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What is a Security Token (STO)?
As regulators crack down on the cryptocurrency industry, people have begun to replace the question “What is an ICO?” with “What is STO?” The term security token (STO) refers to a cryptocurrency coin that passes the Howey Test. Quite simply, by passing the Howey Test, the STO coin or token issuer has proven to the US Securities and Exchange Commission (SEC) that it meets all criteria for consideration as a security. That allows it to legally trade within US borders. There is also a broader STO meaning.
ICO vs STO
Many initial coin offerings (ICOs) avoid selling to US residents so they can avoid trying to meet the SEC’s regulations. An ICO offers a cryptocurrency coin or token for sale to crowdfund a project. It functions in a way similar to stock for a company which is one of the reasons it began replacing initial public offerings (IPOs) a few years ago.
Many firms thought that ICOs provided them a short cut around SEC regulations. The SEC struck down that notion by closing numerous ICOs. One example, the food review ICO from Munchee, Inc. was shut down in December when it filed as a utility token but issued marketing materials as a security. The SEC action forced Munchee to refund the $15 million it had raised, according to Jay Clayton Chairman, U.S. Securities and Exchange Commission.
To be clear, Munchee could have been a STO easily. An STO is simply an ICO that filled out all its appropriate paperwork with the SEC. They are both cryptocurrency coin offerings. Both sell a coin or token as a virtual currency linked to a blockchain. Munchee simply lost its money because it wanted to avoid paperwork and rule following.
Selling as a security requires more paper and time. Companies who try to avoid the bureaucracy either avoid selling in the US or list as an ICO, then try to sneak by the rules. It could have easily offered an STO meaning it could have kept its $15 million fund.
An ICO offers a whitepaper instead of a stock prospectus. The stock prospectus must meet financial industry standards which includes information on the business’ existing financial situation and financial forecast data. At most, the whitepaper includes a problem identification, a potential solution, a coin or token implementation description and an introduction to the business’ leadership.
The problem of shortcuts extends beyond new businesses and startups. Established businesses, already registered and trading have been suspended from the SEC for avoiding registration as an STO. In February 2018, three firms, Cherubim Interests Inc. (CHIT), PDX Partners Inc. (PDXP) and Victura Construction Group Inc. (VICT) were each suspended from the SEC. In every case, the firms started out planning an IPO, then switched gears and offered an ICO instead. Because they did not submit to the SEC 10-K and 10-Q forms, their ICO could not be considered a legal STO. SEC forms 10-K and 10-Q provide an overview of the firm’s finances.
Other violations for all firms include acquiring AAA-rated assets from a private equity investor’s subsidiary in cryptocurrency and blockchain technology. CHIT announced execution of a financing commitment for an ICO launch.
An STO does more than fulfill form requirements. It provides investors rights in the company just as stock does. There’s no question of ICO vs STO because they do not do the same thing or offer the same benefits. Think of it more as a question of stock vs. STO.
STO vs IPO
While the ICO market continues to grow, the traditional route, the IPO market continues to shrink. Since ICOs do not register with the SEC if they are not a security, no registration numbers are available for them, but in 2014, 363 firms registered as an IPO which dropped to 128 in 2016. That represents a decline of 65 percent. According to Chairman Clayton’s estimate, in 2017, the following year of the massive drop, ICOs raised about $4 billion.
The STO market has not grown in the same manner. This perhaps is because it requires the same paperwork as an IPO. It is beginning to take hold though and recently surged in registrations. The STO market could reach a market cap of $10 trillion by 2020.
So, a STO and an IPO are the same thing, but a STO offers a cryptocurrency token instead of the stock that an IPO issues.
One company, Polymath, plans to help businesses meet SEC regulations by providing them a way to crowdfund via STO more easily. It branded an Ethereum-based security token and offers a smart platform for STOs, simplifying the STO process.
Why is an STO so Attractive to Business Owners?
Bluntly, an STO lets the business crowdfund without violating SEC rules which would put it quickly out of business. An STO offers firms a more liquid choice for stakeholders than stock. It’s an easily transferable asset that connects the business to its customers via funding. It works best for companies:
- with more than $10 million in annual revenue,
- that are high growth companies,
- operating globally.
An STO provides blockchain benefits. The ledger technology accompanies any token offering because a cryptocurrency token issues from a blockchain. The firm can create its own blockchain or it can issue by creating a coin on an existing blockchain, such as those that create Ethereum-based tokens, such as those on the Polymath platform.
