Security Token & Security Token Offerings — The Comprehensive Guide

Utility Tokens Vs Security Tokens

A token can be classified into two types at the most basic level: utility tokens and security tokens.

utility token is a digital token of cryptocurrency that is issued in order to fund development of the cryptocurrency and that can be later used to purchase a good or service offered by the issuer of the cryptocurrency. It can be used to transfer value or gain access to decentralized networks.

Examples of utility tokens

security token is a digital token that represents shares in traditional financial assets or ownership in the company who issued it. Thus, a security token is also known as an equity token for this reason.

Examples of security tokens

There is a litmus test called the “Howey Test” to beemployed to judge whether or not the crypto is a security token.

The Howey Test. Source: FINMA

In the USA, the “Howey Test” is a test created by the Supreme Court for determining whether certain transactions qualify as “investment contracts”. If a crypto passes the Howey Test, it is deemed as a security token. A security token is subject to certain disclosure and registration requirements in the respective country.

Source: University of Idaho

In short, one of the major differences between utility and security token is a security token is subject to the securities act and heavily regulated by the government than a utility token.

Initial Coin Offering (ICO) vs. Security Token Offering (STO)

Security token offering (STO) is a fundraising tool which is similar to an ICO. Since security tokens are linked to business fundamentals and subject to the securities regulations, the security token issuers are held accountable for their actions. The shifting preference of investors towards STOs is swiftly replacing ICOs indicated by a drop in ICOs number in 2018.

Number of ICOs by Quarter. Source: Inwara (Market Intelligence Platform)

There was more than $25 billion raised by ICOs in the last two years and this indicated the acceptance of both retail and private investors towards ICOs. ICOs have gained the remarkable traction as a fundraising tool in the first half of 2018, with Q3 and Q4 marking as the slowest quarters in 2018. The average funds raised by ICOs have dropped over 50% in 2018 as the market matures and the preference shifting towards STOs.

Number of STOs Conducting Their Main Sale. Source: Inwara (Market Intelligence Platform)

The graph above shows that October 2018 has the most number of STOs than ever before.

The remarkable traction gained by ICOs has established ICOs as a viable method of crowdfunding. Although ICOs have helped a lot of blockchain projects in fundraising, this fundraising method paves a way for a variety of possible scams as little or no regulations involved.

Source: Satis Group LLP (ICO Legal Advisory Firm)

According Satis Group LLP (an ICO legal advisory firm), an estimated 81% of ICOs are assessed to be scams where the projects were described “had no intention of fulfilling project development duties with the funds” they raised through their ICO. A further 11% of ICOs succeeded to raise funding but were subsequently abandoned before their tokens were listed on an exchange. Only 8% of ICO tokens actually make it on an exchange for secondary trading.

“This noticeable shift from ICOs to STOs is largely driven by the recent bottoming of the retail market (both Bitcoin and Ethereum) and softening demand from retail investors for ICOs.The crackdown has also resulted in investor confidence erosion and this prompted the investors to change their preference to STOs,” by InWara.

Success Rate of STOs. Source: Inwara (Market Intelligence Platform)

There is an increasing number of STOs as over 60% STOs are concluded. According to a report by Inwara, Petro raised $735 million which is the highest till date, followed by Tezos, which raised over $232 million. The companies intend to raise funds are starting to realize that the interests of a sophisticated and/or accredited investors and funds are more inclined towards “security” tokens instead of “utility tokens”, due to values possessed by the security tokens.

Security Token Offerings Landscape

It is being estimated that the growth of STO will grow up to $10 trillion over the next few years.

Source: Polymath Network

There are six sub-categories in the security token ecosystem:

a. Issuance

b. Broker-Dealers

c. Custody & Trust

d. Legal

e. Compliance

f. Trading

Millions of dollars have been pumped into projects that support the issuance, exchange and custody of security tokens.

Source: The Block
STOs Landscape: Breakdown by Industry. Source: Inwara (Market Intelligence Platform)

“Investments and Trading” takes the lead with the most number of STOs so far, contributing to over 20% of total STOs. Financial Services leads the pack in ICOs numbers but for STOs, the sector takes a step back. STOs fueled an influx of investment into real off-chain businesses that provide equity/stake in an exchange of capital.

