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Security Token Offerings 101

Security Token Offerings (STO) Guide: What They Are, How They Work

The initial coin offering (ICO) dominated headlines, good and bad, for the past two years. Going forward, you will see a new term gaining traction: security token offerings. STOs combine the protections and discipline of traditional securities with the decentralized, smart contract-based world of blockchains.

As STOs gain more traction, crypto investors will find more opportunities with fewer risks. This Security Token Offerings 101 will introduce you to the newest crypto investment option and help you understand the roles STOs could play in your crypto portfolio.

This article only provides information to form the basis of your further research. Only you can decide whether to invest in STOs, which STOs to invest in, and the services you use to make those investments. Crypto investing involves higher risks than other, more traditional options. Do your own research and seek the help of a professional advisor to make sure you’re making the right decisions.

What are security token offerings?

Launching security token offerings
Security token offerings are new ways to launch blockchain businesses. Source: Pixabay

For much of the past two years, crypto companies have tried to keep the words “security”  and “token” as far apart as possible. Once labeled a security, a token offering becomes mired in regulations and paperwork. If a project doesn’t complete that process, then it cannot offer its token in the United States and other major markets. A project may not meet its funding caps if it’s cut off from the world’s biggest pool of investors.

However, the flood of fraudulent and incompetent initial coin offerings (ICOs) that began in 2017 may change minds in the crypto industry. The rules and regulations that the traditional finance world imposes on the issuance of securities have a single objective: protect the investor.

Related: A Detailed Guide to Identifying ICO Scams

Defining STOs

First, however, we need to define “security”. At its most basic, a security is a financial instrument that a company issues to raise capital. In exchange, the issuer grants investors certain rights. For example, stocks grant an ownership share of the company and, possibly, the right to profits in the form of dividends. In the case of bonds, investors receive the interest generated on the bond’s principal.

Securities on the blockchain

Tokenized securities do the same thing as traditional securities. Token-holders get a say in how the company operates and they get a share of the company’s profits.

However, the fact that the security token lives on a blockchain gives it many more features than a stock certificate. Smart contract systems can incorporate regulations within the token itself. Know-your-customer rules, for example, can prevent someone who isn’t qualified from buying the token.

The efficiency of blockchains and the elimination of third parties, also make security tokens more efficient ways to raise capital and to invest in secondary markets.

Criticisms

In the eyes of critics, security tokens violate many of the principles underpinning the cryptocurrency community. Securitization means centralization and identification. Big institutions from government regulators to investment banks will exert control over security tokens and the broader crypto markets. Not least of these, the KYC requirements could weaken the pseudo-anonymous spirit of the blockchain community.

STOs vs. ICOs

So what’s driving the industry away from initial coin offerings and towards security token offerings? The legacy of the wild west ICO market is one of extremes. On the one hand, projects like Telegram delivered huge returns to investors while creating innovative services. On the other hand, ICOs let scam artists steal billions of dollars from crypto investors.

Institutional investors, in particular, look at this volatility as a risk they cannot afford. In the traditional world of securities, the long-established processes of regulatory oversight and due diligence make risk manageable. As long as the ICO is the only option, investors can never trust that a project really has any substance.

Do ICOs even exist?

Another uncertainty keeps institutional investors away from the ICO marketplace. Are any of the tokens issued over the past year safe to buy? Companies may call their tokens “utilities” and they may have legal opinions that the tokens are not securities. It will be the regulators, however, who make the final call.

Those concerns flared up in early 2018 after Securities & Exchange Commission chairman Jay Clayton testified before the US Senate Banking, Housing and Urban Affairs Committee. “I believe every ICO I’ve seen is a security,” Clayton said before telling Senator Elizabeth Warren that he agreed that ICOs broke the law.

Should the SEC and other regulators decide to crack down, token issuers will face severe fines and penalties. Token holders who would not have been allowed to buy a security may see their assets taken away or forked out of existence.

Institutional investors see the potential benefits that blockchain-based assets offer, but they cannot put themselves or their customers at risk. The hopes for STOs rest on having credible processes for getting regulators’ blessings.

Investing in security token offerings

Security token offerings are such a new thing that you may struggle to find ways to invest. Science Blockchain co-founder Gregory Gilman described the situation at the StartEngine ICO 2.0 Summit in late April:

“There’s only four [STOs] in the world at this point so there’s not a lot of security tokens out there. All these [alternative trading systems or ATS’s]… are making sure they take their time and get everything right. There’s a significant question from the institutional community whether these ATS’s when and if they will actually show up.”

