Security Token Offerings (STOs): The Next Big Trend in Crypto Market.
A security token represents an investment contract into an underlying investment asset, such as stocks, bonds, funds, and real estate investment trusts (REIT). STOs are generated from ICOs, but all ICOs aren’t STOs. An investor is issued with a crypto coin or token representing their investment.
However, it’s important to first understand what a security is.
Security can be defined as a “fungible, negotiable financial instrument that holds some monetary value,” i.e., an investment product that is backed by a real-world asset such as a company or property.
A security token, therefore, represents the ownership information of the investment product recorded on a blockchain. When you invest in traditional stocks, ownership information is written on a document and issued as a digital certificate (e.g. a PDF). STO follows the same process but is recorded on a blockchain and given as a token.
STOs can also be seen as a hybrid approach between cryptocurrency ICOs and the conventional initial public offering (IPO) because of their overlap with these investment fundraising methods.
ICO’s – Initial Coin Offerings – came to the markets as digital coins to curtail operational costs and facilitate the stock trading process. Some ICOs bit off more than they could chew. While others gave “utility tokens” with no function at all.
Many lost money; some were left high and dry. Hacks and scams stole ICO’s security and trust.
The SEC’s pending regulation of the crypto markets means that now we are on a correct path.
Financial regulation is the basis for minimizing scams, insuring investments, and procuring a clear path for legitimate blockchain businesses to raise money legally. We expect that regulation will bring far more capital to crypto and open this emerging industry to large-scale investment.
STOs are nothing but the revised version of digital tokens backed by physical assets like bonds, stocks, etc.
In 2018, STOs began coming in dribs and drabs. The infrastructure was underway, with most STO issuers having a small investor base and high starting costs.
In March 2018, the US-based Praetorian Group became the first firm to offer an STO. The platform listed itself as a cryptocurrency real estate investment platform. On March 6, the platform registered its seventy-million-dollar ICO with the SEC. The move was deemed necessary by the platform’s developers because they were working within the real estate sector.
The platform utilizes PAX tokens to represent real estate. Tokenization is a strategy that facilitates more accessible and more secure transactions.
In 2019, Santander bank issued a 20$M tokenized bond on the Ethereum network.
In September, Allinfra announced their collaboration with Link REIT to work on tokenization of assets. This year marked that more prominent institutions recognize the use-cases of STOs and want to participate in the booming market.
In 2020, high starting costs were reduced over the months/years. The infrastructure was built. For STOs to emanate, the correct security tokens are to be issued to attract investors.
Security tokens comply with Know Your Customer (KYC) and Anti Money Laundering (AML) laws. This implies that both individuals and businesses must reveal their true identities before investing. KYC and AML laws are standard practices when dealing with financial institutions, which might be the same scenario for crypto services in the future.
KYC stands for Know Your Customer, and AML is Anti Money Laundering-both represents a set of standards and processes that ensure banned or sanctioned parties aren’t participating in the ICO/STO.
How Does A Security Token Offering Work?
An STO, just like an ICO, is created with a smart contract on a network like Ethereum. With a smart contract, it’s possible to replicate a usual deal — all without a middle man’s need, i.e. fully digitally.
Ethereum is the most popular innovative contract platform, and most development activity takes place on it. The key reason why a lot of new fintech applications are built on platforms like Ethereum is that smart contracts are a lot more efficient than usual agreements.
Types of security tokens
Equity tokens state ownership of an asset like company stock or debt.
Debt tokens are equivalent to the short-term loan on an interest rate on the company’s amount loaned. Eg., Steem
Utility tokens provide users with later access to a product/service. Companies can use these to raise funds for the development of blockchain projects.
This Is a token built on the blockchain platform associated with a tangible or intangible object of particular value.
Benefits of Security Token Offerings
SEC, the US regulatory body, identifies STOs as securities. Therefore STOs come under the strict purview of all security investments. Any issuance of security tokens will be treated as per the IPO norms falling under Reg D, Rule 506, and Reg A, Reg S. Currently, the SEC is still weighing options and studying to come up with supplementary guidelines to make the STO market foolproof with no ICO scam /hack repeat.
Security tokens can be used to mobilize funds on items requiring huge investments. With security tokens, the expensive art collectible value can be broken into fractions and issued to investors widely. The appreciation of the art collectables’ value would, in turn, accrue the security token investors. Since security tokens allow investors to buy fractions of fine arts or collectibles, people can expand the portfolios without the need for a large sum of money.
