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In opposition to tokens offered in an ICO which do not give any rights or obligations, and instead provide access to a specific network, platform or service, tokens offered in a STO are actual financial securities that are backed by something tangible like the assets, profits, or revenue of the company, and which offer legal rights such as voting or revenue distribution.
A security token performs the same function as a conventional security, except that it confirms ownership through blockchain transactions and also make fractional ownership possible. Security tokens are subject to federal laws that govern securities, protecting investors on some levels. Security tokens are programmable. Since these securities are tokenized on a blockchain, “smart contracts” can make them act in a certain way, without the use of a third party. For example, a loan “tokenized” on a blockchain could automatically make payments without the use of a traditional middleman like a bank.
"Blockchain technology can help democratize access to an asset class traditionally only available to elite institutional investors by providing investors with the opportunity to invest into a fund via a liquid, tradable, digital token."
What regulations affect Security Token Offerings
The CFTC (Commodity Futures Trading Commission is an independent agency of the US government) views Bitcoin as a commodity, the IRS (Internal Revenue Service is the revenue service) defines cryptocurrency as property, and the SEC (Securities and Exchange Commission) indicated that many ICOs were securities.
Commodities exchanges providing a spot market or currencies do not need to be licensed as a regulated entity, while a platform that offers securities are required to register as a national exchange or Alternative Trading System (ATS) or apply as a broker-dealer.
Companies that are involved with financial assets, such as stocks, bonds, bank deposits and the like are examples of financial assets, are required to comply with consumer protection laws and the Bank Secrecy Act and the USA Patriot Act.
“big opportunity is in digitizing private and public shares.”
Security Tokens Benefits
Issuance of security tokens under Regulation A+. Regulation D, Regulation S and Regulation Crowdfunding also tends to be significantly cheaper and faster, than conducting Initial Public Offerings.
Tokens classified as securities tend to provide investors another option of generating dividends as well as profits and voting rights as is the case with owning shares of publicly traded companies.
Cost Effective
Unlike other financial models for investing, security tokens come with zero administrative costs of buying and selling. Reduced costs essentially allow people to generate a substantial amount of returns on investments.
Fast
The process of buying and selling security tokens to accredited investors also tends to be a little bit fast thanks to automation of Know your customer and AML checks. Liquidity.
Global Trading Capability
Security tokens tend to enjoy high levels of liquidity as they are eligible for trading on the global scene, allowing for anyone around the world to access them. Acceptance as financial instruments as well as increased adoption has also helped bolster liquidity levels.
24/7 Trading
Ability to trade security tokens any time or day also makes them highly desirable to other traditional models that are time constraint.
Security Tokens Disadvantages
Too many regulations, as well as limitations on who can invest in security tokens, is one of the factors that could stifle mass adoption of security tokens. Regulations affecting people who can take part in Security Token Offerings STOs also go a long way in affecting such securities liquidity.
“Secondary trading of private securities often requires various middlemen (such as brokers and exchanges). In addition, the process for tracking trade activity is manual and costly, and there is a significant burden on issuers to safeguard against potential regulatory risk. These inefficiencies can often lead to issuers imposing trade restrictions, making private securities illiquid. To account for the lack of liquidity, the value of private securities is discounted (i.e. the “illiquidity discount”), preventing issuers from capturing the full value of the underlying asset.”
How to Offer a Security Token
If you want to issue a security, you will need to register it with SEC. It is a complex and expensive process meant for the established business.
To avoid this time-consuming process, projects can make use of the JOBS Act from 2012. The JOBS Act was not made for STOs specifically, but it seems to fit the needs of security token issuers. Issuers in the U.S. can apply for three distinct exemptions: Reg S, Reg D, Reg A+ and Reg CF.
Security Token Offering Reg S
Reg S which is a “safe harbor” exemption, only available to firms outside America, therefore not subjected to the registration requirement under section 5 of the 1993 Act. The creators are still required to follow the security regulations of the country where they are supposed to be executed.
The US Securities and Exchange Commission (SEC) adopted Regulation S to clarify the application of the Securities Act registration requirements (US Registration Requirements) outside the United States and its territories.3 Regulation S consists of five rules:
Rule 901, which sets forth the general statement that the US Registration Requirements apply only to “offers and sales” of securities that occur within the United States and its territories;
Rule 902, which sets forth definitions for Regulation S;
Rule 903, which provides a safe harbor for transactions involving issuances of securities that comply with specified guidelines (Primary Offer Safe Harbor);
Cryptocurrency, expressed in a virtual currency or token, is a “digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account or store of value.” SEC Investor Bulletin: Initial Coin Offerings (July 25, 2017).
If offers and sales are made in the United States, compliance may also be
4. Rule 904, which provides a safe harbor for offshore resales that comply with specified guidelines (Secondary Market Safe Harbor); and
5. Rule 905, which provides that equity securities of US domestic issuers sold in compliance with the requirements of the Primary Offer Safe Harbor are deemed “restricted securities” as defined in Rule 144 under the Securities Act and subject to holding periods (and related requirements) before they can be resold without restriction in the United States.
Security Token Offering Reg D
Issuers have to work with the following three rules: Rule 506 (b), Rule 506 (c), and Rule 504. Rule 506(b) and Rule 506(c) have no limit for the fundraising, but allow only accredited Investors in the U.S. Rule 504 does not have restrictions on investor status. Rule 503, issuers are limited to $5 million of capital raise and are required to register the security with state regulators. Reg D also allows for General Solicitation, which allows the companies to advertise their fundraising and projects.
Security Token Offering Reg A
Reg A+ seems appropriate for businesses looking to raise under $50 million and looking to solicit non-accredited investors. Given the restriction to provide two years of financial statements, we could assume that Reg A+ would be a better match for established startups. In contrast to Reg D, securities issued under Reg A+ do not have restriction on resale, which should result in more liquid markets.
Security Token Offering Reg CF
When raising funds with Reg CF startups can raise up to 1.07 million USD. This is meant to quickly fund small projects to boost innovation. We would argue that a lot of projects can be started with 1 Million US if done right. The downside is the 12 month lock on secondary markets.
Sources: Business Telegraph, TechCrunch, ICOAlert, Harbor, IRS, SEC