Security Token Offerings (STOs) are a method of fundraising for crypto projects. In view of the increasing hostility towards Initial Coin Offerings (ICOs), STOs represent a much-needed progression of how projects raise funding.
- The popularity of ICOs has waned due to fraud and misrepresentation
- ICOs offer no investor protection or rights with the project
- STOs, with security tokens, are regulated and offer ownership rights
- Regulatory compliance is costly and time-consuming
Since 2017, $28 billion was raised through more than 1,500 ICOs. Indeed, ICOs were key in supporting the crypto industry, and for people wishing to back these projects, they also functioned as an excellent opportunity for investment. Although, as things stand, the enthusiasm surrounding ICOs has since faded.
Given the enduring crypto bear market, as well as other difficulties including regulatory uncertainty, fraud, and general public wariness about blockchain technology, ICOs have suffered a huge blow, and their popularity started to decline towards the end of 2018.
From this, a new type of token offering has emerged – the STO, which seeks to address regulatory concerns, and so presents a viable alternative for projects wishing to attract investors and raise capital.
The Rise & Fall of ICOs
It could be said that the ICO was the result of a burgeoning industry trying to find its way. Their rise was partly due to the explosive growth of crypto in the later part of 2017. But since the bear market took hold, people have generally become more informed about the space, and it became apparent that ICOs do not represent a safe way to invest.
In fact, as non-securities, investing in an ICO yields zero investor protection, and any returns or tokens promised are at the discretion of the project. Of further concern was the fact that some ICO tokens met the definition of a security, as laid out by the Howey Test, but were passed off as utility tokens in order to side step the more gruelling and expensive requirements to sell securities.
It’s evitable that any budding, yet under-regulated market will attract scammers. And given the limited knowledge of everyday investors keen to ride the boom, combined with the lack of regulatory requirements for ICO fundraising, the crypto market was ripe for the picking.
The advisory firm Statis Group, estimated that 80% of ICOs conducted in 2017 were scams. Typical tricks include using fake wallet addresses to con investors into transferring their funds to another account, and exit scams, where the project team simply disappeared after raising funds. Scammers contributed massively to the decline of ICOs, but in reality, many crypto projects were just as complicit through mis-classification of their tokens.
The Difference Between Utility & Security Tokens
As ICOs lack the regulatory backing to issue securities, the distinction between utility tokens and security tokens is important.
Security Tokens – are digital assets that represent shares in a crypto project. They are backed by another asset and give the holder voting and profit-sharing rights. As a securities product, they fall under the jurisdiction of federal laws. Failure to comply with regulation could result in financial penalties and the threat of project termination.
Utility Tokens – are not created to be an investment. Their purpose is to enable access to the products/services offered by a crypto project. For example, Binance’s BNB coin affords the holder reduced trading fees.
So, the main difference lies in their intended use, but because both security and utility tokens are traded on crypto exchanges, and both can increase in value, it is hard to distinguish them. In consideration of this, in the U.S, The Securities and Exchanges Commission (SEC) apply the Howey Test to make this distinction.
The Howey Test
In 1946, the Supreme Court made judgment on the case of the SEC vs. Howey. This landmark ruling set a precedent for how securities investments should be defined.
It was determined that a transaction will be called a security investment if it meets the following criteria:
- It is an investment of money
- The investment is in a common enterprise
- There is an expectation of profit from the work of the promoters or the third party
If a token meets all three points, then it should be considered a security token.
Any organization in the U.S that issues securities must register their investment contracts with the SEC. There is also a requirement to disclose how shareholders will have their say, how reports on company activities and financial performance will be compiled, as well setting out anti-money laundering policies. These are costly and time-consuming obligations, which is the reason why many crypto projects side-stepped their regulatory duties. However, as the crypto market is maturing, there is growing realization that such actions will no longer be tolerated. And in the drive to legitimize the cryptocurrency space, STOs and securities tokens are a step towards this.
Security Tokens & STOs
An STO is an offering made by a crypto project, where investors pay to receive a security token. It gives an alternative to ICOs, in that the tokens issued comply with legislation of specific jurisdictions.
Under an STO, investors are assured of buying equity, a derivative, or a share of the profits of the organization. In much the same way as traditional shares, security tokens give investors rights to the company, bringing the blockchain space more in line with traditional legacy systems, adding to their mass market appeal through familiarity.
The Future of STOs
STOs, fit well alongside existing regulatory frameworks for securities, meaning their implementation is likely to go smoothly, and it’s expected that demand for security tokens will increase. After all, they offer a number of distinct advantages over ICOs, namely enhanced credibility, removal of middlemen, and the acceptance of blockchain technology as a financial instrument.
Whilst ICOs are unlikely to disappear altogether, because there is still room for utility tokens in this space, the proliferation of STOs will create an environment that investors feel more comfortable investing in, which in turn, can only help with mass adoption.
ICOs have fallen out of favor due to fraud and misrepresentation. STOs offer an alternative way of investing and fundraising, which is more akin to traditional investments by way of company ownership and profit sharing. But compliance is fraught with cost and meeting regulatory requirements, placing a burden on crypto projects. However, this is necessary in order to legitimize the crypto space, stop scammers, and increase mass market appeal.