The blockchain technology generated a wide array of peculiar digital ecosystems, innovative projects, and handy platforms in the financial industry. One of the new instruments that quickly gained ground is a security token – a digital asset that represents an investment. Users get those assets on STOs, which are in a way similar to ICOs and IPOs but have their own distinctive features.
In the next few paragraphs, we will cover a range of questions on STOs and security tokens themselves, as well as utility tokens, talk about global regulations in this field, compare STO to ICO and IPO, and look at its advantages and disadvantages.
What Is STO?
STO stands for Security Token Offering. It is often seen as a hybrid approach between ICO and IPO. During an STO investors exchange money for security tokens that represent certain financial rights or access to particular investment mechanisms (income shares, equity, REITs, bonds, profit dividends, etc.) The process of STO involves a great deal of judicial compliance as it follows investment regulations of the country it is held in.
Security Tokens vs. Utility Tokens
In order to get a better understanding of STO’s peculiarities, we have to talk about different types of tokens.
UK’s Financial Conduct Authority (FCA) in its report on crypto assets names three kinds of tokens:
Exchange tokens — “These are not issued or backed by any central authority and are intended and designed to be used as a means of exchange.“ They fall outside the regulator’s governing perimeter.
Utility tokens — “These tokens grant holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by Specified Investments.” They may be within perimeter if they meet the definition of “e-money.”
Security tokens — “These are tokens with specific characteristics that mean they meet the definition of a Specified Investment like a share or a debt instrument.” They are fully under the scope of the FCA’s regulations if they meet the definition of a “Specified Investment.”
Basically, security tokens represent securities that are actual assets, like bonds, stocks, or property trusts. They are digitized versions of old-fashioned paper-based securities, fungible financial instruments that are linked to underlying investment assets.
In the case of security tokens, investor’s ownership and financial rights are confirmed through blockchain transactions. One can not trade them on a regular token exchange. There are special security token exchanges that abide by different laws and undergo investigations into data sharing, token listings, and investor status. It’s worth remembering that security tokens are not cryptocurrencies. They derive their value from external assets that can be traded.
On the other hand, utility tokens are user tokens that enable future access to the products or services offered by a company. They help users get involved with a native platform or a DApp but are not considered an investment (though they can be one under certain conditions). Usually, utility tokens are valuable in the realm of one particular project.
For example, an Airbnb token, if it existed, would be useful for a person who wants to rent an apartment in another city, but won’t have any value outside the Airbnb ecosystem. However, utility tokens can be exchanged for money and other assets, so they are valuable for investors for a broad array of reasons.
To sum it up, security and utility tokens are different in three ways:
Expectations. In the case of a security token, the company’s value is directly tied to the company’s valuation: the more valuable the company, the more valuable the token. For a utility token, there is no relation between the current state of the company’s valuation and the value of the token.
Purpose. A utility token helps create an internal economy within the project’s blockchain. A security token is an investment contract representing the legal ownership of a physical or digital asset that has been verified within the blockchain.
Scam potential. STOs are so highly regulated that the chances of a sham are zero to none. Utility tokens are highly unregulated and, therefore, subject to fraudulent activities.
STO vs. ICO vs. IPO
Security Token Offering, Initial Coin Offering, and Initial Public Offering are frequently compared to each other. To put it simply, STO and ICO both belong to the digital world but are regulated very differently. IPO and STO comply with similar regulations but function in material and digital environments, respectively. And the difference between an ICO and an IPO is that in an IPO investors receive stock while in an ICO they get a token in exchange for their investment.
Over the last few years, ICOs have notoriously been a target of many fraudulent scams, because the industry is still heavily underregulated. As utility tokens are not investment assets, the government leaves ICOs out of the legal framework. On the contrary, STOs fall into the category of activities that offer an investment contract under security law. They are forced to comply with relevant regulations, for instance, receive money only from accredited investors.
IPOs, as distinct from STOs, issue share certificates on traditional markets, while security tokens exist only on blockchain as digitized proof. The former is far less cost-effective than the latter, mostly because there is no intermediary in STOs. When a company goes public, it has to pay an army of lawyers and agents with their never-ending fees and brokerages. Security token offering implies more direct access to the market and is simply cheaper (and faster) to hold. IPOs appear more cumbersome and costly.
Strict regulation by government
Regulated by AML/KYC
No regulation required
Purchase of stocks only with bank account
Investors have the right to vote
Crypto wallet is required
Only for accredited investors
Not backed by anything
The process is costly
Transparent fundraising solution for both investors and entrepreneurs
STO laws and regulations differ from country to country. In general, regulators are more prone to accept STOs than ICOs, probably because they can be managed with the existing security laws.
STOs are completely banned in China and South Korea, heavily regulated in the USA and Mexico, and are allowed in most EU countries, Australia, the United Kingdom, Brazil, Japan, Canada, Israel, and Singapore. The situation is ambiguous or still unclear for Thailand, United Arab Emirates, and India. There is no coherent legal framework for STOs in Russia as well.
Elaborating on the European Union, France, Switzerland, Lithuania (where the first STO in Europe has been held), and Germany have the most transparent and well-thought-out STO regulations in Europe.
STO Pros & Cons
STO has several evident advantages as well as some disadvantages.
Low barrier for entry. STO can be used to tokenize an asset or a financial instrument in an easy and quick manner while floating on a stock exchange is a time-consuming and costly process that requires a middleman and involves unnecessary fees.
Credibility. STOs comply with government regulations, which makes them a more secure and credible way of managing your assets. Moreover, some compliances can be hard-coded. That would make them virtually impossible to meddle with.
More liquidity. Security tokens trade on specialized security exchanges, so investors have a convenient way to liquidate their assets.
Global investors. Token standards are universal across different regions, so tokens can be easily bought and traded by investors around the world.
Compliance is a two-edged sword. It could be challenging for companies to obtain the level of legal expertise they need in order to play by the rules in every country where they want to sell their tokens.
Platform. STOs require you to create your own tokens as well as a platform to manage their sale.
Young market. It has been only a couple of years since the first STO was conducted. Cautious investors have to keep a watchful eye on the changing trends and new legislation in their counties of interest.
STOs are generally safe procedures, but it’s worth noting that they can be risk-bearing if an investor is not careful enough. The security coin investment itself is not more or less risky than a traditional investment – they both depend on the risks of the company and its business model. However, in the case of Security Coin Offering, there are additional blockchain-specific risks. If a token holder loses the key to their private wallet, they will also lose access to their investment forever. It will be quite impossible to restore it.
Future of Security Tokens
Many crypto enthusiasts and financial analysts believe that security tokens are the future of investment. They will likely fundamentally revolutionize compliance as they can represent any financial asset, whether it is equity, debt, or real asset. The industry is still very young, and there are not enough legal specialists working on essential regulatory issues. Clearly, with the development and implementation of the blockchain technology, more and more legal advisors trained in the crypto investment field will appear. When the regulations around security token stabilize and eventually settle down, the token will begin its ascend as a trusted and reputable investment asset.
Though the security token market has a long way to go, it is becoming more and more evident that it will reach significant levels of liquidity. If we look at the traditional stock exchange market that has been around for almost 300 years, we’ll see that its volume hasn’t always been that high, and most investors were expecting low liquidity at the beginning.
Nowadays, the London Stock Exchange market cap, for instance, is over $26 billion, which is pretty modest compared to the New York Stock Exchange with its staggering $30.1 trillion market cap. Who knows, perhaps an even brighter future awaits the new digital investment instrument.
Disclaimer: This article should not be considered as offering trading recommendations. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor should research multiple viewpoints and be familiar with all local regulations before committing to an investment.