What is a Security Token and what are STOs?
Last updated: 2/4/19
STOs are the new buzzword around the cryptoverse, but what are they exactly, and how are they different from an ICO. In this post I’ll explain exactly what security tokens and security token offerings (STOs) are.
STOs are a way to tokenize tradable financial assets and offer them to the public in a responsible regulated process. Unlike ICOs that are more of a “wild west” type of offering STOs adhere to specific regulations and oversight by regulators. A token will be considered a security if it answers “yes” on all 4 questions on the Howey Test (explained below).
For a more detailed explanation keep on reading, here’s what I’ll cover:
- The evolution of ICOs
- The Howey test
- Security Token Offerings
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An Initial Coin Offering, or ICO for short, takes place when a company sells cryptographic assets known as tokens in order to raise funds for its operations. The tokens being sold play a role in the project and those who buy in early are getting them at a discount, assuming the project succeeds. The company usually opens the sale of tokens for a limited time frame until the money they need to raise is reached.
A good analogy for an ICO would be selling $1 casino chips at 80 cents a chip in order to build the new casino. If the casino comes to life the investors made a wise investment.
A good example of an actual ICO would be Ethereum, where Ether – the token used to power the Ethereum network – was sold to investors before the network launched, in order to fund the project.
Tokens in general are divided into two categories – utility tokens and security tokens. Utility tokens are tokens that promise the future use of a product or service. They aren’t meant to be an investment, they have a utility.
One example that might be considered a utility token of sorts would be a Starbucks gift card. If you buy it at a discount, you’re not really expecting to make a profit by selling the gift card. Effectively, you’ve prepaid for, and expect at a later date, a cup of coffee.
Security tokens on the other hand, are tokens that represent tradable financial assets, for example a share or a bond from a company. Security tokens are meant as a form of investment, they pay dividends, share profits or pay interest in a way that promises future profit.
Put simply, utility tokens promise a product or a service while security tokens promise profit.
While ICOs started out with good intentions, people quickly started seeing the opportunity for easy money and used this mechanism to fuel their greed. In 2017 the ICO frenzy reached its peak. Billions of dollars were invested in so called utility tokens that had as little as a piece of paper describing some obscure future venture. Of course the overwhelming majority of these projects never saw the light of day and a lot of investors lost their money.
Back then the ICO field was completely unregulated and quite the number of scams and manipulations emerged. Investors pumped up the price of specific tokens just to dump all of their holdings once everyone else bought in. Other cases included companies that just completely vanished, along with the money, once the ICO ended and the money was raised.
Instead of a creative way to raise capital, ICOs quickly became a workaround to avoid regulation. Companies that wanted to avoid the long, expensive regulatory path toward the traditional Initial Public Offering or IPO just conducted an ICO instead.
Nobody asks for permission to run an ICO, you just set up a website, some tokens and start selling them to the general public. Also, unlike an IPO, you’re not giving away any control over your company or profits since you’re supposedly selling tokens that only promise future use of your currently non existing product.
As things got out of hand, public complaints increased, companies like Google and Facebook banned all ICO projects from advertising on their platform and regulators stepped in. Regulators wanted to investigate whether these so called tokens shouldn’t be in fact considered as securities. And if so, are the companies behind them meeting the requirements to allow them to sell securities.
In the US there’s a simple test called the “Howey Test” that is used to decide if what someone is selling should be considered a security. It states that a transaction is considered a security sale, if a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.
We can break this long and confusing sentence down to four main questions:
- Was there an investment of money? In the case of ICOs the obvious answer is yes.
- Was this investment done in a common enterprise? Since ICOs raise money for a company which is considered a common enterprise the answer is also yes.
- Was there an expectation of profit? This is a very interesting question, since a company can always claim that its tokens were meant for utility only. However, when you look at the token market you can clearly see that people are buying tokens in the morning and then selling them in the afternoon. Meaning tokens are bought in order to sell them for a profit. So depending on the specific case this could be a yes or a no.