An STO functions like other securities such as bonds, managed real estate trusts and stocks. It is a financial instrument that represents a real asset. One of the main differences is that when someone purchases a traditional security, they sign the transaction on paper. An STO serves the same function, but documents and verifies the transaction on the a blockchain, a digital ledger protected by cryptography. The STO can offer the same financial rights to an investor that a share of stock can. That includes dividends, equity, profit shares, revenue shares, voting rights and bundling with other financial instruments, such as in an exchange-traded fund (ETF) like the First Trust Indxx Innovative Transaction & Process ETF.
STOs offer businesses five main reasons to choose them as the new route to offering securities. These are:
- global capital access: like ICOs, STOs, provide access spanning international borders with an easy entry point that is accessible to all size businesses. While IPOs have been the purview of established firms that have decided to “go public” in order to continue growing, all firms, even startups can offer an ICO or STO.
- flexible marketing methods: the traditional IPO presented challenges to marketing including localized securities regulations, global marketing and language translations, while ICOs and STOs can use 21st century methods like KakaoTalk, Telegram, and WeChat and can incentivize online influencers through bounty programs. Advertising online offers immediate access to translation tools.
- improved terms: STOs provide a better option for the business than either a stock IPO or fundraising through venture capitalists (VCs). With a VC, a firm normally must give up a board seat or controlling interest. An STO negates this. Equity STOs let a firm sell common, not preferred, stock which allows its common stockholders and management to retain controlling ownership. The STO does grant dividend rights, it does not have to offer voting rights. Firms tend to raise more capital using STOs.
- low entry cost: Offering an STO coin makes compliance easier. The STO has its compliance coded into it at the blockchain level. With traditional securities, a firm would need an attorney to represent them in each country it chose to offer the security. With an STO, any country that allows purchase of cryptocurrency is open to the firm. Global consumers may purchase the STO coin/token through a cryptocurrency exchange or from the firm’s blockchain platform directly. The savings in legal fees alone reduces the entry cost.
- greater flexibility that traditional securities: Stock offers a limited range of uses. A cryptocurrency coin can function in multiple ways. For example, the firm can issue an STO that also functions as a utility coin, creating added value. A firm releasing an STO could provide a discount on its service to those who purchase the coin and further benefits to those who buy and hold.
Are Security Token Offerings Legal?
An STO is perfectly legal so long as the firm adheres to the regulations in each country it offers the security. In the US, that means filing the appropriate forms and prospectus, then waiting for SEC approval. In the European Union (EU), that means adhering to the regulations of each country it offers the security in, as well. Rather than offering a combined ruling for all member states, the EU directs each member state/country to set its own rules. These are examples of areas and regions in which firms generally offer their securities. Check with the financial ministry of each country in which you want your business to offer an STO. Aside from the required forms, a firm can normally code all purchase and documentation requirements into its cryptocurrency coin/token as sold from its platform or an exchange.
In the US, determining if a crypto coin meets the merits of consideration as a security is a simple matter of applying the Howey test. The Court created this test in its decision on the Securities and Exchange Commission v. Howey Co., 328 U.S. 293 (1946). According to Howey, a financial instrument is a security if the following four items apply:
- it is an investment of assets or money,
- if the assets or monetary investment occurs in a common enterprise,
- the investor would expect investment profits,
- if the efforts of a third party result in profit.
What Do Investors Need to Know About Security Tokens?
The caveat is STOs represent an infantile market. The first STO occurred only two years ago. It functions as part of the often volatile cryptocurrency market. Issuance by an established firm as a security may influence this, but businesses and investors should understand that the general public and investing public gains its understanding and bases its opinions largely on the media and word of mouth. Globally, regulators continue to alter and create new compliance rules.
Businesses should consider that a firm may not need a security coin/token. It may require a utility coin/token or a cryptocurrency. You’ll need a consultant and an attorney to determine which option would work best for your firm. Investors need to develop a certain savvy around the types of digital assets so they can judge which option they should purchase.
STOs require the firm create and manage the assets on a blockchain. These digital ledgers are not impervious to hacks. The firm needs the personnel and skill set to function in the blockchain/cryptocurrency industry.
Using security coins/tokens provides a wider array of businesses the opportunity to fund raise publicly. An STO allows many more firms to offer assets publicly than the traditional IPO. Small businesses and startups can leverage the STO process to crowdfund and include their customers in their ownership. While it offers an emerging opportunity, each country continues to develop laws and regulations surrounding it. This requires both businesses and investors remain vigilant in the continued development of blockchain technologies and cryptocurrency because the answer to “What is STO?” continues to develop.