Security Token Offerings (STO) are quickly becoming a common way for blockchain projects to raise money. This next generation of Initial Coin Offerings (ICOs) has stricter rules and regulations which in turn provides greater assurances for investors.
What is a Token?
A Token is a digital representation of an asset. Some examples of tokens on a blockchain are:
- Currency system eg Bitcoin
- US Dollars eg Tether
- User reputation eg Augur
- Files eg Filecoin
- Rewards eg Steemit
- Property eg Propy
- A means for accounting, tracking, distribution, etc.
What is a Security?
Securities are tradable financial assets such as bonds, options, shares (stocks) and warrants. These financial assets, particularly public stocks, enable an individual to own a piece of an organisation without having to buy it outright. There are strict rules, regulations and assurances to ensure that if the organisation does well, the individual shareholders are rewarded proportionately.
All Together Now - Security Tokens
Security tokens are generally backed by an asset, such as a company’s profits or shares. STOs require licensing and approval by the SEC or other regulatory bodies. This means that security tokens will have the features and protections of traditional assets, such as shares of company stock, while also leveraging the benefits of being a digital asset.
Security Tokens are an Investment. They follow well established local laws. Projects launching an STO will need to register their intention to offer a security with the relevant jurisdiction. This will include the submission of their background check documentation. The main use-case and reason for contributors to buy the token is an expectation of future profits in the form of dividends, revenue share or valuation increase.
Current 'Utility Tokens'.
Almost all coin offerings to date have been done under the guise of a utility token. Utility tokens provide access to a product or service or are otherwise required to make the system operate. Specifically, utility tokens MUST NOT make any offer of valuation increase or other incentives to return a profit to the owner. Nor do they give token holders any rights to the profit made by the organisation.
There are many projects operating in a very grey area here. There are also projects that want to offer more value to their token holders. However, in order to stay on the right side of the law, they have limited their projects.
What is the difference between a Security Token and Utility Token?
Fortunately, there is case law from 1946 which outlines a set of questions to determine if there is an 'investment' under the terms of the US Securities Act. A project would need to prove its tokens are not securities by answering this series of questions with positive responses.
"An 'investment contract' under the Securities Act of 1933 is one that involves an investment of money from an expectation of profits arising from a typical enterprise depending solely on the efforts of a promoter or third party."
--SEC v. W. J. Howey Co.
These questions can usually be simplified down to three key questions:
- Is there an investment of money?
- Do investors expect profits?
- Are the expectation of profits derived mostly from the efforts of others?
Additional considerations for Security Tokens.
Can't mix and match. Specifically, exchanges will not be able to list Security and Utility tokens alongside each other. There are no Security Token exchanges currently. You will need to look at a new exchange to be able to trade Security Tokens. tZERO are looking to create the first licensed security token trading platform. The current security exchanges (ASX, NYSE, FTSE, etc) are not able to handle blockchain based assets at the moment. However, given the popularity of digital asset trading, I do envision the next generation to support blockchain based assets.
Securities should not have a utility. While it may be easy to understand that utility tokens cannot be a security, the inverse is also true. Given the complex requirements for securities, any utility function (such as gaining access to the platform with tokens) may be considered a security buy-back by the project. Under strict securities regulations, this may be a breach of their requirements and cause significant attention from the regulator.
Requires regulation for projects looking to raise funds. This will hopefully bring legitimacy to projects by reducing the opportunity for fraudulent projects to raise money. The requirements for raising millions of dollars of investment should be a first level filter to prevent malicious actors from flooding the market with fraudulent claims.
Could reignite current security markets. Stock exchanges are already looking at blockchain technology to back their platform. There will be a lot of opportunities for both blockchain and the current financial system to grow together if they can be integrated with each other.
Security tokens accelerate the democratisation of venture capital. Mum and Dad investors could have access to buy in early to the next Facebook, Apple, Amazon or even Baidu, Alibaba and Tencent! (Of course, this also means they could buy into the next Blockbuster, Kodak, Dick Smith, Enron, etc)
Advanced financial conditionals written in smart contracts. Financial institutes could get creative with their marketing material while being transparent with their conditions. For example, higher interest rates could be offered if certain conditions are met by the account owner.
We expect Security Token Offerings to dominate the 2019 blockchain market. They will require an often decried, but perhaps necessary, regulation which will bring assurances to investors. STOs will enable a new range of investors to enter the market and give confidence to old investors through regulated certainty.
Finally, Blockchain-based tokens will give investors legal weight which many had incorrectly assumed they already had. They bring verification of the projects and rights to those investing in them. It will kickstart the next democratisation of funding, enabling those currently excluded from participating in these opportunities.