Over the last few weeks, there has been a growing interest among the crypto community towards Security Token Offerings, or STOs. The combination of a bearish trend in the crypto markets and intensified crackdown by regulatory authorities, especially the U.S. Securities and Exchange Commission (SEC), is driving this trend towards STOs.
During Consensus: Singapore 2018, I had the opportunity to speak to many projects who are currently considering, or undergoing the process of, an STO. I noticed that most of the projects do not clearly understand the implication of conducting an STO or consider whether it is the right choice for their business. Hence, in this post, I have tried to pen down my own understanding of the topic for the benefit of the crypto community.
What is an STO?
Security tokens are tokens which have attributes of a security. Generally, the following can be considered as a security token:
- Tokens representing or giving the right to equity shares in a company/enterprise;
- Tokens representing the right to share in profit or ownership in a Company;
- Tokens representing a loan or any other debt obligation;
- Tokens which are backed by real assets like real estate;
- Tokens representing a unit of a mutual fund or collective investment scheme;
- Pre-functional utility tokens in the United States.
The above list is not exhaustive, as what constitutes a security differs from jurisdiction to jurisdiction. What may be considered a security in one jurisdiction may not be a security in another jurisdiction.
Security Tokens are Well Regulated
Since security tokens are considered securities, they need to follow local securities laws which are very well established in most jurisdictions. This means that if you are conducting a public sale of security tokens, you will need to register your STO with the local securities regulator and provide very detailed disclosures as required for an Initial Public Offering (IPO).
If you are not taking the public route, then you need to follow the private placement route. Which means that you can raise funding only from Professional/Accredited Investors. Also, in some jurisdictions, the security tokens may be subject to restrictions on advertisement/ public solicitation as well as restrictions on transfers such as minimum holding period or the need to transfer only to another Professional/Accredited Investor.
Security Token Hodlers May Not Have Access to Liquidity
None of the crypto exchanges currently in existence can list security tokens due to regulatory restrictions. These crypto exchanges need to obtain a license to operate a securities exchanges to list a security token, which none of them currently have. Further, the traditional stock exchanges like NASDAQ or NYSE who can list a security token would not still be able to list them because they lack the infrastructure for clearing and settling blockchain-based digital assets.
Given the above scenario, there is no visibility on when or where or if at all security tokens will be listed. Until such time, security token holders may be sitting on a very illiquid investment.
Security Tokens are Not Utility Tokens
Yes, you have read it correctly. Security tokens are securities and hence cannot be used like utility tokens. This means you cannot use them as your platform currency or medium of exchange. You also cannot use them to gain access to platforms, to incentivize users for using the platform, or as mining rewards. You cannot airdrop them or use them for bounty campaigns. Securities are subject to numerous restrictions as to transfers, buybacks etc. and hence they cannot be used the same way as utility tokens.
Security Tokens Won’t Convert into Utility Tokens
Many people consider a security token the same as a Simple Agreement for Future Tokens (SAFT). They believe that once the network is operational, then the security token will get converted into a utility token. But this is not the case. Though both SAFT and security tokens are considered as securities, they operate very differently. In theory, SAFT is an agreement to purchase future tokens which will come into existence when the network is operational.
According to the proponents of SAFT, once the network is operational the tokens are already functional and need not be securities under the Howey test. Security tokens are designed to be securities and don’t change their character once the network is operational. Once a security token, always a security token.
One of the main benefits of security tokens is the regulatory certainty on their treatment. But that comes with its own limitations which include higher compliance costs, a smaller pool of eligible investors, restrictions on transferability and lower liquidity.
For certain business models like REITs, security tokens would be the best; whereas, for something like a blockchain protocol or a platform, utility tokens work the best. Both security tokens and utility tokens have their own merits and demerits, and which one is suitable for a particular business model varies on a case-to-case basis. It is essential to have a holistic look at how the choice of token affects the business model. Having a siloed approach — resorting to quick fixes and blindly following the market trends without fully considering the implications of the actions you take — does more harm than good in the long run.
So, take a step back and ask yourself: “Is it the right choice for my project?”
Not sure whether a security token or a utility token is the is the right choice for your business model? Don’t worry, we at ICOMain offer a preliminary one-on-one consultation and review of your ICO project free-of-charge.
Drop me a line on email@example.com and we will help you figure it out.
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