Security Tokens and STOs: A New Frontier for Block Chain and Securities Laws
Block chain-enabled fundraising methods are revolutionizing startup financing globally while offering investors new and exciting investment opportunities in the cryptosphere.
Unlike initial coin offerings (ICOs), security token offerings (STOs)comply with regulations, affording investors similar rights, obligations, and protections that regulated assets have.
In this article, I will discuss how security laws interact with security tokens and STOs.
Happy reading!!
Table of Contents
∘ Exploring The Concept of Security Tokens and Their Characteristics
· Analyzing the Regulatory Requirements for Conducting Security Token Offerings.
∘ The Benefits and Challenges of Security Tokenization, and Compliance with Securities Laws
∘ Challenges of Security Tokenization in Compliance with Securities Laws
∘ Final Thoughts
Security tokens use blockchain to allow for efficient transactions like cryptocurrencies, but are different in all other ways. They emphasize regulatory compliance, automated regulatory reporting, and represent share interest in value-producing assets. This ultimately provides stable value versus the volatility of crypto.
Securrency
💡Key Takeaways!
1. Block Chain-enabled crowd funding methods are innovative financing techniques that startups, companies, and even governments use to raise capital.
2. The process of representing physical assets on a block chain platform is known as tokenization.
3. Block chain technology simplifies the laborious and manual task of transferring assets like real estate, and fine art.
4. Security token offerings ( STOs) are one of the many fundraising methods revolutionizing financing globally.
5. While tokenization has many benefits, it is fraught with risks, including extensive regulations and security risks.
Exploring The Concept of Security Tokens and Their Characteristics
For some years, the crypto space was the forte of anti-establishment investors, primarily because of its decentralized, intermediary-less, and borderless nature.
In the beginning, the goal of crypto was to disrupt and replace traditional finance. Understandably, this led to friction between TradFi and crypto.
Until recently, conventional financial institutions were wary of engaging crypto firms.
The lack of financial services caused crypto startups to explore innovative ways of fundraising.
Conventional companies utilize IPOs, venture capital, and loan facilities to fundraise.
The crypto industry introduced novel fundraising methods, including Liquidity Generation Events (LGEs), launchpads, STOs, ICOs, and Initial Dex Offerings ( IDOs), Initial Exchange Offerings (IEOs) among others.
Indeed, necessity is the mother of invention!
Transferring interests for assets, like fine art, real estate, precious stones and metals, is usually a strenuous task.
Their transfer demand that parties contend with lengthy procedures, which are normally accompanied by colossal amounts of paperwork and bureaucracy.
Distributed ledger technology (DLT) makes it possible to represent physical assets on a block chain as digital assets ( tokens), through a process known as digitization of assets (tokenization).
A security token represents a holder’s stake in a business or asset. Security tokens are subject to security laws, as their value derives from external things.
For instance, a security token issued in Kenya must comply with the Capital Markets Authority Act, among other regulations.
Similarly, security tokens issued in the US must comply with the Securities Exchange Act of 1934 and the Securities Act of 1933, among other applicable laws.
Currently, numerous financial assets exist digitally. Many countries are slowly transforming into cashless societies, where money exists digitally .
In parts of the world where security tokens are legally recognized, firms can issue investors security tokens instead of shares. Both enterprises and governments can issue security tokens.
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Security tokens are issued on a distributed digital ledger, which boosts, among other things, transparency and divisibility. Digitizing physical assets aids in unlocking their value, making it possible to transact them in real time.
Fast Fact⚡
Tokens exist on top of blockchain networks like Ethereum. The Ethereum blockchain is most popular for creating tokens (ERC-20) due to its smart contracts.
It is now possible for illiquid assets to be tokenized and be traded in markets, by leveraging the transparency and security of DLT, and due to the ease of creating tokens.
Block chain technology ensures safe storage of ownership stakes.
STOs have emerged as viable fundraising techniques due to several reasons:
- They offer transparency and security.
- They are compliant with securities laws. Smart contracts automate compliance.
- They provide increased liquidity, especially for unlisted companies.
- They are quick to settle.
- They have no downtime like traditional financial markets.
- They enhance the global accessibility of assets.
