In 2017, a new way to raise money through cryptocurrencies emerged – it was the year of the first Initial Coin Offering (ICO). Since then, over $22 billion has been raised by companies of all sizes – startups to public companies on the stock market. It was the world’s way of acknowledging the viability of Ethereum, Bitcoin and other crypto assets.
What are ‘Security Tokens’ Anyway?
It was only a matter of time before companies jumped on board the ship in an effort to use the platform as a way of raising money. This investment aspect of ICOs caught the SEC’s attention as there was a large possibility of abuse and fraud. Suddenly, the market turned into a regulated way of raising money, and thus the Security Token Offering was born.
In the eyes of the law, a security is defined as an investment contract recognized by the law, anchored upon the expectation of returns or preservation of capital. In which case, ICO tokens aren’t considered more of a store of value while STO tokens are seen as an investment contract.
In other words, a security token is a cryptographic representation of tokens that pay interest, dividends, share profit and generate revenue for the investor.
How is an ICO Different from an STO?
Think of traditional ICOs as a new, novel way of crowdfunding. Anyone who purchases the coin gets a certain number of ‘tokens’ or ‘coins’ to verify ownership, and that’s pretty much that. The company the tokens were bought from don’t have an obligation of profit to the purchaser, or at least, that expectation is not considered to exist. Such a token is referred to as a ‘utility token.’
The difference between a security token and a utility token is that security tokens are backed by tangible assets like profits or the company’s revenue.
Who Do You Need to Involve?
After you’ve decided to issue go ahead with the STO, you might find there are various parties that need to be involved in the process.
- Legal aid: There will be a need to consult legal aid to make sure the STO works within the country’s regulatory frameworks or face the risk of being shut down. This is covered in the next section.
- Issuance compliance: In order to ensure your token complies with current laws, you might have to consult compliance platforms like Polymath.
- Custodians: A custodian, when it comes to STOs, is a company that stores digital tokens on your behalf. It’s a service that’s also normally offered by compliance platforms. Doing it on your own would otherwise be expensive and serves as an attack mitigation front.
- Exchanges: Unlike with most ICOs, companies that issue STOs as opposed to normal coins can only list their coins on regulated exchanges. This may warrant research, but more and more exchanges already support security token listings, eg. Lykke, Open Finance and Blocktrade.
Understanding the STO Landscape
When considering how to raise money through an STO, two main factors in particular stand out and bear serious consideration: regulation and technology.
The regulations the STO will be subjected to depend on where the company is located. In particular, the US and EU are known to be strict with how STOs are performed.
In the US, STOs need to be compliant with Regulation D, A+ or S:
- Regulation D: According to this regulation, an offering can avoid being registered with the SEC as long as “Form D” has been filled. Offerings may then be solicited in compliance with section 506C, whose main focus is requiring verification that the investors are accredited.
- Regulation A+: This allows for investors that haven’t been accredited to buy the tokens for up to $50 million. However, it takes a much longer time and is a lot more expensive.
- Regulation S: This comes into effect when the offering is not in the US and thus not subject to the registration requirement.
In the EU, the sale of tokens falls under the EU’s securities laws. The issuers need to draft a prospectus and receive approval by the individual country’s financial regulator.
Before you’re able to perform an STO, you need to figure out what kind of technology stack you’re going to depend on. The first step is to decide which blockchain your token will reside in, and the second is figuring out how to make the design as easy and secure to adopt as possible.
Most security tokens also adopt the same standard, but usually modify them to take care of regulatory compliance. These put checks on who is able to trade with the tokens, address whitelisting, and wallet locking, for example. This led to the emergence of four main standards that are used in the STO world today:
- ST-20: This is the original security token standard and allows the issuer to set rules like who can interact with the token and how. It also comes with a set of predefined modules
- R-Token: Is an extension to ST-20, but is modified slightly to allow for easier upgrades to newer versions.
- ERC-1400: This standard is meant for more complex securities. It includes features like being able to tell the difference in shares from the same issuer.
- ERC-1404: This standard was created to allow for easier interop between different standards with crypto exchanges and wallets.
When designing your token, interoperability is perhaps the most important thing to consider. This can only be achieved by picking the right standard.
Going contrary to this will mean potential investors don’t have many options to transact with their tokens. ERC-20 is so widely-adopted that most wallets and currencies can be easily integrated into the system.
To Sum Up
Security tokens are propelling the future of legal fundraising and providing superior opportunities to raise funds for businesses. ICO’s that meet new SEC regulations, join hands with the any of the top security token development companies that is technologically-compliant, and have a solid business plan that is future-oriented are sure to succeed in the market.