Security Token Offering: What You Need To Know

What you need to know about STOs

Security tokens have become a substantial area of growth in the cryptosphere. There is still plenty of potential to be realized as the market grows further, with a large and important user base that has a vested interest in the area.

Meanwhile, the legal landscape surrounding cryptocurrencies, cryptocurrency exchanges, and blockchain-based digital assets remains unclear. It has always had an element of ambiguity.

Each country has different views and perspectives on the market and ICOs, with actions being taken accordingly.  This put the market under increasing scrutiny from governing agencies. The SEC is one such example that has taken an interest in the industry.

When the likes of security tokens began to appear and gain traction, it took the market by storm.  The dramatic growth in the popularity of the technology and platforms came as a solution to this problem. Together with the rising popularity of STO’s, this is a market that looks to make its mark.

Defining a Token

A lot of the ambiguity surrounding the regulations involves the ambiguous nature of tokens in the cryptocurrency market. Tokens can generally be split into two different groups: security tokens and utility tokens.

Security Token

Security Tokens share many characteristics of both fungible (ERC20) and non-fungible tokens (ERC721). They are defined by the fact that they derive their value from a tradable, real-world asset or entity. These can come in the form of commodities or equity.

They involve an investment contract where the main draw and use are for likely future dividends, profit or other benefits. While utility tokens have no limitations on who can send or receive them, security tokens are subject to many restrictions based on identity, jurisdiction, and asset category.

Essentially, they are taking conventional securities and tokenizing them for the blockchain. Ownership is confirmed through blockchain transactions. It also allows for fractional ownership.

Otherwise, security tokens are programmable due to their tokenized nature and due to being based on a blockchain. Smart contracts allow for immediate execution when certain parameters are met, without the need for a middleman.

Utility Token

A utility token has a rather similar design, though its use case is different. These tokens provide access, whether in the present or future, to a product or service. Users that hold utility tokens can, therefore, use the particular network and service.

Again, it all depends on the function of the token. They represent a unit of account that grows in value as the network grows. KuCoin’s own KCS are an example of a utility token, as they have actual uses within the exchange and can be spent within the KuCoin ecosystem.

Ultimately, it is security tokens that are liable to follow the established regulations in place for traditional securities. The SEC uses a test to determine how the token should be classified. The test involves finding if the issuance of the token constitutes an investment contract or not, based on certain criteria.

If the token is found to be classified incorrectly and have the wrong credentials, then necessary action will be taken.

Tokenization of Securities

When it actually comes to tokenizing securities on the blockchain, there are different ways to go about it. Compliance doesn’t always have to be an issue in this process.

Projects like Polymath and Harbor have stepped in to help tokenize securities, as well as develop a new standard to which security tokens can be based.

Using the ST20 protocol developed by Polymath, security tokens can be embedded with the regulatory requirements, only allowing verified and authorized participants to access them. This was a major sticking point, and so this ability to restrict trading to on authorized individuals is vitally important. It also takes the complex technical process associated with the process and simplifies it, allowing the securities market to enter the blockchain space. Being so technically and legally demanding, platforms like these will play a fundamental role in the growth of the market.

New Regulations

While each country has their own financial regulatory body that plays a similar role, the SEC is the most prominent example. The ‘SEC’ refers to the ‘Securities and Exchange Commission’, an independent agency of the United States federal government.

Their role is to protect investors and maintain the fair and orderly functioning of securities markets and the facilitation of capital formation. In their scope, therefore, is the realm of cryptocurrencies and ICO’s (initial coin offerings), a market they have begun to take an interest in.

In March of 2018, the SEC released a statement on ‘potentially unlawful online platforms for trading digital assets’, which noted that any platform acting as an exchange and offering security tokens on their platform is required to register with the SEC.

For the majority of exchanges, this is not an issue. The most popular cryptocurrencies including Bitcoin, Ethereum and Litecoin are not counted as securities – meaning they are not backed by a physical, real-world asset. As such, they are not of concern for the SEC and so most exchanges are exempt from this requirement. Exchanges are unable to list security tokens for this very reason.

Security Tokens on Cryptocurrency Exchanges

There are a few barriers that prevent security tokens from being listed on the average cryptocurrency exchange. The biggest and most important issue is the complexity of these tokens. These tokens are inherently complex due to being tied to a real-life asset.

New infrastructure needs to be put in place to facilitate the large-scale trading of these assets, in terms of the issuance of the tokens and compliance with regulations.

As a relatively new development, the legal landscape surrounding security tokens is still rather vague and changing constantly. Now that the SEC is setting its eyes on the industry, with a particular interest in these security tokens, their uptake by regular cryptocurrency exchanges looks unlikely. Instead, it seems the best way to accommodate these new tokens is to create new exchanges.

There is a real incentive for offering security tokens. Security tokens look to many as the next big step that can be taken in the cryptocurrency world. While non-security tokens have their benefits, blockchain-based securities are seen as a true adaption of the traditional finance industry.

Not only does it speed up the traditional process, but it also allows for faster deal execution. It builds more credibility, exposure, and security too.

Venture capitalists are set to benefit thanks to the added liquidity and inherent value they possess. Fees can be reduced significantly, and the investor pool is increased thanks to the online nature of security tokens.

A New Wave of Security Exchanges

Recently, there have been moves by established exchanges towards launching separate, dedicated security exchanges to list these tokens. With the sole purpose of trading and exchanging these security tokens, more time, focus, and care can be given to listing and trading them at scale – something that is not currently achievable on regular cryptocurrency exchanges.

With compliance being the major issue, these security exchanges will need to emphasize and provide reliable data to the corresponding regulatory bodies. Some exchanges have begun to release their platforms and become amongst the first to begin offering some of these security tokens.

Initial Coin Offerings vs Security Token Offerings

When it comes to funding, there are two different formats a project can choose from based on the type of token being sold.

An Initial Coin Offering (ICO) refers to the fundraising for companies looking to develop a new coin app or service in the cryptocurrency space. These do not offer any rights or obligations, instead providing access to a specific platform or service.

A Security Token Offering (STO) follow a similar structure to an ICO. They involve the sale of crypto tokens which are built on a blockchain, which can then be traded, sold, or held. However, participants of an STO are mainly made up of investors instead of users, as STO’s are actual financial securities that are backed by something tangible. This can be assets, profits, or revenue from the company. They also provide legal rights which can include voting or revenue distribution.

Ethereum is developing a unique token standard. ERC-1400 is designated specifically for security tokens. This new standard is currently being tested by the Ethereum community.

Ultimately, the aim is to make Security Tokens more credible by having certain specifications added to the existing ones that will potentially make ERC-1400 compliant with the established ERC-777 and ERC-20 standards.

The Future of Security Tokens

In summary, the SEC has begun to take focus on the cryptocurrency market. Their main issues surround the placement of security tokens on cryptocurrency exchanges that are not qualified or registered sufficiently. As this is not an easy task, these platforms now look to launch dedicated exchanges for security tokens with the necessary qualifications and infrastructure.

STO’s are growing at a fast pace and seem to be replacing ICO’s in terms of popularity, aided by the government crackdowns. Together with the introduction of these dedicated security token trading platforms, it is clear that there are many changes currently taking place within the cryptosphere right now.

Developments like Polymath’s platform make it easier for companies to release security tokens, paving the way for further growth and prominence of Security tokens and Security Token Offerings in the blockchain ecosystem.

The recognition from these governing bodies shows the extent to which the cryptocurrency industry has grown and reflects the growing legitimacy of cryptocurrency and the promise of securities within the cryptomarket.


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