Tokenized Securities (STO) – A Contrarian Overview

From the CMC editorial desk: We have heard lots of arguments, good and bad, for or against security token offerings. But what are some things we should be concerned about regarding STOs? Here, Radical Research provides a tempered view about the context and challenges of security tokens.

Defining securities

In general, a security is defined as a tradable financial asset or instrument that has monetary value. A security is fungible and usually accompanied by a certificate of ownership. It is a representation of ownership in a publicly traded company. Securities usually come in two distinct types: equity and debts.

  1. Equity securities are held by shareholders in the form of common and preferred stock. The shareholders are not usually entitled to dividends but can profit from capital gains when they sell the securities at a price higher than they paid for it.
  2. A debt security, as the name suggests, represents borrowed money that needs to be repaid. The holder of the security receives interest payment(s) and the principal amount. It is considered to be a fixed income security.

A hybrid security is another type of security that has partial properties of equity and debt equities.

Securities are sold by issuers and bought by investors. Many companies raise the capital required for various projects through the sale of securities, and in some cases, it is said to be a better financing solution than getting a bank loan.

How are securities regulated?

The regulation of securities is a very serious issue around the world, and almost every country has a regulatory agency protecting investors from securities fraud, insider trading, and market manipulation. The U.S. Securities and Exchange Commission, one of the most powerful regulators in the world, oversees the securities market in the U.S.

The regulation of securities varies from jurisdiction to jurisdiction although there are some common regulatory measures. There was little regulation of securities in the U.S. at the federal level before the stock market crash of 1929 – which eventually led to the enactment of several regulatory laws that have been amended over the years. The five major securities laws in the U.S. are:

  1. Securities Act of 1933 – regulates the distribution of new securities
  2. Securities Exchange Act of 1934 – deals with securities, brokers, and exchanges
  3. Trust Indenture Act of 1939 – debt securities
  4. Investment Act of 1940 – mutual funds
  5. Investment Advisors Act of 1945 – investment advisors

The laws govern how securities are sold, traded, and how industry professionals, publicly traded and investment companies behave.

Who can buy a security?

While many people know about securities and the potential of investing in them, not everyone is eligible to buy them. High net worth individuals, financial institutions, corporations, and banks – a pool that is commonly known as accredited investors – are more likely to have clearance for buying securities. The accredited investors are deemed to be financially knowledgeable and sound, and have a higher chance of recovering from investments that go south. Some securities are only sold to accredited investors only.

The requirements for becoming an accredited investor vary from country to country but typically, one would need a high net worth (definition depending on country), a constant source of income, and deep knowledge of the finance industry.

There are at least four places to buy securities from:

  1. Brokerages – one of the easiest method to use and may not be subject to a lot of scrutiny.
  2. Buying direct from companies issuing the securities – may be more difficult than using brokerages.
  3. Banks – these institutions do not sell securities but can offer you products such as bonds and mutual funds.
  4. Person-to-person or OTC – you can buy a security from a person or another entity directly without using an exchange.

How can blockchain technology be incorporated into security structures?

Securities trading has experienced disruptions over the past years as a result of emerging technologies such as artificial intelligence and blockchain, and will continue to be affected by continuing developments in these fields. To recap, a blockchain is an immutable ledger that can eliminate intermediaries while enhancing transparency in the field of trading.

For securities specifically, blockchain technology can be used to match buyers with sellers of securities and remove the need for third parties. Through smart contracts, blockchain can make sure that each party keeps their end of the bargain during a transaction.

Blockchain technology can be used to verify data integrity before trading decisions can be taken by AI-driven trading algorithms.

Blockchain technology can also be used as a compliance measure as it allows only qualified people to participate in the buying and selling of securities.

The difference between Utility Tokens and Security Tokens

There is a huge difference between utility tokens and security tokens. To put it simply, utility tokens are a form of digital currencies that can be utilized in order to purchase products or services that exist on the same platform. Some familiar examples would be in-game currencies and loyalty program points, similar to the ones we use at grocery stores or boutiques.

A security token, on the other hand, is the newest cognate from cryptocurrency research. This is the progeny of the idea that cryptocurrencies must be made more secure (probably due to the onslaught of loss of capitals and scams over the recent years) with the influence of regulations. As the name implies, security tokens try to comply with “real world” security regulations within different jurisdictions.

The main differences between the Utility Tokens and the Security Tokens lie in these two main factors:

  • Liquidity of the Assets

Utility tokens do not give you the flexibility to acquire assets. As previously mentioned, these tokens only stay within the parameters of the purpose for which they were created, within an ecosystem. Consider our examples earlier: in-game currencies and loyalty points. You cannot use the in-game currency you have in Game A in a store or to redeem miles, unless they were designed to be interoperable across platforms to begin with.

The power of security tokens lies in external interoperability, due to a more predictable financial value. These security tokens can represent your share in the company, a valuable real estate property, or even a piece of artwork!

  • Presence of a Regulating Body

A regulating body is present to oversee the activities of these tokens since there are financial assets involved. The current regulating body of security token offerings (STOs) is the US Securities and Exchange Commission and other equivalent regulatory bodies around the world.

The regulating body has the capacity to penalize STO providers who do not abide by its rules, similar to regular securities. On the other hand, this makes it possible for STOs to become a form of cryptocurrency with an even wider utilization compared to its contemporary, utility tokens.

Different ways of raising capital through Traditional Securities, ICO and STO

We believe promising projects, new startups, and established companies must have an avenue to raise capital for their ideas, technology, and business expansion. In return, their investors will be rewarded with the success of these companies through the payout of dividends or receipt of the products or services promised.

Let’s look into different ways of fundraising; this includes ICO, STO and traditional ways of raising capital through public listing, IPO.

