What is an STO?

Tokens 101

What is a Security Token Offering?

In its efforts to find avoid excessive regulatory scrutiny, the relatively nascent world of cryptocurrencies has stumbled upon several innovations within the legal framework. First, there was the initial coin offering (ICO). Then came the Safe Agreement for Future Tokens (SAFT). Security token offerings, or STOs, are the latest prototype.

Simply put, STOs are a method for entrepreneurs, venture funds and organizations to raise money by issuing tokens. Security token offerings are a modification of ICOs, in which entrepreneurs also offer coins or tokens in exchange for project funding. A token’s value appreciates after being listed on a cryptocurrency exchange, following an ICO, thereby providing returns to investors. Utility tokens, however, are a regulatory gray zone and have been the subject of much confusion.

STOs eliminate this confusion and uncertainty by categorizing tokens as securities at the outset. The securities are token representations of financial assets, which could be stocks or bonds or any other type of collateral. In some cases, the securities could also represent fractionalized versions of commodities or physical assets owned by the startup or company.  

When an investor receives a utility token in exchange for participating in an ICO, the utility does not represent equity ownership in the platform and is mostly used by members of the platform to conduct transactions on it. Investors in the utility token do not have powers to change the platform’s rules or its management. They also have to wait for an appreciation in the token’s price to realize profits on their investment.  

In contrast, an investor in an equity STO will have ownership of the startup, much as a stockholder owns the listed company in proportion to her stock holdings. They are also entitled to a share of profits, similar to dividends issued by a publicly listed company, from the platform. For example, the purchase of $160 million worth of tokens used in online retail site Overstock’s security token exchange tZERO entitles GSR Capital, a Hong Kong-based venture capital and private equity firm, to 10% of tZERO’s gross quarterly revenue.

The security token offering market is expected to have stratospheric growth in the near future. Polymath, a Toronto-based firm for security tokens, estimates that the market for STOs will skyrocket to $10 trillion in the next two years.

The initial plumbing to harness this value has already begun. According to reports, the Swiss SIX group is planning to build an exchange exclusively for STOs. DX.Exchange, an STO exchange in Estonia, recently began offering tokenized versions of securities of well-known American companies, such as Apple and Tesla, to non-US investors. The exchange uses Nasdaq technology and falls under EU regulation.

According to Bloomberg, each token is backed by an actual share in the company. The shares will be purchased and maintained by MPS Marketplace Ltd., a Cyprus-based company. Token holders will also be paid out dividends, as and when the company involved doles them out to its investors. But the actual companies are not involved in the process.

Where Did Security Token Offerings Come From?   

The genesis of STOs lies in the regulatory problems around ICOs and their associated tokens. Under existing securities regulations, utility tokens require fewer disclosures and fees.

Cryptoasset entrepreneurs took advantage of the status quo by declaring their tokens as utility tokens to save on listing costs. The result was a prolific increase in the funding amount for ICOs, which reached record levels and peaked at $3 billion earlier this year.  

The SEC, which had been watching these developments from the sidelines, swung into action. It clamped down on suspect ICOs and issued multiple warnings through its site as well as official utterances. By August, funding for ICOs had fallen to $326 million. Entrepreneurs increasingly began raising money through private placements — soliciting funds from known, accredited investors rather than advertising to the general public — to avoid  legal scrutiny.

The STO was designed as a way to combine the benefits of an ICO with compliance of traditional offerings — allowing them to retain the structure and global coverage of an ICO without the regulatory entanglements.

What Are the Benefits of an STO?

Given that most securities represent equity or are financialized versions of real world assets, it can be hard to see the appeal over traditional stock market investing. Proponents of the STO tout its several supposed advantages.  

The use of smart contracts is one of the main appeals of an STO because it ensures speedy execution of transactions. Smart contracts also make it easier to bring a global investor base onboard, which is critical for startup entrepreneurs who can  offer equity ownership in their venture to investors elsewhere at significantly lower cost. Contractual and legal systems differ across geographies and startups interested in accessing markets across boundaries typically have to contend with an abundance of regulations and multiple expenses in the form of lawyers and consultants for each region. Meanwhile, token standards are fairly consistent across geographies, which translates to dramatic cost reductions.

