26 jun Initial Considerations on Security Token Offerings
Recognizing security tokens and appreciating the differences between STOs and other forms of public offerings
In 2017, Initial Coin Offerings (ICO) emerged as a massive source of capital fundraising. However, pump and dump schemes combined with extreme price volatility have had their toll on investors’ confidence. Naturally, the development of Distributed Ledger Technology (DLT) applications has begun to expand towards a more reliable form of an investment instrument – the tokenized security. This article aims to cover some of the basic concepts that must be considered when contemplating to arrange or participate in a Security Token Offering (STO). It begins with an analysis of the practical and legal features that distinguish the three major categories of crypto assets in order to establish the defining characteristics of security tokens. Thereafter, it moves on to consider how crypto assets’ issuing procedures differ, through a comparison between ICOs and STOs, and finally, to examine the benefits that the utilization of a DLT infrastructure is capable of bringing to capital markets.
Categorization of crypto assets
At this stage in the development and analysis of blockchain technology there is no universally accepted categorization of crypto-assets. Generally, however, institutional and academic commentators divide them into three broad classes: payment, utility and security tokens. The majority of people are familiar with the concept of payment tokens, most notably exemplified by Bitcoin. These instruments are digital currencies that can be used to purchase goods and services.
Unlike fiat currencies and e-money, cryptocurrencies make use of DLT in order to bypass the need for institutional verification of transactions and instead rely on their network of users (miners) to authenticate transfers. Payment tokens can be further subdivided into pegged (stable) and unpegged coins. The difference is the following: while the value of unpegged coins is left to float freely subject to the supply and demand forces of the market, as is the case with Bitcoin, the value of pegged coins is stabilized by tying it to fiat currencies, commodities, and other crypto assets or through the use of algorithms.
Utility tokens on the other hand operate more like vouchers, entitling buyers to receive a utility or exercise a right within a predetermined environment. At their simplest, utility tokens give access to goods and services specified in advance by their respective issuer. Alternatively, they can also be used as instruments of governance, settlement and ownership within the limited environment for which they were created. As such, utility tokens are capable of acting as both payment and security instruments but their key distinguishing characteristic is that they are confined to a well-defined system, such as for instance a decentralized decision making network, a particular business relationship, or even a computer game.
Lastly, security tokens are analogous to existing financial instruments but instead utilize DLT as a way to execute transfers of ownership. Security tokens differ markedly from the above mentioned categories of crypto assets in that they confer continuing rights on their holders just as traditional securities do. For instance, they may represent ownership, voting and dividend rights in a company, just like traditional company stock, or provide security for a debt backed by tangible assets, similarly to bonds.
Distinguishing between security and other types of payment and utility tokens is crucial due to the fact that the former are subject to strict regulatory control. Under EU law, the term ‘transferable securities’ is defined as a class of securities that can be negotiated on capital markets, such as shares in companies, depository receipts in respect of such shares, bonds, and all derivatives of these instruments with the exception of payment instruments. Since there is no legal definition of ‘security tokens’ in EU financial services legislation, whether a crypto asset is in fact a security depends on whether it exhibits the qualities of well-established financial instruments.
Currently Member States’ national competent authorities determine this on a case-by-case basis by reference to domestic legislation, which is unfortunately a method that yields different results depending on the jurisdiction it is applied in. And although there is no uniform definition of security tokens in Europe, practically speaking these instruments can be recognized by the fact that they give rise to a continuous relationship between issuer and buyer, conferring profit rights on the latter.
By contrast, payment instruments’ sole function is to transfer value. Any hybrid cryptocurrency that also carries investor rights is likely to be classified as a security token, since taking a different approach is liable to open regulatory gaps that would allow issuers to disguise securities by simply incorporating a payment function into their tokens.
Similarly, utility tokens, which also involve a more continuous form of contact, can be distinguished by the fact that they entitle holders to a single action, whether that be a one off consumption or the sole exercise of a right, and expire once redeemed. Nevertheless, the line between security and utility tokens can be blurry, especially when tokens closely mimic financial instruments such as futures and options. Thus, indications that a token is capable of generating large profits through speculative trading could give rise to strong arguments in favor of classifying it as a security.
Distinguishing Security Token Offerings from Initial Coin Offerings
ICOs and STOs are the way in which issuers introduce their crypto assets to the public for the first time. Empirical data has shown that both of these public offerings have great capital raising potential. For the period January 2016 to March 2020 there were a total of 1667 token sales, raising $31.7 billion worldwide, almost a third of which originated in the EU.