“I have one of the four security tokens in the world,” Gilman pointed out. “I want there to be 300 times more this time next year because that means its working and people are trading them. Institutional investors and the ATS’ will all sort of align when there is a market to be made around a number of products.”

Although the pace seems glacial compared to the lightning-fast ICOs of 2017, efforts underway now could start bearing fruit over the next 6-12 months.

Financial industry

Ironically for the disrupt-the-establishment crypto industry, the traditional stock exchanges may be the dominant players in the STO market. Securities tokens are all about inspiring trust through regulatory compliance and minimizing risk through high-speed, reliable trading. Traditional exchanges have decades, even centuries, of experience with regulatory compliance and trading technologies. More importantly, they have trusted relationships with regulators.

SIX Digital Exchange

Swiss exchange for security token offerings
Source: SIX Digital Exchange

The Swiss Infrastructure and Exchange Group (SIX) is one of Switzerland’s largest financial institutions. SIX provides exchange trading of multiple asset classes as well as clearing and settlement services within a single corporate entity. The company is also a major European processor of credit and debit card payments.

In mid-2018, SIX Group announced the SIX Digital Exchange, “a fully integrated trading, settlement and custody infrastructure for digital assets.” Security tokens listed on the SIX Digital Exchange “will enjoy the same standard of oversight and regulation” as assets traded on SIX’s traditional stock exchange.

Thomas Zeeb, who heads securities and exchanges at SIX, told CNBC that SIX the Digital Exchange will serve the fundraising gap between the IPO market at the high end and the friends-and-family market at the low end. “That gap at the moment is being filled primarily by venture capitalists or ICOs — and the ICO market is a wild west market.”

Legitimizing ICOs

The company’s goal, Zeeb continued, is to “provide a way to legitimize ICOs with… a cost-effective way of moving forward — to really bring capital to commerce.”

SIX Group publicly states they expect to roll out the SIX Digital Exchange in the first half of 2019. Once live, the new service will provide several benefits to stakeholders in the digital asset market:

  • End-to-end trading, settlement and custody services.
  • Regulatory oversight on par with traditional securities.
  • Legal and liquid market for entrepreneurs to raise capital.
  • Established trading infrastructure for investors.

Safe on-ramp for banks to launch their digital strategies.

In a conversation with CNN Money, SIX Group CEO Jos Dijsselhof discussed the responsibility a traditional exchange brings to securitized tokens. “We are currently working with all the stakeholders, including the regulators,” Dijsselhof explained. “Of course, those asset classes need to fulfill the requirements we have as a stock exchange in terms of safety, transparency, and a fair and orderly market.”

Canadian Securities Exchange

Canada's future home for security token offerings
Source: Canadian Securities Exchange

In early 2018, the Canadian Stock Exchange announced a new platform for STOs. The Canadian Securities Exchange (CSE) is an alternative stock market founded in 2003. Favored by micro-cap and emerging companies, more than 10% of the CSE’s listings are blockchain-based businesses. The new platform promises to make the CSE the preferred site for Canadian STOs.

The CSE’s CEO, Richard Carleton, explained in the announcement that “the Canadian Securities Exchange expects to be the first recognized exchange in Canada to introduce a fully developed blockchain platform for trading, clearing and settling tokenized securities.”

The CSE’s blockchain platform promises several benefits for institutional investors and other participants in the securities markets.

  • Lower risks for investors: The regulations and policies that ensure the reliability of traditional equities will apply to the new token-issuers.
  • Lower risks for dealers: Building on the CSE’s existing technology means trades will clear and settle immediately.
  • Dealer cost savings: Dealers won’t need to post capital to clearing houses while waiting for trades to settle.
  • Cost savings for equity issuers: Future actions like splits and dividend payments become more efficient thanks to smart contracts.
First Canadian STO

At the same time as the announcement, the CSE agreed to help Canada’s blockchain-enabled 3D printing company Kabuni Technologies become the first Canadian STO. Kabuni’s founder Neil Patel explained that “Security Token Offerings are crucial to building trust and integrity within the financial marketplace.”

The CSE has not provided a target date for launching its platform since Canada’s regulators must still bless the plans.

“We look forward to working with regulators and with corporations seeking to raise capital through STOs to fully realize the benefits of the new platform,” Carleton added.

