What are Security Token Offering (STO)

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What are security tokens

Security tokens – digital analogues of securities, certifying ownership and giving owners the right to exercise their investment interests (right to shares, dividends, share of profits, etc.). These rights are recorded in the smart contract, and the tokens themselves are traded on exchanges. Security tokens are circulated in accordance with the legal regulations of financial regulators of various countries, for example, the US Securities and Exchange Commission (SEC) or the Swiss Financial Market Supervisory Authority (FINMA).

Morgan Creek Capital managing partner Anthony Pompliano, in his article “The Official Guide to Tokenized Securities,” defines security tokens as “digital assets subject to federal securities laws, a cross between tokens and traditional financial products.” He also characterizes security tokens as a “programmable ownership” that can extend to any asset – public or private capital, monetary obligation, real estate, etc.

Why do we need security tokens

Due to the peculiarities of security tokens, from the point of view of a legal perspective, they are treated quite differently from the so-called utility tokens (utility tokens). The latter are popular among ICO organizers, representing a means of gaining access to a company’s product or service. Unlike utility tokens, security tokens are tied to real securities, that is, they are considered a financial investment, and additional regulatory requirements are imposed on the companies issuing them, including reporting.

Security tokens also solve one of the biggest problems of ICOs – the lack of compensation guarantees in the event of a project failure or fraud by the organizers. In addition, they serve as a risk hedging tool for an investment strategy such as the Simple Agreement for Future Tokens (SAFT). This model is considered safer, as it gives accredited investors the opportunity to purchase tokens after the project is launched, however, it is still associated with certain risks: investments are not sent to tokens, but in fact in the promise to receive them in the future.

What are the benefits of security tokens

One of the main advantages of security tokens compared to traditional financial products is the elimination of intermediation in the face of banks and other organizations. This leads to the creation of a completely different environment for investing and concluding deals.

In his article The Security Token Thesis, professor of finance at the University of Oregon and Harbor project adviser (raised $ 28 million in investments to create a protocol for issuing and trading security tokens) Stephen McKeon lists the following key advantages of this asset class:

  • Market Access 24/7
  • Shared ownership
  • Fast execution of transactions
  • Lower transaction costs
  • Increasing market liquidity
  • Ability to automate compliance procedures
  • Simplification of the exchange / trading of such assets
  • Ability to create an ecosystem of related services

How to determine that an asset belongs to the category of security tokens

Traditionally important is the position of the American SEC regarding what should be considered a security. To understand the approach taken by the US financial regulator, it is necessary to return to Florida in 1946, where the orange plantation-owned enterprise called Howey Company offered investors an unusual solution. The scheme suggested that investors acquire a plot of land with a plantation, and the Howey Company makes a clearly stated commitment to work there and pay them part of the income.

However, the transaction was hindered by the SEC – the Commission decided that this scheme is an investment contract and that the participants should have been properly protected. Howey Company challenged this decision, arguing as an argument that it was just about selling land. The case ended up being considered by the US Supreme Court, which took the side of the Commission, thereby laying the foundation for determining what exactly is considered a security.

In honor of the company, which entered into a legal dispute with the authorities, the so-called Howey Test appeared, according to which a transaction is classified as a security if the investor answers in the affirmative to all of the following four questions:

  • There is a fact of investing money.
  • There is an expectation of profit.
  • Money is invested in a regular enterprise.
  • Any profit and its size does not depend on the efforts of the investor, but on the efforts of the counterparty or a third party (promoter).

It is this SEC test that applies today to ICOs and tokens, and if all of these questions are answered in the affirmative, the investor is going to invest in security tokens.

 What is Security Token Offering (STO)

According to a widespread belief, Security Token Offering (STO) is the next evolutionary step after the boom Initial Coin Offering (ICO), which defines the vector of industry development towards a more regulated and transparent market. However, STO and ICO are two different mechanisms for attracting investment, designed for different situations.

First of all, STOs intend to issue digital assets in full compliance with the requirements of securities legislation. This should provide a higher degree of protection of investor rights and lower regulatory risks for token issuers. In addition, STOs are guided by a different target audience – only professional (accredited) investors can participate in such a placement.