The REITs (Real Estate Investment Trust) could be issued as a security token.
However, there is a need to work on semantics, such as breaking the value into fractional ownership.
Security tokens target to remove intermediaries and provide simplicity to investors. Chainiumu, a crowdfund-based platform, was developed with the sole purpose of connecting investors to investors sans go-betweens. This will increase more accountability and transparency in the long run. Companies can enable investment via tokenization with an STO. Since trading restrictions can be embedded into a token with smart contracts, the cost required for IPO or other securities trading can be significantly reduced.
Liquidity depends on the number of traders(sellers and buyers) in a specific market. Speeding up transactions and fractional ownership via asset tokenization can enhance liquidity by enabling more individuals to enter the investment space and buy/sell at higher volumes. Security tokens offer more liquidity in terms of ease in buying or selling in a market or underlying asset not available or complex to buy or sell.
Security token offerings are a win-win situation from an overall liquidity point of view.
Improved access to real-world digitized assets
With $256 trillion of real-world assets available worldwide, there are many opportunities available for asset classes such as fine arts and real estate to open up the trading spheres and be traded easily and quickly with STOs.
The Best Projects In the Security Token Offerings Space
Tezos is an open-source platform for assets and applications backed by a global community of validators, researchers, and builders. Tezos addresses key barriers facing blockchain adoption to date: intelligent contract safety, long-term upgradability, and open participation.
BTG Pactual, the third biggest investment bank in Latin America, and the Dubai-based asset manager Dalma Capital in 2019, announced plans to use the Tezos blockchain to launch security token offerings. In doing so, the banks hope to “address a deal pipeline over $1bn for existing and prospective token issuances,” the companies said in a press release.
Tezos has been billed as one of the early “Ethereum killers.” The startups’ co-founder, Arthur Breitman, told Decrypt last year that his rationale for the Tezos system was to have a “solid, safe ledger” and that this is something you can’t achieve if there’s only one person in charge.
One of the best security token offering issuance platforms is a decentralized protocol that provides a worldwide platform for issuing security tokens and offering a trading tool for digital assets.
Founded by three techies (Arisa Amano, Bob Remeika, and David Sacks), it is one of the most secure STO issuance platforms. The platform simplifies the tokenization process by creating a regulated token known as the R-token. This token originates from the ERC20 token but contains extra features to enable users to check regulator services or on-chain “whitelist”.
The whitelist can be used to establish the requirements for KYC, AML, investor accreditation, and certifying certain specified digital assets.
Harbor primarily helps businesses and individuals issue tokens that are compliant with the set rules and regulations.
A subsidiary of Medici Ventures, the blockchain-focused, wholly-owned subsidiary of Overstock.com, Inc. (NASDAQ: OSTK), tZERO is a technology firm to democratize access to private capital markets.
tZero was developed to provide further legitimacy and oversight to initial coin offerings (ICOs) and to allow companies to create and issue tokenized assets for investors.
Unlike other decentralized blockchain platforms, tZero has been designated an alternative trading system (ATS) and is regulated by the Securities and Exchange Commission (SEC) and FINRA.
Being regulated puts tZero at a substantial advantage when it comes to financial products based on cryptocurrencies, as it can provide services that other platforms may not be able to provide. Because it must comply with regulations, tZero can position itself as a provider of advice, clearing, and verification services to other companies looking to release tokens to raise funds.
Established by Trevor Leverkor, the platform’s primary purpose is to help conventional financial securities integrate with blockchain tech. You can watch this video to set up your security token on the platform in an instant.
Primarily powered by its native token (Poly), Polymath is premised because tangible assets are being drawn towards being a part of blockchain technology.
Polymath comprises four core layers that define the creation of tokens and compliance with the set operating guidelines. These include:
- Protocol layer
- Application layer
- Legal layer
- Exchange layer
Generally, the protocol layer is in charge of all the computation on the platform. In contrast, the application layer allows users to create their security tokens. The legal layer offers guidance to those who wish to create tokens on the forum. And lastly, the exchange layer is more of a closed-end KYC/AML accreditation that offers its users instant liquidity for their assets.
With well-defined structures and a favorable trading environment, the platform is a darling to many investors and companies looking to tokenize their securities.
BankEx is a US-based company founded in 2009 and presently headed by Igor Khmel.
Khmel’s idea was to remove the disparity between fintech and the banking sector by instituting blockchain into its system.