Crypto-centric STO platforms

While the traditional exchanges have their advantages, they lack the agility and decentralized mindset that drives the crypto industry. Several STO platforms launched over the past year to lay the groundwork for securitized tokens.

Polymath

Polymath platform for STOs
Source: Polymath

Polymath’s ambitions aren’t small: “What Ethereum did for tokens, Polymath will do for securities.” More specifically, the startup’s smart contract technology will provide a platform for companies to raise capital by issuing token-based securities. Built on Ethereum, Polymath and its POLY ERC-20 token create an ecosystem to support STOs.

Token issuers can record all the documents required by regulators onto the blockchain to enable fast reviews and audits. Providers of know-your-customer (KYC) services will integrate with Polymath. Before any transaction goes through, the Polymath smart contract will prevent unauthorized people from purchasing the token.

“Polymath presents an open protocol for issuers, intermediaries, and participants to issue and trade security tokens,” the company explained in its white paper. The company’s developers are even working with Ethereum’s developer community to integrate Polymath’s ST20 Protocol into the Ethereum platform.

Harbor

Harbor STO platform
Source: Harbor

Harbor calls itself a “compliance platform for tokenizing private securities.” Rather than creating electronic versions of stocks and bonds, Harbor enhances tokenized assets with the capabilities of smart contracts.

When a company uses Harbor to issue an STO, they build the new asset as a “Regulated Token”, or R-token. This token leverages the Ethereum ERC-20 protocol and lets companies build compliance into the smart contract directly.

Each time a token sale happens, the smart contract reviews the details to make sure the transaction complies with national laws and company policies. Harbor maintains a whitelist of authorized traders who passed Harbor’s KYC/AML review process. In the event of a KYC/AML violation, the smart contract will prevent the transaction from completing.

Harbor CEO Josh Stein explained to Fortune that the tokenization of real estate, rather than corporate equity, will be the company’s first focus. “We’ve talked to multiple property owners primarily in the hospitality and office spaces,” Stein said. “Think marquee, classic commercial real estate in major metropolitan areas. Some of them are looking to raise hundreds of millions of dollars, and we’re talking to them about starting off smaller — about $50 to $100 million.”

TZero

tZero STO
Source: tZero

Once you cut through the buzzword-heavy website, you learn that tZero has big plans to develop a trading platform for security tokens. A blockchain-centric subsidiary of e-commerce giant Overstock, tZero owns several SEC-registered and FINRA-regulated trading companies. Pro Securities, for example, is a registered Alternative Trading System which supports secondary trading of crypto securities.

The company has several technologies either in service or under development that address specific weaknesses of today’s crypto securities markets. For example, tZero already processes up to 18 million daily orders for traditional securities with a maximum capacity of more than 100 million daily orders.

In August 2018, tZero raised more than $100 million in its own STO. Although below the original $250 million target, the number does not include a $160 million investment from China’s GSR Capital.

tZero flaws

William Restis, the lead counsel in the Tezos ICO class action lawsuit, pointed out several flaws in tZero’s STO. He calls the new token “preferred stock light” because it does not give holders equity in tZero or guarantee preferred status for dividends. In addition, Restis estimates that tZero must generate a 40% growth rate for investors to see a return on their $10-per-token investment.

At a higher level, Restis criticizes tZero for making the first high-profile STO such a weak offering. “How is tZERO helping grow this business model by conducting such a crappy offering,” Restis asks. “How are they going to create a community around this type of token if the first one tanks?”

Final Thoughts

People of a certain age may remember the early days of the personal computer industry when new operating systems and hardware competed for consumers’ wallets. Over time, that came to an end as the people settled for the benefits of a Wintel-dominant market. The same thing happened to the internet.

Security token offerings may be an early sign of a maturing crypto community. Or it could be a sign of Satoshi Nakamoto’s vision getting coopted by The Man. The truth probably lies in the middle. The incompetence and malice of too many ICOs fleeced too mainy crypto investors. Wide-eyed visions of a world basking in a decentralized paradise free from governments and big banks was never realistic.

The benefits that security token offerings provide are real. Too real to be ignored. By reducing risk and uncertainty, a strong STO market will convince more institutional investors to enter the crypto markets. A flood of liquidity will make markets stronger and less volatile even as it makes the crypto world less exciting.

 

Christopher Casper

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