This category, according to US law, includes people who meet at least one of the following requirements:

  • Annual income of more than $ 200,000 per person or $ 300,000 for a couple, supported over the past two years and projected this year, in which the person plans to make investments;
  • Net assets in excess of $ 1 million, which do not include the value of real estate in which the person lives permanently;
  • An organization that has assets in excess of $ 5 million, such as a venture or trust fund;
  • A company all of whose members are accredited investors.

In addition, there are many technical details that an investor needs to know in order to participate in STO correctly, and for organizers to raise funds. In particular, when conducting an STO in the USA, issuers should take into account the Securities Act of 1933, namely, several of its provisions: Regulation D, Regulation A + and Regulation S. They describe various scenarios in which companies can offer securities to investors ( Security tokens).

What are the disadvantages of security tokens

The cryptocurrency industry, primarily in the field of ICO, is often perceived as a kind of reincarnation of the ‘Wild West’, where the right of the strong and the ability to crank out a particular scheme are in effect. STO, as has already been said, largely removes this entire process from the gray zone, however, this also means that the sector is losing its previously familiar advantages.

High entry threshold. Since investments in security tokens involve only accredited investors, this automatically cuts off a significant part of the cryptocurrency community, including completely law-abiding participants.

Higher costs for issuers. Despite the reduction in transaction costs, the launch of STO is associated with significant bureaucratic red tape. This means higher costs for lawyers and other professionals who contribute to the smooth launch of the project. Therefore, due to the high costs, STOs are more suitable for companies in the later stages of development (round A and above).

The above-mentioned Anthony Pompliano in his work on security tokens also suggests that the “flip side of the coin” is that when the intermediary is eliminated, its functions are transferred to the buyer and seller. In particular, he draws attention to the fact that parties traditionally responsible for the preparation of marketing materials, attracting investors, ensuring a high level of regulatory compliance and successful conclusion of the transaction are excluded from the transaction. However, one can safely argue with this statement – many companies are successfully developing their own marketing departments without outsourcing such questions.

Where are security tokens traded

Despite the fact that this area is considered promising, the possibilities of investors are still quite limited. Intentions to work in this area are also announced by the existing large cryptocurrency platforms, for example, Binance, as well as large stock exchanges like Nasdaq. Nevertheless, at the beginning of 2019 there was a very small number of licensed trading platforms offering such tools.

Among them, the tZero platform, which officially launched in January, can be noted. The first token to start trading on tZero was KODAKCoin, designed to serve the KODAKOne digital imaging platform. This token allows professional and amateur photographers to receive payment for licensing their work, a share of the platform’s total income and sell the ownership of their work using the secure KODAKOne platform.

At the end of 2018, Harbor startup launched a platform for distributing security tokens, inviting investors to register for the purchase of shares in The Hub residential complex in South Carolina. 955 shares were put up for sale in the form of security tokens at $ 21,000 per unit.

Other startups specializing in technological and financial solutions for this area should also be noted. So, among the creators of the SRC-20 protocol, which is considered the cryptographic standard of security tokens, liquidity providers and other solutions for this area, Blockchain Capital Brock Pearce, Polymath, Securitize, Templum, Securrency, OpenFinance Network and Orderbook from Ambisafe can be distinguished.

During 2019, however, the situation may change significantly, and it is assumed that competition in this market will increase significantly.

What is the future for security tokens

Despite the fact that a number of projects are still desperately trying to avoid a situation in which tokens issued by them are classified as securities, the general trend is going in this direction. For better or worse, this is a question for which there is no single answer.

On the one hand, the arrival of institutional investors, namely, accredited investors, can radically change the entire landscape of the industry and give it an important impetus for development. On the other hand, it must be remembered that by nature security tokens are fundamentally different from cryptocurrencies in their usual sense. There is a large stratum of the community, which categorically refuses to accept the new rules of the game, offering their own solutions based on the Bitcoin blockchain and not without reason believing that the future lies precisely with a truly distributed network with its powerful security mechanism in the form of the Proof-of-Work algorithm.

At the same time, you should not discount players who will continue to adhere to the principles of traditional ICOs. They may go to other jurisdictions, change the rules of the game somewhere, but on the whole they will continue to offer investment opportunities for a wider circle of users.

The trend, however, is obvious, although the transition to it will not be simple. In addition to the need to comply with the rules of financial regulators, the development of this industry also requires the creation of the necessary infrastructure. And that can be even more challenging than just buying bitcoin.

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