This is written by an external blogger, the views and opinions expressed within the post belong solely to the author
For many decades now, doing an IPO has been the ultimate goal for startups all across the world. In the last few years, we have seen a boom in an alternative form of fundraising, one that allowed people to bypass the heavy regulations around IPOs, requiring no lawyers or bankers, in the form of ICOs. Towards the end of 2017, in the midst of the cryptocurrency boom, many companies decided to bypass VCs, retain control of their equity, and raise funds by doing an ICO. Major companies raised hundreds of millions of dollars doing ICOs, even some that had nothing to do with blockchain or crypto, such as Kik Messenger, raised over $100 million with their ICO.
However, soon after, the Canadian company Kik got sued by the American regulatory body SEC for $100 million, which they did not have by the time the lawsuit came. They settled in late 2020 by paying a $5 million fine. SEC had deemed Kik’s offering to be a security, which required registering with SEC among other compliance formalities. In a Senate hearing, former SEC chairman Jay Clinton, in 2018 said “Every ICO I have seen is a security.” The ICO market has also been famously riddled with scams and rug pulls from every corner of the globe.
STO stands for security token offering. Every country has their own definition of what security is, but generally, the term “security” can be defined as a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly traded corporation via stock; a creditor relationship with a governmental body or a corporation represented by owning that entity’s bond; or rights to ownership as represented by an option. In simple words, security tokens are a tokenized representation of an underlying security, and security is pretty much any form of investment where you would have an expectation of profits, anything like stocks, bonds, real estate, etc.
How are STOs different from ICOs, IDOs, and IPOs?
We’ve all heard about companies going public or having their IPOs, which stands for initial public offering. In essence, it’s just the process of a company going from having its stock held by private individuals or venture capitalists, to the stock being offered to the public on stock exchanges. We’ve also seen a lot of ICOs in the crypto space. Legally speaking, according to the SEC, the only legitimate ICOs that are 100%, not securities are the ones where the token isn’t controlled at any point by any single entity, and the only way to obtain it is through a fair and decentralised process, like proof-of-work mining. Bitcoin and Ethereum are the only two cryptocurrencies that have gone through the SEC’s Howey Test and were deemed to not be securities.
ICOs and IDOs are nearly identical, the only difference is that ICOs are generally first offered on centralized crypto exchanges that do their own diligence before listing a new token, while IDOs are offered on decentralized exchanges, or DEXs, like Uniswap or Pancakeswap. IDOs are the version of the initial offering that is the most likely to be a scam, as absolutely anyone can list a token on a DEX and they don’t even need the background check by a crypto exchange, let alone a government regulator.
STOs, or security token offerings, lie somewhere between ICOs and IPOs. STOs are generally offerings of tokens that are based on blockchain technology, just like ICOs, with the major difference being that STOs are always completely regulated. Because of that property, STOs are much less likely to be scams or rug pulls, and invite much more investor confidence compared to ICOs. STOs also provide you with legal ownership over the underlying asset, whether it may be shares in a business, bonds, real estate, etc.
After the regulators started cracking down on ICOs, and after a majority of ICOs turned out to be failures or scams, the crypto industry was forced to look for other options to maintain investor confidence in the crypto fundraising model. When you participate in an ICO, you get tokens that do not give any rights or obligations, rather they just provide you access to a specific network, platform, or service. On the other hand, the tokens offered in an STO are financial securities backed by tangible assets, profits, bonds, shares, or revenue of the company.
STOs are also being called “everyman’s IPO”. Companies are increasingly choosing STOs over IPOs because of a much simpler compliance process, and because of lower involvement of lawyers and no need for investment bankers. STOs are much more accessible to newer, startup companies compared to IPOs. There are also other benefits to STOs for the investors and issuers both, like fractional ownership of assets, efficient 24/7 trading, and much greater flexibility for investors.
As regulator strongholds on ICOs get tighter worldwide, completely unregulated ICOs like the wave in 2017 are not likely to continue for much longer. As governments around throughout the world understand the technology and pass their judgments, STOs are likely to become a much more popular mode of fundraising than it currently is.
What is the World’s current outlook on STOs?
As STOs are a whole different ball game when it comes to fundraising, many countries around the world have different outlooks on them. And as STOs are regulated offerings, their characteristics might differ based on what the regulations are in the country of issuance. Let’s take a look at how some major economies of the world currently look at STOs.
The US – STOs are allowed but are heavily regulated. The US did not create any new regulations for STOs, and they’re subject to the existing regulations surrounding securities. These regulations are some of the strictest in the world.
European Union – STOs are allowed. In the EU, the legislative framework that entered into force in 2018 covers securities and security tokens. STOs fall under the category of transferable securities, and need to submit a prospectus in the country where the STO happens. This prospectus needs to be approved by the country, with some exceptions like Luxembourg, where no approval is required if the offering is under 1.5 million euros.
China – Like ICOs, STOs are completely banned in China. According to the deputy governor of the People’s Bank of China, STOs constitute illegal financial activity. The head of the Beijing Financial Supervision Authority also called security tokens illegal. Fundraising activities can only be undertaken with the express approval of the government.
India – There are no regulations for digital security tokens or STOs in India yet. It is unclear what the government is going to do yet, but the crypto community would be hoping for positive regulations.
Some small countries, which have less friction in their financial regulations because of a smaller amount of investors to protect, have been much more forward in their regulations. Countries like Switzerland, Malta, Luxembourg, Lithuania, etc, have some of the most forward-thinking regulations when it comes to security token offerings, and have become launchpads for STOs from all over the world.
Challenges in STO adoption
STOs have the potential to revolutionise the securities market, but it won’t be all roses. STOs are still at a very early stage, and if adoption really is to reach the projections, the market needs to overcome several major challenges.
The biggest one is a lack of uniform definition and classification. Every country has their own way of classifying what constitutes a security, which causes several legal challenges for the issuers if they want to open up the investor pool worldwide. Some countries also have a paper-based regulatory process, like the need for stamp duties in countries like Hong Kong and India, which would further affect the uniformity.
A major feature of STOs is that they remove middlemen like banks, lawyers, and brokerages, but the flipside of that feature is that all those functions now need to be performed by the issuing company itself, which increases the administrative burden to a significant extent. The issuance process would have to be set up for custodianship, tracking ownership, exchange approvals, Know Your Customer (KYC), anti-money laundering (AML), etc. to make sure they comply with the relevant securities laws.
The realization of the true potential for STOs would only come when governments around the world would create clear and thoughtful regulations, which, if past experience is anything to go by, can take a while to come. However, there’s no reason why the democratizing properties for various asset classes should be ignored when we have the technology to make it happen, so we can only hope that the governments feel the same way.