What Is a Security Token Offering (STO) and Why It Is the Next Step for Blockchain-based Fundraising

What Is a Security Token Offering (STO) and Why It Is the Next Step for Blockchain-based Fundraising

Since their official inception in 2013, having Mastercoin as the first mover, the past few years have seen a massive number of ICOs take place. In 2017 ICOs raised a whopping $5.6 billion in funds for blockchain projects. Estimates further suggest that 30% of the totality of early stage startup funding from last year occurred on the blockchain. This was at least twice as much compared to the amounts raised via Kickstarter campaigns.

In 2018 the crypto market came crumbling down and has lost over a staggering 80% of its total value. Bitcoin, having flirted with the $20,000 price tag, dropped to almost $3,000. Ethereum, at some point trading around $1,400, experienced a free fall to below the $100 mark. Pretty much 99.9% of all tokens have experienced a steady and painful decline in value. 

Nevertheless, the token market’s booming tendency is still very much intact and interest is not fading away — up until December ’18, $22 billion (or supposedly half of that which is quite a lot too) has already been raised by blockchain startups, at least according to data from Bloomberg. CoinSchedule suggests the figure to be over $20 billion, with a total of over 1,000 ICOs having taken place.

The dynamic, however, is a lot more different than previous years.

As ICOs are continuously glazing headlines as fraudulent and sketchy, regulators as well as investors are demanding more. And rightly so — ICOs are simply nowhere near being an ideal environment for safe investments, especially for the Average Joe and FOMO crypto enthusiasts. There’s no more turning a blind eye, something has to be done if the stigma surrounding the space is to disappear.

Fortunately, regulators and investors are not the sole drivers of change.Blockchain projects are increasingly self-policing due to the realization that the average investor is considerably more circumspect than before. Steering away from legal obligations is no longer the norm either — more and more issuers have found out (often the hard way) that compliance should not be feared, but rather embraced. The benefits come twofold — investor flocks will fly around more often and governmental vultures will look to chip away flesh elsewhere.

Alright, so what’s all this negative fuss surrounding ICOs? Let’s look at some stats.

Well, the market is indeed still growing and demand for blockchain-based funding is at an all-time high, figuratively speaking. Though once some deeper digging work is done, the skeletons start coming out of the closet. Reports from ICORating point towards an alarming statistic — 55% of ICOs that took place in the 2nd quarter of 2018 had reportedly failed. For investors this translated into a minus 55% investment loss. Moreover, the average life span of most projects rarely goes beyond four months, as examined by one of the more well-known crypto news outlets.

Similar negative trends, again researched by ICORating, continued through 2018. The total amount raised through Q3 was just over $1,8 billion, compared to over $8.3 billion in Q2. Additionally, more than half of the projects did not manage to pass the $100,000 fundraising mark in the third quarter. Another report from Satis Group goes as far as to claim that almost 80% of all ’18 ICOs were scams.

Of course, startups generally tend to fail, but once we compare the success rate of ICOs to that of Venture Capital (VC)-backed projects, the difference is quite substantial. Entrepreneur.com data (sourced from a Harvard study) refers to a 75% failure rate for VC-funded ventures, while CBInsights reports that almost 70% of examined tech startups within the US end up in the graveyard. It is worth stressing out that the VC ecosystem is not identical (since VC-backed startups usually receive hands-on mentoring), but there is nonetheless at least a 15% negative differential compared to ICO fundraising.

Coupled with financial regulators’ rather pessimistic stance towards ICOs, ever-lingering legal uncertainty, pump-and-dump schemes and the growing distrust among the general public, their viability seems to steadily decline as alternatives are highly sought after to meet market demand.

However, for all the current woes of the crypto market there seems to indeed be a cure — and at this moment it seems to bear the following name — Security Token Offering (STO).

What is a Security Token Offering and how is it different than an Initial Coin Offering?

The STO idea first became the word on the street in May last year. It was introduced by Polymath, which is widely considered the go-to platform for security token offerings — with a vision to become the Ethereum for STOs with its emerging ST-20 token standard. On the same note, Ethereum has announced its very own security token standard as well — the ERC-1400.

Their introduction is mostly fueled by the lack of inadequate safeguards for investors looking to pour some much needed financing in the crypto space. Naturally, investors like to see a guarantee or a protection of some sorts and momentarily this is not the case, as exemplified by various Ponzi schemes and dubious fundraising practices.

At its very core, a STO is not too different than the ‘classical’ Initial Coin Offering. Purely technically speaking, they’re more or less the same thing, but the one important differentiating feature is that the STO generally falls under the regulatory umbrella of financial securities regulation.

