by Content Team

13 January 2024

Blockchain

Blockchain Crowdfunding Insights- Security Token Offerings or Initial Coin Offerings

Security Token Offerings or STOs are emerging to be the new way of crowdfunding since they offer investors with the governance and protection that is not provided by Initial Coin Offerings or ICOs. A Toronto-based company, Node Blockchain Inc, has published a recent study supporting the idea of STOs being the future fundraising methods to support the growth of the blockchain industry.

An ICO issues either a coin (cryptocurrency) or utility token. STO issues a security token, which is a digital stock certificate. It is different from a utility token. A utility token is treated to be a commodity, like gold with a useful value, but isn’t used for security. To compare STOs and ICOs in detail, we need to explore the concept of security first.

If you are not familiar with blockchain technology, its history or use cases, reading the following articles in advance is highly recommended:

Also, reading our previous article or Initial Public Offerings versus Blockchain Initial Coin Offerings Crowdfunding is highly recommended as it reviews the differences between traditional Initial Public Offering investments and blockchain ICO. Furthermore, it discusses the causes of the ICO bubble that led to its downfall.

Security

A security is a tradable financial asset. The legal definition of a security varies by countries. In some countries, a security includes equities and fixed income instruments. In some other countries, hybrid instruments such as convertibles, equity warrants, and so on are included in the definition of a security. In the US, commonly known securities include debt securities such as commercial papers; bonds and debentures; equity securities such as stocks; or a more exotic type, derivatives, such as forwards, futures, options, and swaps. We will explain the definition of security and how to determine whether a coin is a security under the US securities law in another article (read this). In the UK, securities, as outlined by FCA, include equities, debentures, alternative debentures, and units, along with stakeholder or personal pension schemes.

Securities are different from commodities. For example, equity securities represent ownership of a company, while commodities are items of useful value, but are not considered as a right to ownership. Securities can only be traded at registered trading platforms and participants that trade securities are required to be registered broker and dealers under the applicable securities laws. Commodity or currencies trading platforms for spot markets don’t need to be licensed. For instance, cryptocurrency exchanges are not regulated and do not need to be licensed. In the US, the Commodity Futures Trading Commission (CFTC) defines bitcoin to be a commodity and the Internal Revenue Service (IRS) defines cryptocurrency as property. SEC views many ICO issued tokens to be securities, which the blockchain community has a different view. For example, in July 2017, SEC declared the DAO token to be a security.

In the real word, the definition of a security is far more complicated. For instance, an e-money or payment service can be considered a security. Normally, a country’s security regulatory agency publishes guidelines to define what qualifies as a security.

In the US, the Supreme Court has created the Howey Test to determine whether a transaction is an investment contract. Under the Howey test, you have to ask the following four questions:

Whether it is an investment of money
Whether it is expecting profits from the investment
Whether it is an investment of money in a common enterprise
Whether there is any profit from the efforts of a promoter or third party

If the answer is yes, a token sale is considered to be a security that’s subject to securities laws.

Any business that’s involved in tradable financial assets (securities) is required to comply with laws for financial services and consumer protection. Two well-known laws are the Bank Secrecy Act (BSA) and the USA Patriot Act.

BSA, which was signed into law on October 26, 1970 by President Richard Nixon, requires businesses to do the following:

Maintain records of cash transactions of negotiable instruments
File reports if the total transactions in a day exceed $10,000
Report suspicious activities, which may imply money laundering, tax evasion, or other criminal activities

BSA is also referred to as the Currency and Foreign Transactions Reporting Act and is more often called an AML law.

The USA Patriot Act, which was signed into law on October 26, 2001 by President George
W. Bush, is passed by congress to strengthen national security in response to the September 11 terrorist attacks in 2001. The act has ten titles. The third title is called anti-money- laundering to prevent terrorism, modifying parts of BSA and the Money Laundering Control Act (MLCA) of 1986 to prevent terrorism.

Pursuant to the USA Patriot Act, the US government issued regulations, making KYC mandatory for US financial institutions. Any businesses that conduct security transactions need to follow regulations on KYC as well. KYC stands for know your customer or know your client. KYC is the process in which businesses collect and verify information about the identity and address of their customers. Companies use this information to ensure that their services are not misused for illegal activities such as money laundering, criminal activities, or bribery. The KYC procedure is required to be completed by companies while opening customer accounts. Post an account opening, the process also needs to be followed periodically.

