What is the Difference Between an ICO and STO?

Tokens 101

What is the Difference Between an ICO and STO?

In the cryptocurrency alphabet soup, an initial coin offering (ICO) is, perhaps, the most known acronym. Now, enthusiasts have one more to remember: Security Token Offerings (STO).  While ICOs are more established, STOs are emerging as an alternative. This is partly because the market for ICOs, which was unregulated until early last year, has increasingly come under the SEC’s scrutiny. Multiple warnings and crackdowns from the federal agency — including for scams and unlawful promotions — have dimmed investors’ ardor for such offerings. Funding for ICOs dropped drastically this year and the market has receded as entrepreneurs increasingly use private placements from venture capitalists to raise money.

In contrast, the market for STOs is just getting started. The first STO was held last year and Polymath, a Toronto-based firm that helps companies issue security tokens, has predicted a $10 trillion market opportunity for security tokens within the next two years.

ICOs and STOs share several characteristics. Both are forms of fundraising used by entrepreneurs to raise capital for their ventures. In both types of raises,, entrepreneurs offer coins or tokens. Both cater to a diverse array of clients, from institutional investors to accredited and retail ones. Given the similarities, it might be easy to confuse them, but there are structural differences between the two. So how should investors evaluate the best type of offering for their money?

Here is a brief primer.     

ICOs Vs. STOs

Security tokens represent ownership in the underlying platform

This is the most important point of difference between ICOs and STOs. Most ICOs use utility tokens, whose main use is for transactions within a platform. Crypto entrepreneurs declare their tokens utility tokens because they are less costly and have fewer regulations associated with them. That said, they do not serve any other function besides that of conducting transactions within the platform.

On the other hand, security tokens are similar to equity instruments in that they represent ownership of the underlying platform. A security token derives its value from an external, tradeable asset. As such, a security token entitles its owner to a share of profits from the platform. The concept is similar to dividends issued by a listed company. Those dividends can be considered a type of liquidity event for holders of shares. For holders of utility tokens, the only form of liquidity event is an appreciation in the token’s price.

Both target different audiences

Specific guidelines from regulators dictate whether a token should be offered to retail or accredited investors. The riskier the asset, the less of a chance that it would be available to retail investors. With this context in mind, STOs are legally marketable to accredited investors. ICOs, on the other hand, have a broader audience and are marketed to retail and accredited investors. This is largely because regulation for ICOs falls within a gray zone.

STOs can only be held by registered broker-dealers

There is no such requirement for ICOs. Entrepreneurs can conduct ICOs from their own platforms,  which are not regulated by government bodies or central authorities. While there have been efforts to form self-regulatory organizations for the governance of ICOs, ICOs are still considered by many to be the Wild West, with scammers running rampant.

It’s a race  of sorts between different cryptocurrency exchanges to become the first broker-dealer. For instance, North America’s biggest cryptocurrency exchange, Coinbase, has applied for a broker-dealer license, made several acquisitions and dramatically increased the number of tokens listed on its platform within the last two months. These moves will likely enable Coinbase to ride the swell of security token offerings in the coming years.

Diversity of Offerings

For the most part, utility tokens serve just one function: conducting transactions on the platform. The universe of security token offerings is bigger. Financial assets are the most common form of STO but it is also possible to convert almost any asset into a security and sell direct ownership through an offering. An Andy Warhol painting was recently fractionalized and sold to token holders. Similarly, real estate in Manhattan was sold to token holders in fractions. In some instances, companies can also convert liabilities on their balance sheet, such as debt, and package them as securities for the markets. A token issued by the company would be the equivalent of a corporate bond and would trade accordingly in the markets.

STOs have multiple standards

ICOs are conducted on Ethereum’s blockchain and are mostly governed by the ERC-20 standard, which enables easy distribution and transfer of tokens between issuers and investors. Protocol standards are important because they are akin to programmatic compliance with existing regulations across geographies. It is essential that they remain customizable because the scope of such offerings spans multiple countries.

Because ICOs are governed by a fairly loose set of rules, ERC-20 is not compliant with existing securities regulations in several regions. Several standards, outlined by the respective platforms offering security token sales, have emerged in the absence of a blockchain standard. For example, Polymath uses the ST-20 standard on its platform. Harbor, another platform that offers similar services, uses the R-Token System, which is ERC-20 compatible.    

Will STOs Replace ICOs?

The regulatory pressures on ICOs have led many startups to shelve the option for now. Meanwhile, STOs offer another, albeit more expensive and regulated, method for startups to raise money from investors. Does this mean that ICOs will be replaced by STOs? Probably not. Despite recent hurdles, utility tokens serve an important function on platforms. They are vehicles for transmitting and exchanging value within a platform.

Utility tokens are essential to certain ecosystems in order to keep their economy intact. Consider the case of gaming platforms, where internal tokens can be used to purchase goods, ammunition or additional lives if a character is in danger of being killed. For platforms that are focused on providing tangible services to customers, a cryptocurrency can be an important fractional representation of service metrics used within the platforms.

Filecoin raised $257 million for its platform in a 2017 offering. According to its white paper, the Filecoin utility token serves a dual purpose. First it is earned by miners by providing storage to clients. Second, clients can also use Filecoin to purchase storage space or distribute it. “…Filecoin mining power is proportional to active storage, which directly provides a useful service to clients,” the white paper  states.  “This creates a powerful incentive for miners to amass as much storage as they can and rent it out to clients.”

Contrast Filecoin with  Aspencoin, a security token offered by Colorado-based St. Regis Aspen Luxury Resort. According to its website, the coin represents equity in the resort. “Aspen Digital Token will represent an indirect ownership interest in one deposited share of the Company’s common stock, par value $0.0001 per share (our common stock),” the site states. In other words, the digital token does not serve any other purpose besides the fact that it represents a fractionalized version of the company’s common stock. It cannot be redeemed to purchase services, such as food or lodging, at the resort, nor does its structure provide incentives for mining.

For both Filecoin and Aspencoin, the tokens help the respective organizations to raise funds from investors. However, the structure and distribution of their tokens ensures that the incentives for investors in the offerings are different.

The benefits of utility and security tokens are not mutually exclusive and can actually be combined to benefit a single blockchain. Recently, there has been a move by certain blockchains to construct a dual token structure on their platforms. The utility token, in such cases, would function as the means to exchange value between different actors in a platform, while the security token would target investors interested in profits through fluctuations in the token’s price on cryptocurrency exchanges.

An example of this approach is the Ignite ratings blockchain, a decentralized ratings and intelligence platform. It released two tokens last year – IGNITX and IGNT. The IGNT token is a utility token that is used for a variety of purposes within the company’s ratings platform. According to a Medium post from the company, users will be “rewarded” for participating in the company’s rating process using the IGNT token. The IGNITX token, however, serves no other purpose other than being traded on cryptocurrency exchanges and being used to buy IGNT tokens.      

In some cases, the dual token structure may result in stablecoins. Maker platform takes this approach with its MKR and DAI tokens. The MKR tokens are used for internal transactions, such as stability fee payments for their smart contracts or voting on governance structures for the platform. The DAI token is traded on exchanges and is considered a stablecoin, meaning that its price is pegged to that of its collateral and does not fluctuate. In this case, however, there has been no security offering and both tokens may be considered utility tokens.

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