When a blockchain project issues a security token, they’re essentially issuing a security from a legal point of view. Securities bear the characteristic feature of being backed by a particular asset or right, thereby having a collateral for investors in case things go south. The most common examples here would be voting rights, right to revenue share and profits, etc.

Contrastingly, most ICOs sell ‘utility tokens’, which grant investors access to a platform or a service on a speculative basis (that is if said platform or service is developed in the future). This makes security tokens, as a financial instrument, a lot more similar to traditional shares within a company.

The implications of issuing security, share-like tokens come manifold.

Besides providing investors with some type of control over their investment, the regulatory burden on issuers is substantially heavier.Conducting an STO subjects issuers to a plethora of additional legal requirements in addition to KYC & AML rules which already apply within most jurisdictions handling ICOs.

For example, issuing a security is associated with conducting due diligence checks, including both financial and technical audits. Securities regulators typically employ designated entities, most commonly ‘committees’, which are tasked with overseeing market trades and possible price manipulations resulting from insider trading. These requirements spill over exchanges too as they are also faced with an elevated standard of legal compliance to be able to issue security tokens.

The byproduct of all these additional requirements is enhanced legal certainty and investor confidence — a solution to one of the most prominent issues in the space.

Additionally, the offer of a security token may serve as a signal to the market on behalf of the issuer — more or less saying:

 “Hi. This is my project and it’s approved by law. Safely invest your hard-earned money here. We’ve got you covered.” 

In a space surrounded by a negative stigma, such an innovation is more than welcome to gain back investors’ trust.

The practical case for tokenizing assets and financial instruments 

As pointed out earlier, we’re slowly moving towards an all-encompassing digital economy. Digitizing securities, like company shares, is simply a logical step to innovate in the financing domain.

Digital ownership of assets is able to massively simplify and automate some processes such as dividend payouts, shareholding voting, etc. Currently these require the involvement of additional professionals such as auditors, bankers and lawyers. Digitizing them could therefore pave the way towards eliminating middle-men, resulting in huge savings on due diligence and governance as a whole, for companies of all stages.

Moreover, digital ownership is trustless. This means that a security token holder, who uses their own wallet as means of storage, is fully in control of their assets at any given point rather than using an intermediary to handle the movement of assets. Besides reducing costs, this feature enables token owners to freely transact with their tokens on-demand, at any given time or place.

On that account, the market for digital assets is open 24/7 whereas traditional capital markets function on an open-close basis. This is yet another feature that aids to the development and democratization of global financial markets. A Japanese trader, for example, would not be barred by geographical limitations when they are looking to trade an asset originating from, let’s say, Europe. Global investor participation furthermore logically improves liquidity, simply because of the wider pool of investors available.

Transparency is another main driver to tokenize securities. Blockchain’s technical design promotes the introduction of a digital, fully accessible register of all share/token-holders. Over the counter share sales? Insider trading and tipping? No more — it’s all tracked and promptly recorded.

The time to settle is also greatly reduced as digital, blockchain-based transactions are almost instantaneous. Security transactions normally involve a number of parties, which makes settlement relatively slow, not to mention overly complex. Although trades are almost instant, the actual change of ownership on most prominent exchanges usually takes around two (working) days to complete.

Lastly, tokenized assets can be fractionalized — ownership of lucrative assets such as real estate or movables such as art may be divided between multiple owners. This again promotes the participation of more and more investors from varying geographies, thereby paving the way towards an inter-connected global market infrastructure.

STOs, the future of blockchain-based fundraising? Our verdict.

STOs provide a much needed increase in legal certainty in the space. They seem to be the logical next step in the development of digital assets. Ideally, STOs could pave the way towards mass adoption of blockchain-based fundraising not only for startups, but for corporates as well.

Investors, arguably the main beneficiaries here, will also be given the chance to directly partake in the day-to-day operations of their investment targets. They will be able to keep track of progress, voice a concern and overall enjoy a position of enhanced influence as a result of operational transparency.

Their varying upsides, coupled with their presumed ability to repair the relationship between issuers and regulators, may prove decisive in the long run, especially in jurisdiction such as the US where blockchain projects are not necessarily favored within regulatory circles.

On a global scale, STOs could further the democratization of capital markets commenced by the ICO as they present an opportunity for investors to safely and quickly direct value across multiple jurisdictions. Estimates actually show that the STO market could potentially reach a market cap of $10 trillion come 2020.

Nevertheless, a stable environment may only come into fruition with orchestrated efforts, including collaboration between regional financial authorities and the promotion of an open culture between issuers and regulators.