A security token performs the same function as conventional security, except that it confirms ownership through blockchain transactions and also make fractional ownership possible. They 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.”
Security Token Offering Regulations
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 lastly, 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. They 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.”
Benefits to Security Tokens
The issuance of security tokens under Regulation A+. Regulation D, Regulation S and Regulation Crowdfunding tends to be significantly cheaper and faster than conducting Initial public offerings.
Tokens classified as securities tend to provide investors with 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
- Global Trading Capability
- 24/7 Trading
The Disadvantages of Security Tokens
Too many regulations are one of the factors that could stifle the mass adoption of security tokens. This includes the limitations on who can invest in 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);
- Rule 904, which provides a safe harbor for offshore resales that comply with specified guidelines (Secondary Market Safe Harbor); and
- 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 ©, 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 do 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 restrictions 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 USD 1 Million if done right. The downside is the 12-month lock on secondary markets.
The STO Market Today
Despite the obvious benefits STO brings, the current market conditions for security tokens are not great at the moment. What promises to bring more liquidity has not yet proven itself. Simply because not many people are trading or purchasing tokenized assets. The beauty of initial coin offerings is that it democratizes fundraising. An average joe could invest very early on in a project from his mobile phone but that is not possible with STOs. Only accredited investors and institutions have access to the market. In addition to that, the projects raising funds through STO are severely lacking in quality. Think of the many ICO projects a year or two ago and put them on STO. Only a handful of projects stand out from the crowd and that has to change.
The tokenized real estate market is still only available to institutions and accredited investors. That raises the question - why go for STO when it is completely fine in the traditional way? Except that it is not fine and tokenized assets can only bring the traditional market to the next level. Here's an excellent article that covers the current STO market.
Sources: Business Telegraph, TechCrunch, ICOAlert, Harbor, IRS, SEC
Looking for an STO Consultant?
Moonwhale Ventures has positioned itself to provide STO solutions, helping businesses with our STO Financing service. Moonwhale will assist you in One-Stop-Shop solution for your security token offering:
- Token Economics
- Token Creation & Issuances
- Marketing Materials
- Private Sale Fund Raising
- Public Sale Fundraising
- Secondary Market Trading