Security Tokens and STOs: A New Financial Frontier

Security Tokens & STOs

There were a lot of promises during the 2017 ICO boom. Brand new start-ups offering utility tokens that had no utility, on a blockchain that was not needed.

2018 was a wake-up call for the cryptocurrency community. An indication that the ICO status quo was not written in stone and that valid alternatives needed to be explored.

One of the most promising alternatives to the ICO and Utility token is that of a tokenized security or more commonly known as a “Security Token”. Could Security Token Offerings (STOs) and these assets eventually become the new norm in a more reputable ecosystem?

In this post I will attempt to answer that question and give you a general overview of the security token industry.

What is a Security Token?

A security token is a token that derives its value from the value of some underlying asset. This can be anything really from a share certificate, a bond, commodities, property etc.

Due to the fact that these are tied to some underlying asset, they are subject to regulations that govern securities. In the US these are the strict issuance rules that are outlined by the SEC.

So, when you buy a security token you are buying a share in an asset of some type. You are buying the rights to the future performance and cash flows from that asset.

Security Token vs. Utility Token
Security Token vs. Utility Token. Image Source

These are in contrast to utility tokens which were not developed for investment purposes (despite them being marketed as such). Utility tokens give the holders the ability to access and purchase future services on some decentralised blockchain.

ICOs to STOs

While utility tokens are issued in the unregulated and often wild west ICO markets, Security tokens will be issued in much more controlled and reputable Security Token Offerings (STOs).

While ICOs often feared falling fowl of SEC rules on securities, the STO will issue completely within the regulatory framework. They will go through all the applicable licensing and legal frameworks such as Regulation D, Regulation S, Regulation A+, and Regulation Crowdfunding.

Why do this?

While ICOs were a revolutionary way for blockchain start-ups to raise financing, they also attracted some bad actors and general opportunists. If we couple this with the relative inexperience of most of the investors, it created a number of negative externalities.

Pulling off a dubious ICO or developing a shoddy product is much less likely when the founders went through the regulatory rungs required to conduct an STO. It creates a safer environment for participants to invest in start-up companies.

Security Token projections
Potential for Security Tokens. Image Source

Moreover, it can be seen as a stamp of approval for the project.

It will be easier for a start-up to make a case to investors about their project, roadmap and most importantly, team members. One would feel more comfortable investing in a team that has completed the required compliance procedures than in one that has made some promises in a white paper.

So, in essence, the STO will have the best of both worlds. They will be reputable and have certain protections that regulated securities have all while still being inclusive enough to average retail investors.

Improving Traditional Finance

Apart from being more reputable than a standard ICO, security tokens also have benefits over more traditional means of raising financing.

  • Decreased Issuance Cost:
    For one thing, because security tokens are issued through the use of blockchain technology and smart contracts, the need for numerous transactional middlemen decreases. These numerous layers of participants who all feed at the trough increase the cost of the issue dramatically. So, if issuing tokens cuts out the middlemen then you can decrease costs
  • Faster Execution:
    Following on from the above example, these middlemen also tend to slow things down. They will have to inevitably sign documents, refer to council, seek authorisations etc. All of this will have to be done manually which will also increase the time that it takes before these can eventually hit the market. Automated issuance will drastically reduce this.
  • Large Market Opportunities:
    Generally, when it comes to early stage investment, it is usually reserved for a limited subset of investors in a particular region. With security tokens, you open the investment to anybody from any geographic region. A small retail investor in Africa can just as easily buy into a US STO than the Silicon Valley based VC firm can
  • 24/7/365 Trading:
    The cryptocurrency markets are continuous. Unlike with traditional financial markets that have to close for the day (equity and Bond markets) or those that have to close on the weekend (forex & commodities), crypto assets can be traded every hour of every day.
  • Easier Storage
    Security tokens possess all of the same benefits of cryptocurrencies. For one, they are very easy to store. All you merely need in order to prove ownership of the token in question is access to the private keys.
  • More Liquidity
    Just like cryptocurrenices, Security tokens are also easy to trade and transfer. A mere transaction on the blockchain is what is needed to hand over the token to another party. They could also be traded on exchanges thereby further increasing their liquidity. This is particularly relevant for those examples where the underlying asset is physical in its nature (think property, commodities, artwork etc).

So, security tokens are not only well positioned to pick up the baton ICOs left off, but they could also be a serious disruptor in traditional financial circles.

The Security Token Ecosystem

While security tokens are still a relatively new phenomenon, there are quite a few companies and projects that are building interesting solutions and ecosystems.

One of them is Polymath which is a project that is developing a platform for companies to issue their very own STOs. This platform will provide for a framework whereby issuers can use standardised templates to issue the tokens.

Strangely enough though, they have their own utility token called the “POLY”. This is an ERC20 standard token that was issued through an airdrop. The POLY token will be used on the platform as “fuel” to pay for services that are attached to the issue (compliance, legal etc). I have previously covered Polymath (POLY) if you wanted more information.

Polymath Overview
Overview of Polymath Network and Templates for Issue. Image Source

Another interesting securities token project is that of tZero. tZero is a blockchain subsidiary of Overstock Inc. and they will be issuing the tZero token. They completed a massive ICO private sale that began last December and ended in August.

tZero was able to raise a total of $134m with the majority of the funding coming from GSR Capital, a Chinese private equity firm. This ICO was designed so that it could comply with SEC regulations and is one of the reasons that they were allowed to continue the raise.

With a similar model to Polymath, tZero is developing a platform whereby companies can raise funding. However, they are also building out an exchange on top of this where people can trade security tokens in a decentralised fashion on top of the blockchain.

tZero Roadmap
tZero Roadmap as Presented in Earnings Reports. Image Source

There is also the prospect that large cryptocurrency exchanges such as Coinbase could eventually offer SEC regulated securities. This was on the back of their purchase of a range of broker dealer firms. It would give Coinbase the required broker dealer licences which would allow them to manage the trade in these assets. According to Asiff Hirji, Coinbase COO:

Ultimately, we can envision a world where we may even work with regulators to tokenize existing types of securities, bringing to this space the benefits of cryptocurrency-based markets — like 24/7 trading, real-time settlement, and chain-of-title

Given the size and influence of Coinbase in the cryptocurrency world, this is could supercharge the adoption of Security Tokens.

Tokenizing the Future

There is no doubt that cryptocurrencies and ICOs have paved the way forward for a more decentralised and inclusive financial ecosystem.

However, as with any nascent technology, there have been some challenges. The unregulated and unrestrained growth of the ICO and the subsequent fall have exposed some of these challenges.

Through the use of security tokens and STOs, numerous projects are trying to shape a new financial paradigm. Investing in new and exciting technology does not have to come with the risks that are often associated with an ICO.

There are already a number of STOs that are going through the regulatory steps required for potential listings in 2019.

While 2017 was the year the ICO, could 2019 be the year of the STO?

Featured Image via Fotolia

Nic is an ex Investment Banker and current crypto enthusiast. When he is not sitting behind six screens trading Bitcoin, he is maintaining his numerous mining rigs. Twitter: @nicrypto