Some of the major competitors of Bankex include Loopring, Stellar, and MakerDAO. However, the numerous services that Bankex offers to its users for asset tokenization and storage distinguish it from all other blockchain cryptocurrency platforms.
We ask you to DYOR, or do your research, and have just a little more faith in the projects you participate in.
The Positive Side of STOs
Security token offering offers enormous benefits.
It is pretty easy for businesses to promote themselves to the public with security tokens as individuals willing to invest are fees of exchange fees, brokers fees, and the costs involved in due diligence processes.
STOs also allow you to divide underlying assets into smaller assets, acting as a facilitator for fractional ownership, which can help make offering more affordable to investors and complete the transfer of tokens easier on a secondary market.
Challenges for the future development of STO
Many countries have banned STOs (and cryptocurrency trading in general), including China, South Korea, Vietnam, Algeria, Morocco, Namibia, Zimbabwe, Bolivia, India, Lebanon, Nepal, Bangladesh, and Pakistan.
While in other countries — like Thailand, STO regulations are not as clear-cut, as governments are still undecided as to how it should be regulated. Thailand’s Securities and Exchange Commission (Thai SEC) concluded that Thai-related STOs launched in an international market break the law.
But in an article by the Bangkok Post, deputy secretary of the Thai SEC, Tipsuda Thavaramara, said, “At the moment, we have not decided whether STOs fall under the SEC Act or the Digital Asset Act, but it depends on the STOs conditions and the details in its white paper.”
Increased regulation is the biggest challenge STO platforms face.
Processes will have to be set up for custodianship, tracking ownership, exchange approvals, Know Your Customer (KYC), AML, etc., to ensure they comply with the relevant securities laws. And although the process is cheaper than a traditional IPO, the additional upfront work makes it more costly. It raises the entry barrier compared to utility ICOs.
Furthermore, by removing some middlemen like banks, brokerages, and lawyers, performing these functions now falls on the company’s shoulders, further increasing the administrative burden.
The regulations in certain jurisdictions might also limit who can invest in the STO, which reduces the overall investor pool.
Lack of wider acceptability
Due to ICOs’ lousy reputation in the market, the STOs will need time to attain trust. How can one deal with insider trading and market manipulation, which remains extended to STOs?
STOs need major financial organizations to testify for it: this will heighten acceptability among their peers and clients. This may take some time, even with the security of regulatory requirements.
The hour’s need is to introduce regulatory requirements, which will act as an excellent first line of defense and protect investors.
Although security token offerings are introduced as a ‘badge of honor’ from regulatory authorities, the investors will need more education to build their trust and start investing in STOs.
Integration of systems
This business will need to construct protocols/interfaces to haul data and write and maintain the existing system architecture.
This may employ specific skill sets and duly boost costs, both in terms of human resources and enhancing the systems to interface with SSTO-specific blockchain technologies (e.g. smart contracts).
Finding the right fit to strengthen security tokens isn’t walking in the park.
This may increase initial acquisition costs, but this will spread out in the long run.
- According to Security Token Advisors, 15 countries have defined security tokens around the world;
- Of the top 100 largest banks globally, 39 of them are working on security tokens or blockchain applications.
- Curzio Research, a private US-based company, completed a security token offering for company equity listed on a secondary exchange. They used Rule 144 to trade with retail investors! It was the first of its kind;
- Tons of new players joined this year like Shareable Asset and Propine from Singapore; there is MountX in Mexico, Akemona in the US, a few new platforms partnered with Securitize to launch in Japan, Max Crowdfund in Germany started doing deals and Currency Works;
- FAT Brands blockchain-based bond was rated by Morningstar and given a higher grade for blockchain usage;
Future of Security Token Offerings
The security token market cap thrived by over 500% in 2020, and the best is still yet to come for security token offerings.
Tokenized real estate will continue to take center stage in the industry. With fund vehicles coming to the market this year, many investors will get a link to the investment class.
The industry is expected to see thousands of security token offerings and over 100 new listings on secondary markets worldwide, a 10x improvement from 2020.
STOs are indeed regulated, but the expectation still exists that each offering will be thoroughly researched and vetted by investors, just like with IPOs or private placements.
Hitesh Malviya is the Founder of ItsBlockchain. He is one of the most early adopters of blockchain & cryptocurrency enthusiast in India. After being into space for a few years, he started IBC in 2016 to help other early adopters learn about the technology.
Before IBC, Hitesh has founded 4 companies in the cyber security & IT space.
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