- They offer various possibilities of fractional ownership.
- They possess the capability to open up new markets for initially frozen assets ( e.g., private equity).
- They reduce the cost of listing firms in the stock market
Different types of Tokens That Bestow Rights
In crypto, projects looking for capital issue tokens to investors representing utility or a stake in a project.
Crypto fundraising initiatives benefit from a global pool of investors.
Thanks to the transparency and security DLT offers, crypto projects are able to access capital faster and efficiently.
One of the biggest advantage crypto fundraising initiatives have is that they do not need to deal with intermediaries.
Below are a few types of tokens crypto projects offer investors/supporters for their contribution:
Debt Tokens
Generally, companies raise funds by taking out loans, and issuing corporate bonds.
Today, companies may issue debt tokens to raise funds. Debt tokens represent the debt a firm owes the holder. Debt tokens accrue interest.
Debt tokens are categorized into two: variable debt tokens and stable debt tokens.
The interest rate attached to variable debt tokens fluctuates, while that of stable debt tokens remains stable.
Equity Tokens
In conventional markets, equity represents an investor’s stake in a company or asset. The same principle applies to equity tokens.
Additionally, holders of equity tokens are entitled to a share of an enterprise’s profits, and subject to the terms of an offering, they may have voting rights.
Utility Tokens
Utility tokens are critical for crypto startups, firms, and project development groups, as they help secure funds for block chain projects.
After the successful completion of a project, utility token holders may use them to conduct transactions with the issuer.
What other use cases do these tokens offer users?
- They enable users to access the functionalities of a network.
- They enable users to get rewards for particiapting in a project, software fee discounts, and bestow voting rights in a project.
- Utility tokens are used as gas fees.
- They provide liquidity, as many are traded on exchanges.
Fast Fact⚡
Utility tokens do not represent a stake in a project or confer rights to profits or dividends! However, due to regulatory uncertainity, there is always the risk of utility tokens re-qualifying as security tokens.
Asset-backed Tokens
Asset-backed tokens represent physical assets on a distributed digital ledger.
Assets on a block chain platform can range from real estate to commodities, vehicles to fine art, etc.
These types of tokens allow fractional ownership and unlock previously illiquid assets.
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Almost any illiquid asset today lends itself well to moving onto the blockchain and becoming tokenized. It will create a deeper market with improved price discovery and should increase the value of those assets.
David Sacks, General Partner, Craft Ventures, Former COO, PayPal
Analyzing the Regulatory Requirements for Conducting Security Token Offerings.
Companies sell security tokens via Security Token Exchanges.
Security token exchanges enable firms that can’t issue an initial public offering (IPO) to fundraise within the confines of the law.
Security token exchanges are controlled by the same rules and regulations that apply to conventional exchanges.
For instance, they are required by the law to provide surveillance and oversight while upholding fair and orderly markets.
💡Learn More: Legal Obligations of Crypto Exchanges You Need To Know
An enterprise looking to engage in a security token offering must comply with the securities laws of its jurisdiction.
For instance, a company conducting an STO in the US must comply with the SEC requirements of reporting and disclosure.
💡For the benefit of lay investors, issuers of security tokens must provide investors with intricate details about their offerings in plain English. Issuers satisfy this requirement by publishing a white paper.
The company must also satisfy prevailing anti-money laundering, and Know Your Customer standards.
Before issuing an STO, a company must contemplate the ramifications of regulation .
For instance, under American laws, enterprises seeking an offering must register with the SEC or apply for an appropriate registration exception.
Within the EU, companies looking to make an offering must register with the European Securities and Markets Authority ( ESMA).
In the EU, security token offerings fall under the purview of the Markets in Financial Markets Directive II( MiFID II).
Companies offering multi-jurisdictional STOs must ensure compliance with all rules and regulations provided for under various local laws. They must get authorization from local regulators before commencing an STO.
As mentioned earlier, security tokens represent various interests and assets.
Before an STO, a firm must consider the underlying asset, as different legal rules apply to different asset classes. Additionally, issuers need to consider issues related to governance and corporate structure.
For instance, before issuance, a company must ensure that its incorporating documents empower it to undertake such an activity.
