A security token offering (STO) is similar to an initial coin offering (ICO), except that an STO involves security tokens. These security tokens are backed by real assets like commodities or equities.
As a result, the tokens sold through these offerings can take many different forms, such as equity tokens and debt tokens. The former type, for example, raises money for a company by offering investors equity ownership in that firm. Entrepreneurs can potentially "tokenise" anything that an applicable law considers a security, including notes, debentures and options.
Businesses have already started harnessing the resources presented by STOs, a development that technology entrepreneur Darren Marble pointed out: "Established companies are already beginning to tokenize equity in their business, and startups now have a new vehicle that may provide faster and easier access to capital," he wrote.
Another way of putting this is that STOs have opened up a significant opportunity for businesses to raise funds and also avoid the risks inherent to many ICOs by issuing qualified securities.
Regulation And Compliance
One major difference between STOs and ICOs is the regulatory treatment of the digital tokens they offer. The tokens offered through STOs are subject to federal securities regulations. This makes them different from the digital assets sold through ICOs, which the U.S. Securities and Exchange Commission (SEC) has stated are securities in some cases and not in others and that it depends on the individual circumstances involved in the sale.
While ICOs have at times taken a "wild west" approach to fundraising by trying to generate as much money as possible without considering the source, entrepreneurs holding STOs have the ability to create whitelists and blacklists. By taking this approach, they can more easily comply with key regulations like anti-money-laundering (AML) and know-your-customer (KYC) reporting requirements. Some service providers have entered the space to provide entrepreneurs with help in setting up STOs. Certain companies, for example, have started offering turnkey solutions to automate the due diligence associated with KYC/AML and verifying accredited investors.
One such provider, Polymath, has even started working on a standard for STOs named ST-20. By offering this standard, the company hopes to make it easier for people to both create and buy security tokens.
The ST-20 standard offers several benefits.
- When using the standard, technologists and entrepreneurs can store legal documents on the blockchain.
- Tokens issued using this standard can be altered indefinitely, meaning that the entrepreneurs issuing them can upgrade these digital assets, if needed, to comply with the enactment of new regulations.
- Entrepreneurs can take tokens distributed using the ST-20 standard and cut them up into tranches, meaning groups that have individual characteristics. Individuals holding an STO could create tranches based on characteristics like lock-up periods and voting rights, for example.
- Another aspect of tokens sold using the ST-20 standard is that they can be moved from one place to another through forced transfer. This aspect allows the issuer of a specific token to take units of that token out of a wallet and move it elsewhere without first securing the permission of the person holding those digital assets.
While this may seem a bit odd or even antithetical to some of the basic principles of the digital currency space, it is crucial for security tokens to have this aspect if they are to meet the same regulations that non-token securities must adhere to. Should a legal development require it, the issuer of a security token may need to move units of these digital assets from one place to another in order to be compliant with existing regulations.
One major benefit that tokens sold through STOs have over similar digital assets distributed through ICOs is their built-in investor protections. Securities laws have been around for decades, and simply selling a digital asset as a security token places it under the protection of this legal framework.
Because the tokens sold through ICOs could potentially be considered securities, entrepreneurs holding these digital token sales have used creative techniques in an effort to avoid being subject to securities laws. More specifically, their marketing communications have frequently used terms like "buyer" and "purchaser" instead of "investor" and have provided disclaimers that, for example, have indicated that future returns are not guaranteed.
Because of this specific language, companies holding ICOs have greater flexibility with the money they raise, and they can use the funds however they see fit. Further, language like this seems to indicate that the tokens sold have no intrinsic value.
This setup contrasts with STOs, in which entrepreneurs offer tokens backed by specific securities.
Entrepreneurs looking to hold STOs should keep in mind that they will have to register with the authorities where they want to sell securities. For example, if the founders of a business want to sell a security token in the U.K., they will need to register with the proper authorities. However, anyone interested in taking this path should keep in mind that if something is a security in the U.K., it will also be considered a security in other jurisdictions, such as the U.S.
As a result, entrepreneurs who are interested in holding STOs should keep in mind that doing so will likely require them to register with the authorities in more than one jurisdiction.
Another potential consideration for those interested in STOs is that security tokens may lack liquidity. At the time of this writing (December 2018), digital currency exchanges lack the ability to list security tokens. Also, more traditional exchanges like the New York Stock Exchange don't have the resources needed to clear and settle trades of these digital assets, and are also incapable of listing them.
Due to these factors, those who obtain security tokens may be unable to sell them for some time.
One more variable those interested in STOs should consider is the role that the U.S. Commodity Futures Trading Commission (CFTC) plays in regulating digital currencies. The CFTC has asserted in the past that it has the authority to regulate cryptocurrencies as commodities covered under the Commodity Exchange Act (CEA).
The CFTC confirmed this position in September 2015 when it issued its first order against Coinflip, a San Francisco-based company that conducted business using the name Derivabit, in addition to its CEO, Francisco Riordan. This company was running an unregistered Bitcoin options trading platform, and the CFTC charged both Coinflip and Riordan with failing to register with the government agency or meet the rules needed to obtain an exemption.
More than one federal court later upheld this position. In March 2018, Jack Weinstein, U.S. District Court Judge for the Eastern District of New York, ruled that the CFTC had the authority to sue New York resident Patrick McDonnell and his company CabbageTech for fraud. By doing so, the judge confirmed the CFTC's position that it has the ability to regulate digital currencies.
In September 2018, a separate federal court also upheld that position, when Rya Zobel, a federal judge for the U.S. District Court for the District of Massachusetts, ruled that the CFTC has the authority to prosecute fraud related to digital currency.
Investors can benefit significantly from knowing about STOs. Entrepreneurs may also benefit from learning about these offerings, as they can be a great way to raise money and also obtain regulatory clarity.
Entrepreneurs interested in these offerings should keep in mind that before holding an STO, they must register with the proper authorities. This could mean registering with the appropriate regulatory bodies in more than one jurisdiction.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…