Security Token Regulations

Image result for security token regulation different countries
Source: Kepler Finance

USA

In the USA, STO falls under Federal Securities Law and is regulated by the Securities and Exchange Commission (SEC). The STO is bound to one of the regulations under the Securities Act of 1933: Regulation DRegulation A+, or Regulation S.

European Union

The sale of a token will fall under the EU’s pan-European securities laws as laid out in the prospectus directive and the prospectus regulation if the newly issued token has the features of a securities offering. The issuers will need to draft a prospectus and receive approval for the prospectus by the country’s financial regulator in which they are operating.

Singapore

In Singapore, A Guide to Digital Token is set out under the Securities and Futures Act (SFA) by Monetary Authority of Singapore (MAS) and any STOs would be subject to applicable rules and regulations.

Why Is Security Token A Viable Alternative?

1. Bringing Credibility Back

There is a real deficit of accountability in the ICOs because of a lack of regulation for utility tokens. In order for the crypto space to regain some credibility, it should make sense by amalgamating the crypto space and the traditional finance space together.

2. Improving Cost Efficiency

Traditional financial transactions can be expensive due to the cost of execution and getting the pieces together. IPOs require a lot of resources such as time and money. It is not suitable for companies with limited resources such as startups. Other costs such as middlemen fees i.e. bankers can be eliminated with programmable smart contract feature of a token. Smart contracts help to automate recurring things such as periodic dividend payments. This further cutting administrative costs even further. In the future, smart contracts may reduce the complexity, costs, and paper works.

3. Speeding up the Execution Process

Traditional finance involves a lot of middlemen which simply increases the execution time and subjects to the higher possibility of human error and mistakes. By removing the middlemen, a security token can be issued faster than traditional securities with increased speed and reduced complexity.

4. Exposure to the Free Market

Conventional investment today are extremely localized and geographically limited. For example, it is generally hard for Chinese investors to invest in private US companies and vice-versa. With security token, token issuers can market their security to anyone on the internet as long as the investors have access to the internet. This helps to promote a free market.

5. Wider Investor Base

Since anyone can invest in a security token, thus the number of investor increases exponentially and creates a huge investor base and brings more liquidity in.

6. Lack of Institutional and Market Manipulation

With the removal of middlemen, the chances of corruption and manipulation by financial institutions and regulators decrease drastically and may even be removed from the investment process.

7. Easier Liquidation and Higher Liquidity

With a wider investors base, it will be relatively easy for investors to liquidate their security tokens through secondary trading on the trading platforms. Security token changes the way ownership is managed and how the activities after the investment are automated.

8. 24/7 trading and Faster Settlement

A security token is tradable 24 hours 7 days with an almost instant settlement by using blockchain technology. The transparency feature of blockchain technology increases investors’ trust and credibility towards the trading system and process. A digital token is definitely one of the useful and effective tools for collecting and managing capital.

The Flip-Side of STO

  1. Shifting of Responsibilities

Removal of middlemen can reduce the cost of capital and execution greatly. However, the removal of middlemen also leads to the shifting of responsibilities onto the buyer or the seller in the transaction. The middlemen such as financial institutions serve a lot of important functions in the ecosystem such deal underwriting, preparation of marketing materials, solicitation of investor interest, insurance of high levels of security, and compliance regulation. Without middlemen, the issuers and investors will the responsibility the digital token is safe, secured and compliant to invest.

2. Licensing is Required

Being compliant with the regulatory frameworks means a security token requires a license from a regulatory body such as the SEC. Although the process of preparing the application is not as tedious as IPOs, it takes a longer time to prepare and to get approved by the regulatory body as compared to ICOs. Security token issuer shouldn’t think that the issued digital token will get approved immediately and millions of investors around the world will rush to buy their token like ICOs. Token registration and issuance is not that straight-forward and it takes months of work by key stakeholders to ensure the successful issuance of the security token.

Challenges Towards Security Token Proliferation

The overall security token overview looks inspiring and promising, but the security token issuers are faced with a variety of challenges.