- are the profits connected directly to efforts of a person or entity who are not the investor? This question is a bit confusing, so here are some other ways to look at it: “Is there a person, that isn’t the investor, who is in charge of making this venture succeed?” You could also ask “Is this a passive process for the investor?” In most cases the answer to these would be a solid “Yes” as the investor’s involvement in the project ends usually once he or she invested funds and got tokens in return.
Now you can see why so many ICO companies are considered to be selling securities by regulators.
Bitcoin, for example, doesn’t fall under this category since there’s no one person making the decisions. Many open source projects can have the benefit of the doubt since you can’t say that there is one person calling the shots, it’s more of a group effort and that disqualifies them from the fourth question.
While most companies classified their token as utility tokens in order to avoid security regulations, when they were reviewed by the authorities, almost all of them were said to be selling securities.
Today, most ICOs aren’t open to the public because of the fear of regulators and are privately funded by small groups of investors. So on the one hand we have ICOs – A completely unregulated form of raising money from all around the world, that’s fast and easy to execute and is filled with scams, frauds and just plain negligence.
And on the other hand IPOs – A long, expensive, exhausting road of raising money from investors by vetted, legit companies.
But today, there’s a new type of offering called a Security Token Offering or STO. A kind of middle ground between an ICO and an IPO. Let me explain.
An STO is the process of selling security tokens to the public while avoiding the long exhausting process of an IPO. There are no utility tokens in STOs and everyone participating is considered an investor. STOs are intended to be compliant with Anti Money Laundering requirements and securities laws.
You might be wondering how are STOs possible? How can you sell securities without regulatory oversight? The answer is through exemption.
In the US for example, you’re exempt from registering with the SEC if you fall into one of three regulations:
Regulation D, Regulation Crowdfunding or regulation A+.
Regulation D means that STOs are exempt from registering with the SEC if they raise money only from accredited investors, meaning anyone with a net worth of $1 million+ or with an annual income of $200,000 or more in the last two years. The company can raise an unlimited amount of money in this manner.
Regulation Crowdfunding states both accredited and non-accredited investors can participate in the offering, but there is an annual limit to how much an STO can raise – $1,070,000
Both regulation D and regulation CrowdFunding have a one year lockup limit. This means that investors need to wait for one whole year before selling their security. This is done to prevent pump and dump schemes and protect other investors.
Regulation A+ means the offering must be qualified by the SEC, sort of a mini IPO. Once it is approved, everyone can participate in the STO, which is limited to $50,000,000. There is no lock up period for a Regulation A+ exemption. You could buy and sell your tokens in the same day just like you currently can with cryptocurrencies.
So, once a company falls into any one of these regulations, it can sell security tokens as part of an STO, with no threat from the SEC coming down on it to shut it down and throw the proprietors into jail.
STOs have a lot of advantages. For starters, they remove the threat of scams through the implementation of regulation and oversight. While ICOs were traded on shady and unregulated exchanges, STOs are traded on verified exchanges.
Also, STOs open up bigger markets for investors since almost every asset class type can be tokenized. From the fundraiser’s perspective, a wider audience of investors can be reached, as digital securities are easily marketed and transferred across borders.
Of course many people think STOs are a bad thing since in some cases, regulation D for example, they offer the investment to accredited investors only. This seemingly excludes the Main Street investor while allowing only the rich to benefit.
On top of that, the lockup period and cost of compliance may deter many investors and companies from participating in STOs.
In the end, STOs have various pros and cons. I believe that at this point in time, they are more suited for early adopters, who are looking to invest in something new and exciting while still subject to some oversight, which offers a certain degree of investor protection.
These are just the early days of STOs and as we move forward, more and more companies, not just crypto related, are thinking about how they can “tokenize” their assets in order to raise funds.
What are you thoughts about STOs? Let me know in the comment section below.
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