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Media

What is a Security Token and a Security Token Offering?

Matthew Warner | May 2019

TL;DR: At the most basic level, a security token is a digital representation of tradable financial assets such as shares in a company’s stock; a security token offering is a regulatory-compliant method of raising funds by selling blockchain-based security tokens.

History of the Security Token and Security Token Offering
At the height of the ICO craze the cryptocurrency and blockchain world was tarnished by a number of bad actors who used the lack of regulation and scrutiny around ICOs to con people out of their investments. Given that cryptocurrency already had an (undeserved) bad reputation in the eyes of the general public, this hindered the huge number of legitimate projects who were looking to use ICOs to start up revolutionary new businesses.

At the time – referred to as the Wild West of crypto days – there was a particular project which brought this issue to the attention of regulators. Known as the DAO (Decentralised Autonomous Organisation), the project was intended to run a decentralised company using smart contracts and managed to amass approximately $250 million of funding (depending on the price of ether used at the time) through its ICO. Unfortunately, a vulnerability in the DAO code was exploited to withdraw approximately $70 million worth of ether. This led to a number of huge and far-ranging consequences, but the one most relevant here was to bring the issue of ICOs to the attention of the United States Securities and Exchange Commision (SEC) which eventually produced a report that included the following statement:

“Tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws. The Report confirms that issuers of the distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws.”

Whilst no legal action was taken by the SEC at the time, it warned that all future ICOs (or other cryptocurrency fundraising methods) would be subject to the relevant regulations as determined by the use of the token as a security or utility token.

Whilst many lamented this decision, and US citizens were effectively restricted from participating in further ICOs as the fundraisers barred US participation to avoid this ruling affecting them, others realised the power of embracing the regulation for fundraising with security tokens. Thus, the STO (Security Token Offering) was born.

What is a Security Token?
At its core, a security token is an investment in a company; it is a digital representation of tradable financial assets, such as shares in a company’s stock. A person purchasing security tokens would expect financial gain from holding it – as opposed to a utility token where they would gain another benefit (such as access to a service for example).

The most commonly used metric to determine if a token is a security token is the Howey test, which states that a token is a security if:

  1. There is an investment of money (you pay for it).
  2. There is an expectation of profits (you expect financial reward).
  3. The investment of money is in a common enterprise (there is a group of investors for the project).
  4. Any profit comes from the efforts of a promoter or third party (you don’t work for the profit, the company you invested in does).

Securities can come in the form of stocks and shares, bonds, debentures, notes, options, warrants or various other forms of tradable financial asset.

What is a Security Token Offering?
A Security Token Offering (STO) is essentially the same as an ICO, except it conforms to regulatory requirements for security tokens. That is to say, it is a regulatory-compliant method of raising funds using tokens issued on a blockchain.

What are the benefits of security tokens and STOs?
The benefits of using security tokens and STOs can be broken down into two main aspects: The benefits of using blockchain-based fundraising compared to traditional methods, and the benefits of STOs compared to ICOs.

  1. Blockchain-based fundraising Vs. Traditional methods

The benefits to blockchain-based fundraising are similar to the benefits of blockchain.
These can be broken down as follows:

  • Immutability. Using cryptographic certainty and immutability of blockchains, and coding of smart contracts, allows STOs to facilitate trustlessness. Once a smart contract is entered into, the outcome (funding of a project, the result of a vote etc) will occur once the conditions have been met, or (if specified, the funds will be returned. You don’t have to trust the intentions and morality of a person you are dealing with or have external safeguards; however, you do need to be sure that the coding of the project and any smart contracts are sound.
  • Removal of middle men. As a trustless system, STOs can avoid the need for middle men and the inefficiencies that they create. This opens up a host of benefits including making it less prohibitive to invest and allowing trading to be carried out 24/7. This reduction of third parties also means that there is less chance of skullduggery.
  • Automation. Automation through smart contracts is one of the main ways that an STO can be made more efficient than traditional methods. You are not waiting on a person to approve or progress at various points. Once a goal is met it can be instantly executed.
  • Speed. Both removing middle men and automation lead to a faster and simpler process when compared to traditional methods.
  • Efficiency. The reduction of middle men and automation also leads to greater cost savings through efficiency.
  • Global. A borderless system, blockchain opens up the potential pool of investors to a much wider, global level, which is also unrestricted based on biases and prejudices.
  • Fractionalisation. Using a blockchain-based system with an infinitely-divisible token allows for investment at a micro-level. For example: 1 token could be offered for $100, or 100 tokens could be offered for $1. This provides a much deeper pool of potential investors across the world who would never be able to afford to participate in traditional investment. This can also allow for people to invest with others to own a fraction of, for instance, a piece of art or real estate.  
  • Liquidity. Security tokens and STOs can enjoyed vastly superior liquidity due to the ability to be offered at potentially infinitely small denominations, the removal of middle men making transfers fast and efficient, and the option to trade on digital exchanges with no down-time.
  • Flexibility. Smart contracts and tokens can be customised to do anything that can be coded, providing limitless potential options to benefit the investor. This could be anything from increased dividends for those who hold the tokens longer, to proportional voting rights for token holders.

         2. Benefits of STOs Vs. ICOs
Although ICOs drew a lot of attention and investment very quickly, they had issues with their unregulated nature. STOs remedy this; however, as they are still a new development, the regulations and procedure for implementing them has not yet become standardised and straightforward. The benefits of STOs over ICOs include:

  • Legitimacy and credibility. Whereas ICOs garnered a reputation as being a prospect fraught with risk and an ecosystem full of scammers and con men, STOs can be considered legitimate avenues of crowdfunding as they seek to comply with regulations. This will encourage greater adoption of STOs as people realise the huge benefits they can bring whilst simultaneously trusting the process.
  • Protection. Regulations exist to provide protection. Whether for companies or individuals, having regulations allows projects and technology to develop in a safe and secure manner.
  • Adoption. Without regulatory compliance, blockchain- and cryptocurrency-based measures would never be accepted by the public. Compliance with regulations was the vital step to turn ICOs into STOs in order for the blockchain-based crowdfunding method to become mainstream.
  • Interfacing. By bringing STOs into the public eye and mainstream development, there exists a potential for STOs to interface with existing infrastructure and further develop solutions to improve the ecosystem and transform the way funding and business operates. Not only does this allow a wider audience to enjoy the benefits of STOs, but it also brings the expertise of that audience into contact with STOs and blockchain solutions. By bringing in people with different talents and potentially high-level or obscure knowledge, you enabling the possibility for experts from traditional business to help develop new solutions whilst avoiding pitfalls or exploring previously unknown avenues.

Links to useful articles:
https://blockgeeks.com/guides/video-guide-what-is-an-sto/
https://www.ccn.com/what-is-an-sto
https://medium.com/swlh/the-story-of-the-dao-its-history-and-consequences-71e6a8a551ee
https://www.sec.gov/news/press-release/2017-131
https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html