What are security tokens and Security Token Offering (STO)?

Security tokens are digital analogues of securities that certify ownership and give their owners the right to exercise their investment interests (the right to shares, dividends, profit shares, etc.). These rights are recorded in a smart contract and the tokens themselves are traded on exchanges. Security tokens are traded in accordance with the legal regulations of different countries’ financial regulators, such as the U.S. 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, something in between tokens and traditional financial products.” He also characterizes security tokens as “programmable property rights” that can extend to any asset-public or private capital, monetary obligation, real estate, etc.

Because of the nature of security tokens, they are treated very differently from so-called utility tokens from a legal perspective. The latter are popular among ICO organizers as a means of gaining access to a company’s product or service. Unlike utility tokens, security tokens are linked to real securities, which means that 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 guarantees of compensation in the case of 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 launch of the project, but is still associated with certain risks: investments are not made in tokens, but in fact a promise to get them in the future.

One of the main advantages of security tokens compared to traditional financial products is the elimination of intermediation by banks and other organizations. This creates a completely different environment for investing and transacting.

In his article The Security Token Thesis, Stephen McKeown, Professor of Finance at Oregon State University and Co-Director of the Harbor Project (which raised $28 million in investments to create a protocol for issuing and trading security tokens), lists the following key advantages of this asset class

• 24/7 access to markets
• Equity ownership
• Fast execution of transactions
• Reducing transaction costs
  Increased market liquidity
• Ability to automate compliance procedures
• Facilitation of exchange/trade operations with these assets
• Possibility to create ecosystem of related services

Traditionally, the U.S. SEC’s position on what exactly should be considered a security is important. To understand the approach taken by the US financial regulator it is necessary to go back to 1946 in Florida, where a company called the Howey Company, which owned orange plantations, offered investors an unusual solution. The scheme called for investors to buy a plot of land with a plantation, and for the Howey Company to make an explicit commitment to work there and pay them a share of the proceeds.

The deal, however, was thwarted by the SEC – the Commission decided that the scheme was an investment contract and the participants should have been properly protected. Howey Company challenged the decision, arguing that it was just a land sale. The case eventually came before the U.S. Supreme Court, which sided with the Commission, thus beginning the definition of what counts as a security.

After the company that got into a legal dispute with the authorities, the so-called Howey Test emerged, according to which a transaction is classified as a security if the investor answers affirmatively to all of the following four questions:

1. There is the fact of an investment of money.
2. There is an expectation of profit.
3. The money is invested in a common enterprise.
4. Any profits and their size are not dependent on the efforts of the investor, but on the efforts of a counterparty or third party (the promoter).

This is the test that the SEC applies to ICOs and tokens today, and if all of the above questions are answered affirmatively, then the investor is going to invest money in investment (security) tokens.

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

First of all, STOs involve the issuance of digital assets in full compliance with securities laws. This should provide a higher degree of investor protection and lower regulatory risks for token issuers. In addition, STOs are aimed at a different target audience – only professional (accredited) investors can participate in such an offering.

This category, according to U.S. law, includes those who meet at least one of the following requirements:

• Annual income of more than $200,000 per person or $300,000 for a married couple, maintained for the past two years and projected in the current year in which the person plans to make the investment;
• Net assets in excess of $1 million, which does not include the value of real estate in which the person resides permanently;
• An organization that has more than $5 million in assets, such as a venture capital or endowment fund;
• A company whose members are all accredited investors.

In addition, there are a host of technical details that an investor needs to know in order to properly participate in an STO and organizers need to know in order to raise funds. Specifically, when conducting STOs in the United States, issuers must take into account the Securities Act of 1933, specifically several of its provisions: Regulation D, Regulation A+ and Regulation S. They describe different scenarios in which companies can offer securities (security tokens) to investors.

The cryptocurrency industry, especially ICOs, is often perceived as a kind of reincarnation of the “Wild West”, where the right of the strongest and the ability to pull off this or that scheme are in effect. STO, as has been said, takes the whole process out of the gray area in many ways, but it also means that the sector is being stripped of its previously familiar advantages.

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

Higher costs for issuers. Despite lower transaction costs, there is significant red tape associated with launching an STO. This means higher costs for lawyers and other professionals that contribute to a smooth launch. Consequently, because of the high costs, STOs are more suitable for companies in the later stages of development (Round A and above).

The aforementioned 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 taken over by the buyer and the seller. In particular, he points out that the parties traditionally responsible for preparing marketing materials, attracting investors, ensuring a high level of regulatory compliance, and successfully closing the deal are excluded from the transaction. It could be argued, however, that many companies have successfully developed their own marketing departments without outsourcing such matters.

Despite the fact that this area is considered promising, the opportunities for investors are still quite limited. The intentions to work in this area are stated by existing major cryptocurrency platforms, such as Binance, as well as major 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 is the tZero platform, which officially launched in January. The first token to begin 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 revenue, and to sell ownership of their work using KODAKOne’s secure platform.

In late 2018, startup Harbor launched a platform to distribute security tokens by inviting investors to sign up to buy shares in The Hub apartment complex in South Carolina. There were 955 security token shares for sale at $21,000 per unit.

It should also be noted other startups, specializing in technological and financial solutions for the field. For example, among the creators of the SRC-20 protocol, which is considered the cryptographic standard for security-tokens, liquidity providers and other solutions for this area are Brock Pierce’s Blockchain Capital, Polymath, Securitize, Templum, Securrency, OpenFinance Network and Orderbook by Ambisafe.

During 2019, however, the situation may change significantly, and competition in this market is expected to increase markedly.

Although a number of projects are still desperately trying to avoid the situation where the tokens they issue are classified as securities, the general trend is going in this direction. Whether this is good or bad is a question to which there is no clear answer.

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

At the same time, we should not discount players who will continue to adhere to the principles of traditional ICOs. They may leave for other jurisdictions, change the rules of the game, but in general they will continue to offer investment opportunities for a wider range of users.

The trend, however, is clear, although the transition will not be easy. In addition to the need to comply with the rules of financial regulators, the industry also requires the creation of the necessary infrastructure. And that may prove to be even more challenging than simply buying bitcoin.