Despite their loud pronouncements, most token offerings have tokens that are deemed securities in most jurisdictions instead of being deemed a utility. All of these projects violate securities laws. As of right now, the Initial Coin Offerings (“ICO“) space is a little dicey, to say the least. In order for the ICO space to regain credibility, it makes sense to amalgamate the crypto space and the legacy finance space together.
Security Token Offerings (“STO“) are created and issued by companies looking to raise money, just like an ICO. Unlike ICOs, however, security tokens are backed by real assets – equity, debts/loans, or investment funds, for instance. As such, security tokens fall within existing securities laws and regulations. Issuing security tokens that abide by regulatory frameworks, however, is more efficient than conducting an ICO using utility tokens. More significantly, it can also reduce legal risk and provide protection for both the company and the contributors – especially since Financial Market Authorities have increased their enforcement initiatives.
(i) What makes your token a security?
Securities definitions are similar in spirit around the world, but vary from jurisdiction to jurisdiction. Securities in the EU are mainly (a) shares in companies (“equity securities”) and (b) bonds issued by companies (“debt securities”), which are (in both cases) negotiable on the capital market, or (c) other securities which give a right to acquire such said securities or give rise to a cash settlement (besides payment instruments). In the US, the definition is wider and puts more weight on (a) the purpose of the investment and (b) what the entrepreneurs are doing with the invested funds, rather than on the actual instruments the investors are receiving in return for their money. Stocks, bonds, notes, investment contracts, security future, participation in profit-sharing agreements are some of the financial instruments defined as securities in the Securities Act of 1933. This master list included both the obvious (e.g. stocks, bonds), along with the not so obvious (e.g. investment contracts), but unfortunately didn’t entire solve the puzzle. In 1946, the US Supreme Court weighed in and created the famous Howey Test, the de facto standard for analyzing many securities issues today. Under the Howey Test, a financial instrument qualifies as an “investment contract” for the purposes of the Securities Act of 1933, if a buyer (a) invests money, (b) in a common enterprise, (c) expecting a profit, (d) predominantly from the effort of others.
(ii) Pros of STOs
Security tokens are a logical gateway to bring traditional investors into the world of crypto-assets.
STOs provide much greater flexibility in terms of how you run your business – comparable only to a privately-held company. Unlike a privately-held company, however, security tokens can be traded, making them much more liquid investments.
Security tokens have more transparent value based on the underlying assets, meaning your business is less likely to be shorted.
Security tokens allow you to divide underlying assets into smaller units, enabling fractional ownership.
Although compliance is slightly more complex with an STO than an ICO, compliance can be hard-coded into the security token through new standards developed on blockchains. The KYC checks can also be coded in so only accredited investors can buy or trade them, essentially automating ongoing KYC checks. As these standards improve, it should make it virtually impossible to violate securities regulations.
(iii) Cons of STOs
Security tokens fall under existing securities regulations. As such, companies running an STO will have to comply with the same securities regulations. The complexity of legal regulations over multiple jurisdictions still carries risk, however, so you’ll need legal expertise covering every region you intend to sell your tokens to ensure compliance with local securities regulations.
Unlike traditional securities, which have exchanges and brokers established around the world, you can’t simply call up your broker or NOMAD, if you’re listing on the AIM, and as them to create security tokens. STOs require you to create your own tokens as well as a platform to manage their sale. Get this crucial technological part wrong and you’ll end up in financial and legal hot water.