Issuers must consider how many token holders are allowed to participate within a jurisdiction. For example, under US laws, only 99 residents can participate in an STO.
The Benefits and Challenges of Security Tokenization, and Compliance with Securities Laws
Like traditional securities, a security token represents a stake in an asset, or a project.
Security tokens must comply with the rules and regulations that apply within the jurisdiction they are offered.
Tokenization simplifies and automates the laborious and manual processes that issuers of securities have to go through to provide securities to financial markets.
Tokenization will help financial markets access greater liquidity and bigger pools of potential investors. The world is rapidly embracing token-based assets.
💡Also Read: The Intersection of Block chain Technology and Securities Laws
Indeed, tokenization makes transferring certain assets within digital platforms happen faster.
As geographic barriers are removed, opportunities for global trade increase tremendously.
As previously mentioned, digitization of assets will help markets unlock certain assets that have been illiquid for the longest time. Tokenization provides us with new ways of fractional ownership.
Compared to traditional securities, a larger number of individuals can invest in security tokens due to, among other things, reduced investment costs.
Tokenization enables issuers of tokens to reduce friction while creating, selling, and purchasing tokens.
Utilizing distributed ledger technology enables enhanced efficiency and minimizes errors during the creation, and issuance of security tokens.
💡The financial industry spends billions of dollars annually on compliance. Block chain technology makes compliance affordable by programming regulatory requirements into tokens. Smart contracts ensure participants are compliant.
security tokens guarantee better compliance.
Block chain technology makes any form of corruption readily apparent, by providing one source of truth to all parties. Any information added is available to all parties in real-time.
This also helps minimize conflicts relating to record keeping. Users utilize shared ledgers and smart contracts to create fractionalized real estate, dynamic ETFs, etc.
💡Since time immemorial, governments and regulatory agencies have resisted innovative ideas. They generally tend to prefer legacy technologies. Despite this, their approval is necessary for a token-driven economy to materialize.
Challenges of Security Tokenization in Compliance with Securities Laws
Despite the advantages of tokenization, digitization of assets has its risks. For instance, extensive regulations limit the flexibility of security token offerings.
While extensive regulations help legitimize STOs, highly stringent regulations may lock out the public, and stiffle innovation.
The crypto industry experiences widespread policy and regulatory changes, causing the value of STOs to fluctuate. Market fluctuations usually cause losses to investors.
The speedy and anonymous nature of tokenization may result in high compliance costs.
Unlike traditional markets, which have had the luxury of years to create compliance infrastructure, the crypto industry is still in its infancy.
Creating comprehensive infrastructure that inspects transactions for financial misconduct and criminal activity requires lots of money and time.
Asset tokenization platforms rely heavily on open-source software for development purposes.
This exposes tokenized assets to risks, such as cyber-attacks, theft, and programming errors.
STOs are susceptible to risks, which demand expensive compliance investments.
One of the greatest challenges to the establishment of token-based economies is security.
Virtual assets are highly susceptible to volatility risks. Crypto heists, cyber attacks, and regulatory changes increase volatility.
Block chain forks may distabilize digital assets, making them unfavorable for users as mediums of exchange.
Final Thoughts
Before issuing an STO, ensuring compliance with regulatory requirements is mission critical.
Due to the risks associated with digital assets, securities agencies worldwide are developing more stringent rules to curb criminal activities.
The crypto industry has become notorious for financial misconduct. The crypto industry is littered with cases of financial misconduct that have cost investors billions.
Tokenization promises to be a disruptive business technology. It will cause the creation of novel asset classes, and new primary and secondary markets. These markets will be characterized by minimum friction, and low entry costs.
Regulatory and government support is vital to realize the potential of tokenization . The potential of tokenization can only be realized if it receives regulatory and government support.
Adopting new technology is difficult for most people. Surprisingly, institutions also need time to adopt new technologies.
Most prefer legacy systems, which despite meeting their purpose, hinder growth. The primary reason why individuals and institutions find it difficult to adopt emerging technology is because of the inherent apprehension such innovative ideas elicit, and with good reason too.
However, due to widespread demand by investors, retail and instituional, the crypto industry is pushing toward a merit-based direction, enhancing innovation and credibility.