  • Traditional Securities, Initial Public Offering (IPO)

Initial public offering (IPO) or initial selling of company’s share in the stock market is a type of public offering. These shares of a company are sold to institutional investors and retail investors who are also individuals. An IPO is underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Through this process, a privately held company is transformed into a public company. IPO can be used to raise new equity capital for the company concerned; to monetize the investments of private shareholders such as company founders or private equity investors, and to enable easy trading of existing shareholdings or for future capital raising.

Although IPO offers many benefits, there are also significant costs involved, such as banking, legal and auditing fees. It also requires public companies to disclose important and sensitive information for the accountability to its public investors.

  • Initial Coin Offering (ICO)

Raising capital through ICO is when a company raises money from the public and the company offers in return its cryptocurrency or token at a value determined by them. This is often a utility token used in its own ecosystem or can be traded at cryptocurrency exchanges for other tokens.

Since 2017, we have seen Initial Coin Offerings (ICO) as a way of crowdfunding being exploited by numerous projects. Some examples of unsavory outcomes include exit scams, simple projects with inflated expectations, failed projects or projects that become too complacent after huge amounts of funds raised, and project teams that see ICO as “free money” from the public with no accountability.  

With more than USD 13 billion raised in 2017 and 2018 through ICOs, the trend of ICOs is declining due to regulations and current market conditions.

Source: ICOData

Details of an IPO are disclosed to potential purchasers in the form of a document known as a prospectus through the assistance of an investment bank who also act an underwriter – while an ICO is prospected to investors with just a whitepaper. Although the outcome of raising funds may seem to be very similar to IPOs, the process of underwriting is missing, which has traditionally helped to correctly assess the value of shares, or in this case, the value of the token. Since most of the ICOs are offering utility tokens, some may argue that there is no intrinsic value.

  • Security Token Offering (STO)

Since Jan 2018, billions of dollars in market capitalization were lost during the crash of the cryptocurrency market. The total market cap today is only about USD 109 billion(update at time of publication) according to CoinMarketCap. Many projects raising capital or going to raise capital are looking into STO as an alternative, thinking that this will help to raise money in the current market climate.

The concerns around buying Security Tokens

STOs are still in the early stages. While many cryptocurrency platforms and providers are predicting a boom in STOs in 2019, STOs are still new players on the cryptocurrency block.  Also, the presence of the regulatory body is a discouraging bit for many investors looking to start investing in the blockchain market as regulations usually come with overly detailed processes and lots of paperwork that are costly and burdensome to those who must comply with them. This does not affect large corporations as much as it does small businesses and new startups. The costs of regulation may end up not being absorbed by the businesses but being passed on to the end users.

Even though security tokens are regulated by security laws, these cryptocurrencies do not utilize the need of a broker. Having no middlemen makes transactions cheaper and faster. However, the loss of the middleman does not come without risk. Without the presence of banks and other financial intermediaries to act as a clearinghouse, buyers are exposed to the risk of fraud even with the regulations in place. A crucial function of the financial institutions when it comes to investments is in the security of having underwriters. STOs can hold collaterals in physical assets (stocks, real estate properties, etc.) instead, but it can be difficult to ensure delivery of non-digital assets – a problem endemic to most off-chain assets including gold and other commodities.

Beyond that, there are several challenges facing STOs at the current moment:

  • Liquidity concerns, no secondary market

To date, there are no STO exchanges operating in the secondary market, although there are many in the planning phase to acquire a license. An STO exchange will operate as a broker between traditional securities and tokenized securities. These brokers would be subject to stringent securities laws including how much commission they can take, annual filings, KYC checks, and account maintenance.  

  • Disparate regulations from different jurisdictions

The jurisdiction that an STO is registered in may have laws which are not applicable in another jurisdiction as countries have different securities regulations. Getting approved as an STO exchange by several jurisdictions is time-consuming and difficult, without any guarantee of success. Therefore, it would almost be almost impossible for any one exchange to be able to service clients on a global scale in the STO market.

  • Centralization

When an STO exchange is over-bounded by controls and regulations, there is no decentralization, a core tenet cherished by true supporters of blockchain technology. The authorities have control over the company, individuals, and projects. Arguably, a centralized financial network can never be fully open due to the authority’s access and exchange controls.

Can STOs really change the way of crowdfunding and investment in crypto markets?

STOs are unlikely to change the future of crowdfunding and investments in crypto markets completely in the short term. One may contend that regulatory authorities have stepped in to bring sanity into the ICO market after a year of mayhem and unwanted investor outcomes. As a result, due to the hype, the next wave that blockchain companies are trying to capitalize on to continue to raise capital  is by offering security tokens.

The main foreseeable advantage of security tokens is that they are in compliance with securities laws. Security tokens can be built using smart contracts which can be coded to execute when only certain conditions are met, such as a token buyer needing to be an accredited investor. In short, smart contracts determine how the token is sold and traded on the market. This way, the developers are forced to embed compliance in the code.

Conclusion

STOs may seem safer than ICOs paving the way for traditional investors to start investing in the blockchain space. However, it also seems like STOs could just be the next hype with the strong hand of a regulatory body in the fray.

But with underlying assets involved, such as real estate, being represented by a cryptocurrency such as an STO could be riskier without the presence of a middlemen, such as property valuation companies. Who’s to say that the current STO providers would be able to produce enough investment security for the STO investors?

Technology has always played a crucial role in finance and shaping the direction of the industry. Blockchain technology is also changing the face of finance as it has allowed retail investors to participate in the markets and make sizeable returns on their investment. While the market is moving away from its Wild Wild West era, a new set of properly balanced regulations could possibly allow blockchain technology to take the financial sector into a higher level.

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