If you’ve been paying attention to the news there’s a high chance you’ve seen the boom in the cryptocurrency market and the rise of the Initial Coin Offering (ICO) as a method of fundraising. Recently, some companies have begun to embrace these regulations through a new fundraising method, the Security Token Offering (STO). The Security Token Offering involves registering with the relevant financial authorities to ensure compliance and provide additional security for investors.
A Quick Brief on ICOs and their classification
To understand the benefits of the Security Token Offering let’s take a look back at the ICO model to see exactly where the improvements on this model lie. ICOs were relatively easy to conduct and enabled founders to raise millions of dollars to fund their ideas. This was made possible due to the creation of the Utility Token.A Utility token functions in a way similar to that of a gift card or prepayment, in that they can be used to purchase services from the issuing company. Under this classification companies were able to avoid the strict regulations associated with the sale of securities.
This also allowed the cryptocurrency ecosystem to develop without government intervention, making it truly unique as compared to traditional financial systems. Without this intervention, greater emphasis could be placed on things like privacy and consensus.
During the ICO boom the only real requirements for conducting an ICO were developing a blockchain compliant token, distributing a whitepaper, and assembling a team. As ICOs initially relied on public money, marketing was also an essential part of the process. It was due to the ease associated with the ICO method that scammers began to emerge and calls for regulations started.
While there are certainly benefits to the ICO model, many people, from regulators to evangelists alike, noted that in many cases the tokens generated in ICOs strongly resemble securities and didn’t have the utility they claim to have. Regulators have been aware of this, as SEC Chairman Jay Clayton famously stated:
“I believe every ICO I’ve seen is a security.”
Since a security token is a regulated security it can provide the same benefits that traditional financial instruments provide. Ownership of a security token can provide the holder with voting rights, dividends, ownership, and other benefits that have long been associated with the stock market and other financial markets.
What Constitutes A Security?
To further understand the differences between these two fundraising models, we’ll have to take a look at what actually constitutes a security. The definition of a security was established in the U.S. Supreme Court case, SEC vs Howey. It was in this case that the Howey Test was developed. The Howey test states that any transaction with the following characteristics can be classified as a security:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
A huge number of ICOs would, unfortunately, be considered securities with the application of the Howey Test. While many ICOs were able to escape being formally accused of being securities, the notion that regulation could largely wipe out the industry has kept many institutional investors from diving headfirst into this new asset class. Many believe this legal grey area is what has prevented the industry from truly reaching the mainstream and widespread adoption. Many believe that the Security Token Offering will be the next stage of the revolution in finance enabled by blockchain technology.
So what problems does the Security Token Offering solve?
The greatest benefit that security tokens offer is the fact that they go through traditional financial channels to achieve compliance. This alone is estimated to bring in a larger number of traditional financial investors.
Institutional investors are often bound by charters and contracts which determine what types of investments they are allowed to make and the amount of risk that they are allowed to take on. ICOs, due to their legal grey area, have been considered to risky to invest in by these investors.
Digitizing Traditional Finance
With the advent of this new compliant fundraising method, many predict that the market for this type of offering could be in the trillions of dollars. Trevor Koverko, head of Polymath, a company leading the STO revolution, has predicted the market could reach 10 trillion dollars in just a few years.
This is possible due to the fact that not only will new assets be able to be created using this method, but traditional financial instruments will also have the ability to be tokenized. With tokenization, markets will be able to operate 24/7 and with a uniform standard allowing assets to be traded around the world with very little friction.
“The next mega trend in crypto will be assets migrating to the blockchain in the form of tokens. pretty much any security is better denominated as a token than traditional forms of ownership. This is the future, not share certificates in filing cabinets.”
– Travis Koverko
This benefit alone makes the Security Token Offering worth considering. While there are a range of other benefits, we’ll go in greater detail regarding each of the benefits with the STO process in another blog.
So if Security Token Offerings are compliant with regulations why not just IPO?
In many ways the Security Token Offering resembles the Initial Public Offering (IPO), which has been a vehicle for raising tremendous amounts of cash for companies around the world. However, not just any company can conduct an IPO. IPOs require a tremendous amount of reporting, compliance, preparation, earnings, and cash.
In a study conducted by PWC it was reported that on average companies spend $4.2 Million dollars which can be directly attributed to the offering. This figure also excludes underwriter fees which can be between 4-7% of the total amount raised in the offering. This is likely still considerably lower than the actual cost of conducting an IPO. As you can see, this method is strictly for large well-established companies.
In fact, due to the costs of an IPO and the ongoing costs of being a public company, the number of IPOs has been drastically declining since the days of the dot-com bubble. Most of the IPOs happening since the early 2000s have been massive tech companies, with a noticeable absence of smaller companies. If you’d like to read further on the decline of IPOs, two Harvard researchers, Marshall Lux and Jack Pead, published an in-depth study on the matter you can find here.
The Security Token Offering on the other hand allows companies to launch their offering at almost any stage of the company lifecycle. Both established companies and even those still in their seed funding stage can utilize this method. While the compliance and preparation necessary to conduct an STO certainly won’t be cheap, it will almost definitely be cheaper than the costs associated with an IPO. For a bit more info on the marketing side of conducting an STO you can check out another of our blogs here:
So what does the future look like for Security Token Offerings?
The ICO boom seems to have died down a bit with fewer projects launching and less capital flowing into the crypto market. However, it’s our personal belief that the ICO model is certainly not dead. Blockchain technology is still in its infancy and we’ll likely see new applications coupled with the ICO fundraising model emerging as time goes on.
Will Security Token Offerings Replace ICOs and Established Cryptocurrencies?
It is unlikely that security tokens will replace entrenched cryptocurrencies like Bitcoin as they will both function and trade differently. It is also entirely possible that rather than replacing the utility token market, security tokens may rekindle interest and drive another boom
While there have already been a few successful Security Token Offerings, the market is still waiting on regulators to weigh in. However, we can clearly see that some big players are beginning to make moves in preparation of the expected boom. The industry seems to be developing rapidly, with developments like:
- Partnerships being formed between industry giants like Sharespost and Securitize
- Both new and old exchanges applying for regulatory approval to trade tokenized securities like the Gibraltar Stock Exchange, Coinbase, and the launch of Tzero.
- The emergence of Security Token Issuance platforms and new blockchain protocols designed specifically for security tokens by companies like Polymath, Harbor, and Open Finance.
All of this robust development suggests that a wave is coming. Regardless of how regulators react to these developments we’ll likely see significant changes to both the worlds of traditional finance and cryptocurrency in 2019.