STO verses ICO

The biggest difference between STOs and ICOs is that STOs issue a token that is considered to be a security, whereas ICOs issue a token (or coin) that can be a utility, commodity (or currency), or a security. This could result in many differences in the offering processes.

Regulatory risk: SEC may view an ICO as an issuance of a security and take actions against fundraisers, including canceling ICOs and returning raised funds to the original investors. STOs, if done properly and compliant to security laws, will not have such a risk. The following are examples of the reasons:

Requirements on AML and KYC: STOs have to follow the AML and KYC laws or regulations and ICOs do not have such obligations.
Requirements on securities laws: STO issued tokens need to follow the relevant securities laws and ICO issued tokens do not need to follow.
Intermediaries involvement: The ICO process does not require services provided by bankers, lawyers, or any other intermediaries. The STO process involves these intermediaries. Some recent studies show that the involvement of intermediaries and middleman entities help to improve and create efficiencies.
Ideology: The STO fundraising approach moved away from the decentralized ideology (for example, still having intermediary involvement) that is a core idea in blockchain industry, whereas ICOs follow the idea of decentralization.
Secondary trading markets: ICOs issued coins are traded at cryptocurrency exchanges that do not need to obtain licenses, whereas STO issued tokens have to trade at licensed exchanges via registered broker-dealers at higher costs because of the required supervision and employment of licensed staff.
Governance and control: An STO process provides a governance and control framework that makes scams and fraud much less likely, whereas an ICO lacks sufficient control, which can lead to many scams.
Documentation: STOs need to comply with applicable securities laws since it issues a security, whereas ICOs do not need to comply with applicable securities laws and instead just need to provide (at most) a white paper.
Cost/duration: STOs are more expensive and take a longer time to complete the process of registration with the securities regulatory authority and comply with the securities and other regulatory rules for issuing a security, whereas ICOs do not need to follow such processes. This leads to lower costs as well as a shorter duration to complete an ICO.

Security token issuers are subject to other constraints, which we will discuss later. These limitations are time-consuming, intrusive, and expensive.

STO versus IPO

Both STOs and IPOs issue new securities, and therefore adhere to securities laws. Both need to follow AML as well as KYC. They differ in several key areas.

An IPO process is time and resource consuming. The JOBS Act, signed into law on April 5, 2012 by President Barack Obama, permits startups and small businesses to be able to raise capital from the public without going through the lengthy IPO process. Title III of the JOBS Act, also called the CROWDFUND Act, and it defines a method for companies to issue securities via crowdfunding, which were not permitted before. In essence, the JOBS Act modified the Security Act of 1933 and eases securities regulations to make fundraising easier for startups and small businesses.

Although the JOBS Act was not created especially for the blockchain and cryptocurrency industries, the STO process utilizes the act for obtaining an exemption from IPO to issue a security token. This significantly reduces STOs duration and costs. Currently, security token issuers in the US can apply for one of three exemptions: Reg D, Reg A+, and Reg CF. They differ in the following places:

The annual offer limit
General soliciting
Investor requirements
SEC filing requirements
Restriction on resales
Preemption of state registration

Other differences between STOs and IPOs are summarized as follows:

IPOs are restricted to institutional investors. Often, an IPO is a local event in a country. Accessing foreign investors can only be afforded by established companies due to the associated costs and risks. Some jumbo and high impact IPOs such as the Alibaba listing on NYSE on September 18, 2014 may attract global investors but are limited in scope. A foreign investor needs to have a broker account at the country when an IPO takes place, which is not necessarily easy to achieve. STOs provide an easy way of reaching an individual, as well as institutional investors globally, thanks to crowdfunding. In other words, STOs are not limited by geographic borders and are open to more investors over the internet, regardless of the size of a company. Past examples of ICOs that have raised tens of millions of USD within the first minute testify the advantage of reaching out to a global pool of investors. Reaching out to global investors will lead to greater secondary market liquidity post STO.
With an IPO, a security issuer does not work with investors directly. Instead, between them, there are multiple layers of middlemen. For example, at one side, the issuer works with the underwriters (investment banks), who in turn work with global broker-dealers to attract investors. On the other hand, an investor works with a local bank, who then interacts with a broker-dealer to participate in the offering. The STO process still involves intermediaries such as lawyers.
However, a security token issuer directly interacts with investors on an STO offering platform.
IPOs are suitable for established companies normally with recurrent revenues and tested business models. These companies present smaller risks to investors. As a result, IPOs attracts high quality institutional investors. For example, by law, certain institutional investors such as insurance companies are restricted from investing in securities with high risks. They may not be qualified to invest in STOs.
Compared to IPOs, STO issuers pay far less to investment banks and broker- dealers. Since the majority fees of an IPO go to underwriters, the overall costs of STOs are much lower than those of IPOs.
Security tokens are created with smart contracts. Compliance that’s relevant to STOs can be programmed and enforced in code. For example, rules such as transfer restrictions and security lock-up period can be programmed into the security token. That will make STO and post STO administration faster, cheaper, easier, and more robust. IPOs do not have this advantage.
Security tokens allow for fractional ownership, just like a BTC can be split into fractions. IPO issued security has the smallest unit, one share, which cannot be divided further.