  1. Lack of Legal and Regulatory Framework/Regulations

Many jurisdictions outside the United States still lack a legal and regulatory framework to enable security token offerings, although recent actions by countries intend to change that. In the United States, as security token offerings are by definition securities, STOs must follow the same rules as traditional securities offerings and are regulated by the Securities and Exchange Commission (SEC). Leaving legal and regulatory aside, the barriers to entry are high transaction costs for an emerging fundraising method that are expected to drop as legal, tokenization, and other technology costs drop with more service providers.

In most countries, all the frameworks and regulations related to digital tokens are still under preparation. Although security token is a new asset class, it is still operating by old laws, which may create some collisions. This will be a long process for all entities to come to a common conclusion, but it will be worth it.

2. Infrastructure Development

One of the major bottlenecks in the wider adoption of security tokens is a dependency on the entire infrastructure stack to be fully functioning before tokens can be issued and traded on a secondary exchange. Delays in deployment from any of the ecosystem players could provide a hurdle that offsets adoption of security tokens as an alternative asset class for institutional investors.

3. Custody Issue of the Underlying Asset

One of the most common issues for an asset-backed security token is who will take custody and responsibility of the underlying asset? A series of questions which is related to the custody issue would include the responsible party to build the necessary facilities for the custody of a whole range of different physical assets and the counterparty who will act as the insurer for the asset-backed security tokens. The issuance process of security token is as complicated as traditional securities. Thus, these issues have to be resolved in order to ensure the security token is sustainable even after the issuance.

4. Limited Early Liquidity

The STO market size cannot be expected to appreciate as aggressively as the ICO market did in 2017 due to overall cryptocurrency price dipping. Indeed, this is part of what makes security tokens attractive: growth is more organic and tied to growth in business fundamentals. This makes security tokens attractive to value investors but limits the volatility that pure short term speculators appreciate. It is important to keep in mind, however, that value investors are speculators as well: they intend to hold securities on a longer timeline.

5. Changing General Perception with Education

A security token is born out of the cryptocurrency revolution and thus some investors will not feel comfortable in an unknown environment, so we need to pay attention and be ready to educate them. It is generally perceived that the crypto market has a higher chance of default compared to traditional securities. A lack of business fundamentals coupled with lax disclosure requirements means that little more than speculative hype and market manipulation controls the price of digital tokens that make it onto a trading venue. This makes it difficult for investors to participate in STO as it would be very difficult to justify any decision based on accepted business principles.

The challenge here is to educate people that compliant security tokens are not only regulation-compliant, even better, but they are also regulation-enforcing. The security tokens are not only meeting requirements of existing regulations, but also automatically blocking any wrong transaction in code. Educating investors on the security token as a viable tool to complete the crypto market by resolving the flip-side of ICOs.

It will also be critical that the media plays a balanced role in building the foundation for STO acceptance. Attempting to hype the STO with the same aggressive tactics applied to ICO could be a fatal mistake that sets the industry back months if not years. It is also imperative for security token issuers to effectively communicate the difference between ICO and STO.

Summary

Will STOs overtake ICOs?

In future, STOs might overtake ICOs. This is because STO can be legal and regulated and investors can invest in STOs with a genuine expectation of returns. The price of STOs is not directly influenced by/correlated to the Bitcoin’s price movement and thus less volatile. Positive cash flow can be reasonably expected as the growth is more organic and tied to the growth in business fundamentals. This is generally more healthy for the digital economic ecosystem.

As of right now, security token has a far less market share as compared to utility tokens. However, security tokens are something which can become huge in 2019 and needs to be embraced by everyone soon. It is believed that tons of capital flow from the traditional finance market to security tokens instead of utility tokens. This shift is happening because security tokens are considered to be safer compared to utility token because of the strict regulations.

Security tokens will also transform equity just as bitcoin has transformed currency because they afford the owner a direct, liquid economic interest and the expedited delivery of proceeds. Most of the companies want to leverage the power of blockchains and smart contracts in their business which they can surely do through such programmable security tokens. Since most of the ownership can be tokenized, it would be a massive multi-trillion dollar addressable market.

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