Security Token Offerings (STOs): ICOs Getting Mature

Photo by Chris Liverani on Unsplash

What is an STO?

STO stands for ‘security token offering’. It is a type of ICO but in STO the coin issued is actually security, meaning that the process of offering and the issuer itself shall be subjected to the securities regulation of the country in which they conduct the STO.

How did we get here?

The world of crypto tokens is wild when it comes to regulation. Not only we see new tokens announced with intriguing features quite frequently but also we hear concerns associated with this diversity as well as regulatory attempts trying to catch the latter.

We are familiar with attempts to circumvent regulation when it comes to crypto tokens. In fact, not long ago, ICO whitepapers were trying to make it absolutely clear that the crypto token they accompanied was not a security within the meaning of securities regulation. Of course, this was not, and still is not, surprising given that issuing securities could be burdensome in terms of both money and procedure.

This idea that the regulation must be avoided was in line with the general thinking of the crypto community until recently. After all, the crypto tokens were introduced and supported by the so-called cyberpunks and there was a real hype around the word ‘crypto’ fed by the dream of becoming a millionaire overnight.

However, things also have gotten a bit serious over time. First, the public attention had regulators interested in the crypto world for policy concerns mainly the investment protection. Secondly, ICOs, especially starting from the DAO, proved themselves as easy and effective -may be also a little bit dangerous- alternative fundraising mechanisms even in a short period of time. So we saw a shift from anti-regulation attitude to pro-regulation attitude. It started with ICOs being regulated or being subjected to current regulations.

Pros and Cons: ICO vs STO

The first thing to mention is that STOs are regulated and regulation comes with additional costs. Additionally, STOs’ regulatory complexity limits global accessibility as well. On the other hand, regulation polishes the image of ICOs as risky and manipulative investments. By doing so, it makes ICOs more attractive to a broader group of investors from reluctant individual investors to big regulated ones. In the end, STOs provide us with something in the middle of ICOs on the one hand and traditional securities on the other.

The DAO and the SEC’s Involvement

Maybe the biggest step on the way to STOs was the DAO hack and the following report issued by the SEC in September 2017. In this report, the US financial watchdog applied the so-called Howey Test, a test to decide whether an instrument constitutes an investment contract under the US securities regulation. This test originated from a US Supreme Court case dated back to 1946 and today it is a well-established one. As a result, the SEC held that the DAO tokens are investment contracts and, hence, securities.

What SEC has done with the DAO was a bold move. But it also created a safe and foreseeable legal environment under which ICOs can be conducted. In other words, some ICOs in the US were now regulated activities.

Spread of STOs

The US is not alone in fostering a legal environment for STOs. Swiss financial authority FINMA has already published its guidelines for ICOs in which it classified crypto tokens as payment, utility and asset tokens. FINMA states that asset tokens shall be treated as securities, meaning that asset token ICOs are actually STOs.

There are also EU members involved in the rise of STOs. Naturally, issuing security in an EU member state triggers the application of harmonized securities regulations such as the prospectus requirements. Estonia is one example. EFSA accepts the applications for EU-compliant security token offerings. As another example, German authority BaFin approved its first STO, Bitbond, quite recently. The advantage of conducting an STO in the EU is that by being compliant with the EU prospectus regulation, you can easily access to other EU member states as well.

Where are we going?

ICOs made tokenized assets popular and now STOs are bringing them to another level so that more sophisticated products can be introduced under the protection of regulatory authorities. PwC’s report on STOs and ICOs. Naturally, for STOs to be as popular as ICOs, they need to be made accessible by the public. For ICOs, this has been achieved through exchanges. Thus we can expect to see STO exchanges come into play or current exchanges to seek regulatory approval for the trading of security tokens.

The more problematic part, especially for us lawyers, is the regulatory uncertainty and complexity that might be introduced with the spread of STOs. In this sense, STOs are both a step back and forward at the same time. Before initiating an STO, issuers must ensure compliance with local securities regulations as well as the regulations of other countries in which they offer their security token. This might not be an easy task since, in addition to the established securities regulations, new crypto-specific regulations are implemented all around the world.

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