In our blog post about the Top 10 blockchain trends for 2023, we briefly discussed our prediction for the growth of the STO market. In case you’re unfamiliar with Security Tokens and STOs, this post will go into a little more detail about how they work and why they’re worth keeping an eye on.
What are Security Tokens & STOs?
When trying to understand exactly what Security Token Offering means, it can help to break down the words that make up the term:
In this case, security refers to a kind of investment product that is backed by real-world assets, such as stocks, bonds, or real estate. These assets are fungible and tradable financial instruments that can provide income for investors. With this in mind, a security token is therefore a blockchain-based representation of the ownership of an investment product. Investing in stocks the traditional way leaves you with ownership information that is written down and issued as a digital certificate. A security token offers the same function, but instead, information is recorded on the blockchain and issued in token form.
Pretty straightforward right? Next let’s take a look at the different kinds of offering processes that exist, and how they compare to one another.
STO vs. ICO vs. IPO
If you’re familiar with the idea of Initial Public Offerings (IPO) or Initial Coin Offerings (ICO), you may be wondering what the difference between these terms is. These three offering types all have similarities but differ in terms of their characteristics and regulation.
- Initial Public Offering: This is when a private company first offers shares to the public in a new stock issuance. IPOs give companies an opportunity to raise capital when going public. This is also a key time for early investors to cash in on their private investment in the company.
- Initial Coin Offering: An ICO is a means for entrepreneurs to raise capital through digital coins or cryptocurrency. Investors can buy into an ICO to receive a new cryptocurrency token issued by the company. ICO tokens usually offer utility such as granting the right to use a platform, product, or service once it has been developed.
So therefore a Security Token Offering is when an investor is issued a token that represents their investment in something. Similar to an ICO, it is a means to enable digital funding, but a notable difference is that STOs are required to comply with security laws. Both offer blockchain-based fungible tokens and hold monetary value, but STOs require extensive regulation and can not be traded on ordinary token exchanges.
For this reason, many people consider STOs to be a kind of hybrid offering, representing the middle ground between ICOs and IPOs. They function like the certificates that investors get issued when investing in the stock market, as similar information is recorded. However, STOs record this information on the blockchain and are represented by a token.
How are STOs Regulated?
STOs are being increasingly embraced by many mainstream and institutional investors due to the fact that they are subject to regulations. ICOs often sidestep legal frameworks by arguing that their coins are for usage (not investment) because they give users access to a platform or dApp. This lowers the barrier to entry and makes ICOs more available to the public. However, it also carries more risk due to the lack of regulation.
It can be tough to launch an STO since it must comply with relevant regulations (varying across jurisdictions) and offer an investment contract under securities law. This makes them less flexible but adds a level of security that other cryptocurrency mechanisms can not offer.
The Securities and Exchange Commission (SEC) in the US is where many jurisdictions are looking regarding the issue of legally defining ICOs and Security Tokens, and how they should or shouldn’t be regulated. In 2017, the SEC released a report that concluded that ICOs can be classed as a security if they fall under the definition of an investment contract:
- “An investment contract is (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others.”
The fact that some ICOs may be subject to federal securities laws is what initially prompted the development of STOs. However, SEC decisions are not fixed, and since STOs are a relatively new concept, it is likely that bills and laws will be tweaked or introduced. Businesses looking to launch STOs should be prepared to respond to new laws and frameworks following the ever-changing regulatory environment.
It is important to note that not all countries will follow the decisions of the SEC. Some governments are completely against the idea of STOs and cryptocurrency in general, while others are still undecided about how to regulate these digital assets.
Advantages of STOs
- Lower risk than ICOs: required compliance with securities laws lead to more transparency and accountability, making STOs a safer choice for investors.
- Easy to assess token pricing: the fact STOs are backed by real-world assets means it is easier to assess if tokens are fairly priced. On the other hand, it can be difficult to evaluate the price of ICO tokens, especially if they’re offering utility functions.
- Removes the middleman: STOs can be cheaper than IPOs because they eliminate the need for banks and brokerages. Smart contracts also reduce the reliance on lawyers, and the nature of blockchain technology removes the need for paperwork. This can allow early-stage businesses to raise capital quickly without paying large fees.
Challenges of STOs
- Subject to government decisions: the rulings of governments will likely determine how the STO market evolves and grows, making global launches or expansion complicated. This can also be an inherent issue for those that advocate for decentralized blockchain technology.
- Limited to accredited investors: in the case of the US and numerous other jurisdictions, non-accredited investors can not own STOs. This makes STOs much less accessible than other tokens and ICOs.
- Heavy regulation: STOs can be more expensive than ICOs due to regulatory requirements, and they are often subject to secondary market trading restrictions.
Lambda256 and Luniverse are working to develop reliable and flexible STO services for enterprises. Make sure you follow our Twitter and join the Luniverse Discord to get insights about the STO industry and find out what we’re working on!