocurrencies and therefore, investors require its more in-depth understanding.
As security token offerings need to comply with the SEC’s rules and regulations, it means security tokens have to incorporate many more legal contracts.
The rewards for developing a comprehensive system for security token exchange could be enormous. Around $256 trillion of real-world assets exist in the world and associating them to the investors through blockchain could bring a massive change in the financial markets.
The opportunity for crypto securities is genuinely vast, regarding the asset classes such as fine art and real estate that have suffered a lot in history due to restricted liquidity and commerce.
“But security tokens can unlock the liquidity of real-world assets by connecting them to the blockchain.”
We shall now discuss how regulations can have an impact on the security token offering.
What impact can regulations bring to the Security Token Offering?
Security tokens are investment contracts which are sold with the expectation of future returns for its holds covered by securities laws.
The laws may vary from country to country; therefore, companies need to make sure that all regulatory requirements are met before soliciting funds from investors.
The USA and Switzerland took the initiative to become the first countries that have legitimized the tokens. It is believed that 2018 was a year when cryptocurrency started to mature. As a result, the US Securities Exchange Commission also began an investigation on crypto organizations and the nature of tokens.
As a consequence, companies started filing the SEC’s Form D to launch an STO. The statistics available in the EDGAR database says that a total of 18 blockchain and 40 crypto related ventures have filed Form D with SEC since 2014.
Raising funds via STO is compliant with the legal regulations, allowing crypto ventures to sell security tokens to large organizations.
Being a federal government agency, SEC has to protect investors, maintain ordered and fair functioning of the securities market and facilitate capital formation.
As per the Federal Securities Law, no company can sell or issue security tokens without the registration in the SEC. To be called as a security token, it needs to qualify a Howey test.
The Howey test established by the US Supreme Court determines whether a transaction represents an investment contract or not. The following conditions must be met, and a transaction can be considered as an investment contract if:
- It is a money investment
- Profits are expected from the investment
- Investment of money should be within a common enterprise
- Profit comes from the efforts of a promoter or third party
Federal courts define a common enterprise as an organization where investors can pool assets or money together to invest in any project.
Apart from the Howey test, there are many other legal regulations which should be met while launching a security token.
Security tokens are compliant from the initial stage as they are subject to certain federal security regulations.
Security tokens in the USA need to subject to the following regulations:
- Regulation D
Regulation D is a Securities and Exchange Commission (SEC) regulation which allows startups or smaller companies to raise funds through debt securities or the sale of equity without the need of registering securities with SEC.It is required for companies to file a Form D with the names and addresses of their directors and executives and some details related to the offering.
- Regulation S
Regulation S offers an SEC compliant method for non-US and US companies to raise funds outside the USA.A US-based company does not need to use Regulation S. The offering subjected to this regulation can issue both debt and equity securities. The creators should follow the security regulations of the country where they can be executed.
- Regulation A+
Regulation A+ allows the creator to provide SEC-approved security to non-accredited investors via a general solicitation for up to an investment of $50 million.With regulation A+, the US or Canadian companies can combine public funding with private funds from venture capitalists for creating a large round of fundraising.
Why Security Token Offering?
1. Improved access to real-world digitized assets
STOs have come up with a new approach to open up the trading spheres to assets which cannot be traded easily and quickly. With $256 trillion of real-world assets available across the globe, there are a lot of opportunities available for asset classes such as fine arts and real estate which have suffered due to limited liquidity and commerce.
2. Cost Reductions
Launching an IPO is quite expensive. On the other side, companies can enable investment via tokenization with an STO. As a result, it cuts down the legal and admin costs while keeping the process and company transparent. Since trading restrictions can be embedded into a token with smart contracts, the cost required for IPO or other securities trading can be significantly reduced.
3. 24/7 Trading
With the evolution of Blockchain and cryptocurrency, trading can be done 24/7, meaning 24hours a day and 7days a week.
4. Fractional Ownership
There are only a few industries like real estate, collectibles or fine arts which have been drawing investor’s interest over the last few years due to their uncorrelated nature. As a result of which the value of these assets does not deviate as compared to other assets.
Since security tokens allow investors to buy fractions of fine arts or collectibles, people can expand the portfolios without the need of a large sum of money.
5. Increased Liquidity
Liquidity depends on the number of traders(sellers and buyers) in a specific market.
Speeding up transactions and fractional ownership via assets tokenization can enhance liquidity by enabling more individuals to get entry to the investment space and buy/sell at higher volumes.
The Positive Side of STOs
There are many reasons for looking at the positive side of the STO. Security token offering offers enormous benefits.
First of all, it is quite easier for businesses to promote themselves to the public with the help of a security token. It happens because individuals willing to invest do not have to pay exchange fees, brokers fees, and the costs involved in due diligence processes.
STOs also allow you to divide underlying assets into smaller assets. It acts as a facilitator for fractional ownership which can help to make offering more affordable to investors and make the transfer of tokens easier on a secondary market.
When should your business consider a Security Token Offering (STO)?
As a company, you should consider launching an STO only if you want to earn a lot of capital and your organization should align with the following factors:
- Turning over more than $10million per year
To raise funds successfully with an STO, your company should generate a high valuation. The higher will be the profits and turnover of your organization, the higher will be the company valuation.As a result, it will increase the amount of capital you may get for the percentages of your business.
- Running a global business
Rather than staying limited to the regional audience, you should know how to market the global audience to expand the potential of an STO and raise more capital quickly.
- Willing to take a slight risk
The regulations around the Security Token Offerings can change at any time in different places. It could place the investment source at risk, especially if the countries with high spending power like the United Kingdom, United States, Germany, South Korea and Russia tighten their regulations.Though such risk could be very slight, you should be prepared to take it in every situation.
- Funding method that attracts your current base of customers
While looking out for the new customers for your STO, you should not forget your previous and existing base of customers. You should go for a funding method that appeals to your customers. Also, consider issuing an asset that can be transferred easily.
If your organization falls short of the above points, it may not be worth jumping into the Security Token Offering. A failed attempt at launching an STO could have financial implications for your business.
Real Examples of STOs
It is one of the first companies to issue their stock with the help of an STO. The security tokens launched by LXDX would give the purchaser ownership within the exchange directly.The tokens were issued at one Euro per token which brought $57 million to LXDX for the financing round.
Preflogic is also launching a security token with smart contracts which facilitate Regulation D, S and CF. The company’s STO Wizard platform enables anyone to become a security issuer without the burden of legal costs that limit the STO sector currently.