Challenges of STOs

STOs have a lot of potential. It is quickly becoming the best hope for replacing ICOs to drive the blockchain industry’s future growth. On the other hand, STOs face challenges as well.

Where to trade a security token is one of these challenges. Cryptocurrency has established secondary markets for providing liquidity post ICOs. For example, as of Jan 20,
2019, https://coinmarketcap.com/ showed that there are over 16,312 cryptocurrency markets. Secondary markets for trading STOs security tokens are scarce. So far, there are only a few reports on new security token trading platforms going live.

For example, https://www.overstock.com/ has recently announced that its tZERO security token trading platform would go live by the end of January 2019. An STO trading platform can be a newly built trading venue on an existing Alternative Trading System (ATS) or on top of a cryptocurrency market. For example, Binance, the largest cryptocurrency exchange by volume, is teaming up with some stock exchanges to enable security token trading. The lack of sufficient security token trading platforms will affect a security tokens’ liquidity. In turn, it negatively affects the efforts in attracting investors.

Where to register an STO is another challenge. For issuing a security token, an issuer needs to file the offering with a regulatory agency somewhere, which implies that the issuer is subject to that country’s securities laws, such as AML/KYC, and regulations. When security tokens are issued globally, the corresponding STO needs to be filed with the security agencies of related countries. If security laws and regulations contradict to each other, the question is how to resolve their differences.

Similarly, these countries’ securities and exchange laws progress over time. It is nearly impossible for an STO trading platform to service clients on a global scale. Even if this were possible, the associated costs and efforts could be very high. Consequently, it may not make business sense to maintain a global security token trading venue. Solutions need to be worked out in order to support a security tokens’ borderless characteristics.

A third challenge is the loss of decentralization. When an issuer files with a regulatory agency, the offering process is no longer decentralized. The government agency has control over the offering process, the security token, the company, and the project. The startup has to follow the relevant laws and rules in that country. This will make blockchain decentralization enthusiasts less in favor of STOs.

Whether STOs are supported by a government is an additional challenge on this list. In the US, SEC is taking supportive steps in accommodating fundraising methods such as STO since the regulation agency views the blockchain industry positively. However, many other countries have not taken the same stand. Some countries view STO less favorably. For example, in December 2018, the PRC government officially confirmed that STOs are illegal in China.

Summary

In this article, we discussed a traditional fundraising roadmap for a startup. At its formation stage, seed money and angel funds are often tapped to support activities such as ideation, the creation of a company, and the development of a Minimal Viable Product (MVP). VC funds will usually invest in the startup to finance the work after an MVP is formed. PE funds will invest in a startup (company) that reaches its growth or later stage and will most likely have an established business model so that they can seek additional working capitals. IPO is the step for turning a privately held company into a public company by listing its equity securities at stock exchanges. Mezzanine capitals bridge funds before an IPO takes place.

We then discussed ICOs, which is a primarily crowdfunding-based fundraising method. ICOs became the default choice by many blockchain startups thanks to its many advantages. For example, ICOs are fast and cheaper and can reach public investors globally. We then listed the issues that are faced by ICOs and the recent downfall of ICOs.

STO was then introduced as a promising replacement to ICO in the attempt to address the shortcomings of an ICO. We explained in detail about the concept of security in order to differentiate between a utility token that’s issued via an ICO and a security token issued via STO. We discussed the differences between an IPO and an STO. We ended the discussion by pointing out a few STO challenges.

The next article or Comprehensive Review of Blockchain Security Token Offering under US Securities Laws, we will discuss an overview of applicable US security regulations on fundraising and the application of such regulations on registration and exemptions, such as Regulation D, Regulation A+, and Regulation CF, to STO in detail, along with the development of US security laws in blockchain/digital security tokens.

This article is written by Brian Wu who is a senior blockchain instructor at Coding Bootcamps. He has written 6 books on Blockchain.

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