STOs also have a “superior asset universe” as compared to traditional markets because they enable varied forms of tokenization, in addition to stocks and bonds and other forms of equities. For example, physical assets like real estate can be tokenized using smart contracts. The tokens could be representations of actual holdings as opposed to a financialized version of the asset. Within traditional markets, the route to such ownership would be indirect and through shares of a real estate company or trust. But even that would not entitle investors to actual ownership of physical real estate. By reconstituting real estate as fractions, the assets can be made available for cheap to retail and overseas investors.

STOs offer benefits to issuers of securities as well. Such offerings are another avenue to source liquidity for companies. DX.exchange, where shares of American companies are being made available to non-US investors,  exemplifies this approach. While the concept and execution seems similar to depositary receipts, the tokens have the advantage of being used on a blockchain, allowing for greater transparency and faster execution.

Companies can also convert assets on their balance sheet to tokens and offer them to investors. STOs can  open up markets, like corporate bond and sovereign debt, which have traditionally only been available to institutional investors and large organizations, to retail investors.     

Hurdles for STOs

Despite the benefits outlined by enthusiasts, it might be premature to sound the gong on an STO revolution.

The main problem for STOs is the same problem that beset ICOs. While STOs promise much, it is not clear how the legal framework will evolve. As of now, they are a legitimate method for companies and startups to raise funding using blockchain and smart contract technology. But there are several issues around smart contract technology that need to be ironed out, including how the technology’s guarantees will be enforced.  

A lack of information from authorities  leaves the door open to conjectures that could snowball into major risks or ambiguity in interpretation.

For example, a Chinese government official recently said that STOs are illegal in the country. The nation, which accounted for 90% of all crypto transactions until the beginning of 2017, banned ICOs later that year. (That action did not prove to be a dampener for ICO markets which metastasized to a $6 billion market by February of this year.) If more governments take a similarly hostile stance against STOs, it could significantly affect the reach and liquidity for such offerings. It could also lead to a direct decline in the number and quantity of such offerings.

The absence of infrastructure for security token offerings is another hurdle. The promises of STOs could fall short unless a sound infrastructure, including exchanges and firms offering their services to startups, is developed. Smart contract technology is also still being scaled for operations. According to reports, smart contracts for STOs are mostly being developed on Ethereum’s blockchain, which can only handle 15 transactions per second — hardly enough to execute the ambitious future being planned for STOs.

As mentioned, STOs allegedly permit  retail investors from across the globe to participate in funding events that were previously reserved for institutional entities alone.

There are two problems with this assertion.

First, it is unclear how retail investors might participate in such offerings. It is unlikely that the SEC will change its regulations to allow retail investors access to risky assets. This means that they will likely have to make these investments in foreign markets, where the scope of regulations is unclear. Consider the case of DX.Exchange, which has business and regulatory relationships that span three continents. An Australian investor in the exchange will have to contend with a financial authority outside his or her home country, in case of problems with their investment.    

The second problem might be the very presence of retail investors. Thus far, markets driven by the presence of retail investors have had thin liquidity and are prone to greater volatility.  

Are STOs the Future of Crypto?

Despite the hurdles, STOs might very well be the future of cryptoassets. By ensuring regulatory compliance for tokens, STOs pave the way for institutional investors and pension funds to invest in blockchain and cryptoasset-related products. In that sense, they represent the first iteration of a combination of the power of blockchain and existing financial markets. They also broaden the number of assets available for tokenization and investing. In doing so, they will introduce more liquidity into the system and make the market bigger.

Anthony Pompliano, founder of Morgan Creek Capital, holds out the prospect of digitally native equity tokens (instead of tokens backed by shares in a company). “In a world where these digitally native equity tokens become popular, companies would be able to more efficiently manage their cap tables, create new categories of value for investors (ex: claim on cash flow that is automatically dispersed onchain), and access global capital markets much earlier than normal,” he wrote.   

Meanwhile, utility token investors might continue to resist the advent of STOs given that the returns offered by such tokens are not as high as those offered by utility tokens, according to Trevor Koverko, Polymath CEO.

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