Zichain: Security Token Offerings explained

International crypto finance group Zichain explains Security Token Offerings and their possible future in the financial industry

A Security Token Offering is a token-based fundraising that is fully compliant with securities regulations

STO is definitely a leading contender for buzzword acronym of the year, with numerous experts proclaiming it to be the future of the crypto industry. Yet for all the hype around it, the idea behind a Security Token Offering remains somewhat elusive - today we will delve deeper into the inner workings of this new instrument.

Explained in a nutshell, a Security Token Offering is a token-based fundraising solution that is fully compliant with securities regulations. As financial market watchdogs around the world adopt a more rigorous approach towards token assets, STOs are a logical next step and a welcome development for the industry.

Does it mean that these new instruments are strictly better than Initial Coin Offerings (ICOs)? The answer is more complex than it would seem. STOs have a number of key advantages as they safeguard investor rights and mitigate regulatory risks for token issuers. At the same time, since STO is a type of private security placement, it is a considerably more costly endeavour when compared to an ICO, which is basically a glorified crowdfunding campaign. STO also has a different scope, since it can only target professional investors. All in all, ICO and STO are different funding mechanisms meant to be used in different situations.

The ICO market experienced explosive growth last year but seemed to have run out of steam by mid-2018. ICOs raised more than US$17bn in the first half of the year, but only around US$5bn in July-November. Yet while STOs are expected to dominate the industry in the coming years, it would be premature to expect the ICO model to disappear completely. STO is associated with higher costs for the issuer, so it would work best with B2B companies and established startups looking for later-stage financing (Series A and beyond). In the near future, ICO will most likely still be used by projects at pre-seed and seed stages, as well as for community-driven products relying on their user base for funding instead of institutional investors. If the market reaches a certain level of development where ready-made STO solutions become available and drive down costs associated with these offerings, even smaller companies may gradually adopt the new model.

So what exactly would it take to launch a Security Token Offering? First of all, an in-depth understanding of the regulatory and compliance framework in your chosen jurisdiction is of paramount importance. For example, if you are planning an SEC compliant token offering but do not have a single clue about what Regulation S, Regulation A, Rule 506 (b), etc. actually mean - you definitely need to hire a qualified securities consultant and pay for legal advice. The choice between these different registration exemption rules would define your legal obligations - and you will have to craft your strategy with those in mind.

Secondly, be ready to foot a considerably higher bill for legal services and compliance. KYC/AML process would most certainly become more prolonged, multi-tiered affair. It is impossible for any regulation compliant exchange to completely forgo these procedures. At the same time, regulators expect due diligence from issuers as well. For example, SEC requires you to confirm that an investor qualifies as an “accredited investor” in accordance with securities laws. It may come as a shock after the carefree approach of the ICO era, but STOs will have multi-stage KYC at both the exchange and issuer levels.

Finally, remember that STOs would require a different type of marketing campaign than ICOs. The latter were often similar to crowdfunding, with a large proportion of the funds coming from the project’s community and user base - thus ICO marketing relied heavily on social media. Only professional investors can participate in STOs - and they are an informed audience that is much harder to impress. Promoting your product and business model to professional investors would require a lot more effort and a considerable marketing budget.

The advent of Security Tokens seems to be inexorable, but it may yet encounter a few bumps on the road. A lot would depend on the actions of regulators and their endorsement of the scheme. Presently the U.S. Securities and Exchange Commission is clearly at the forefront when it comes to token asset regulation. There is little doubt that SEC decisions regarding STOs in the coming months will be emulated by national regulators across the globe.

Another issue is liquidity of the nascent STO market - there aren’t that many licensed exchanges where Security Tokens can be listed. It may take considerable time for market infrastructure to evolve enough to accommodate higher levels of liquidity. At the same time, it is worth mentioning that this is mainly a matter of perspective - Security Tokens are currently not as liquid as other tokens or traditional securities, but they are much more liquid than traditional venture investments, for example. This is why it is reasonable to expect VC funds to be among the early adopters of the STO model - both from the buy-side and the sell-side (since portfolio tokenization is already a thing).

It may be still too early to say whether Security Tokens would really become the revolutionary new way to raise capital. One crucial indicator that is worth paying close attention to is its rate of adoption by non-blockchain companies in the next couple of years. It could prove to be a valid instrument for a wide range of medium-sized businesses that are looking for funding but cannot support the costs of a traditional private securities placement. If that happens, we will know that STOs are here to stay.

STOs are an exciting topic for a wide range of market participants and have been discussed at length during some high-profile industry events this year, but it still seems like everyone has his own idea about what a Security Token actually is and how it should work. It will take at least a year for these different notions to coalesce into some kind of market standard. Mass adoption of this new instrument also requires concerted efforts from both the regulators and institutional investors - and the recent crash in the crypto markets could somewhat dampen the momentum. Security Tokens are definitely coming, but whether it will be a trend for 2019 or 2020 remains to be seen.

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