However, there are significant differences between the two procedures. As already mentioned, the most notable distinction is tied to the level of regulatory supervision, which is much higher for STOs due to the various investor protection measures applicable to transferable securities. Payment and utility tokens, on the other hand, currently exist in a somewhat of a ‘Legal Wild West’. Despite their similarity to e-money, the European Banking Authority (EBA) has expressed the opinion that since cryptocurrencies are not issued by state authorized entities and do not represent fiat currencies, they fall outside the definition of e-money and consequently outside the scope of the Electronic Money Directive. This entails lower barriers to entry for issuers, who do not need to worry about state approvals. Furthermore, due to the fact that ICOs sell non-security assets, issuers are allowed to rely on automated distribution of tokens and are even free to permit anonymous participation by buyers.
Although more rigorously regulated, STOs are by no means an inferior capital raising procedure. On the contrary, the fact that issuers have to comply with strict legislative requirements increases investor confidence in the trustworthiness of the financial instruments on offer. Furthermore, while cryptocurrencies rely on mass adoption of their platform in order to increase and maintain price, STOs derive value from the profit streams of underlying businesses and assets. This ultimately renders security tokens less vulnerable to speculation and market manipulations, making them more suitable for long term investors.
Application of DLT based securities to financial markets
From a legal point of view, once an instrument has been recognized as a security it becomes irrelevant whether it takes the form of a security token issued through an STO or a traditional security issued through an Initial Public Offering (IPO). In both cases we are concerned with the sale of transferable securities and therefore the same regulatory requirements apply to the issue, servicing and settlement of these instruments regardless of whether they utilize a DLT network. This substance-over-form approach means that tokenized securities have to be issued using all mandatory legal documentation, such as offering memorandums and prospectuses, and once in circulation become subject to anti-money laundering (AML), Know Your Client (KYC), Countering the Financing of Terrorism (CFT), and settlement finality rules. Hence, the main differences between traditional and tokenized securities arise as a result of the DLT infrastructure used in STOs, rather than the legal status of the issued assets.
One of the advantages of security tokens is that they are programmable, meaning that certain predetermined actions and prohibitions can be embedded into the financial product itself. Using ‘smart’ contracts, which are in essence self-executing pieces of code that follow contractual terms, tokenized securities can be made available for sale exclusively to a particular group of individuals or set to automatically trigger transactions upon fulfillment of predetermined conditions. These automation structures can be used to successfully limit investor pools and process corporate actions with minimum delay. They could also enable tokenized securities to self-service, distributing dividends and accrued interest rates automatically at preset dates or upon achievement of pre-specified financial targets.
In addition, the use of DLT achieves greater transparency in relation to the ownership and movement of securities and increases the traceability of transactions. This fact has two main implications. First, it could facilitate the oversight conducted by national competent authorities over publicly traded securities. Thus, instead of having exchange operators report irregularities, authorized bodies with direct access to the DLT network could exercise firsthand monitoring and control. Second, it would enable a transition from a linear to a networked model of trade and post-trade processing. Currently listed securities undergo a chain of intermediation in order to successfully transfer ownership. Once issued, traditional financial instruments are deposited into central securities depositories (CSDs), traded by brokers, cleared by central counterparty clearing houses (CCPs), and then finally settled between accounts at CSDs and central banks. In order for this system to work, each intermediary needs to obtain information from the previous one, then record their own action and pass the revised data on to the next. Information regarding tokenized securities, on the other hand, is publicly available on the distributed ledger and updates with each transaction, enabling direct access to intermediaries and removing the need to repeatedly share and reconcile data among them.
Note, however, that on its own blockchain technology simply creates the opportunity to take advantage of the hypothetical market organizations outlined above. Realizing those concepts would require both a degree of infrastructural implementation by the various market participants as well as appropriate legislative amendments to redistribute monitoring and reporting obligations. While DLT can reduce the complexity of security issuance, trade and post-trade procedures, it is unable to obviate the need for intermediaries. The fact is that listed and over-the-counter (OTC) securities are legally required to go through CSDs and CCPs in the course of trading.
It must also be recognized that there is value in the services such institutions provide as they guarantee investors’ security, finality of transaction and allow for position netting. As long as security transactions undergo clearing procedures, settlement periods of 1 to 3 business days will persist irrespective of the format of the financial instrument. Consequently, at this stage, the advantages of DLT are best suited to accommodate securities issued by private companies, such as depository receipts in respect of private company shares and corporate bonds, or in other words financial instruments which can be traded peer-to-peer. DLT securities of this character can benefit from a wider geographical reach, lower transaction costs, and reduced settlement periods.
Development of DLT applications has enabled security instruments to become entirely digitalized, though legislation is naturally still lagging behind this innovation. The lack of a uniform European approach in relation to the definition of crypto securities means that national jurisdictions can reach different conclusions in their assessment of financial instruments and this uncertainty will persist until appropriate harmonization measures are introduced at EU level.
Nonetheless, there are some generally accepted features, such as buyers’ profit rights and issuers’ relationship continuity, by reference to which most security tokens can be identified. The major implication of finding that a token belongs to a class of security instruments is the increased level of regulatory supervision to which it will be subject. While this entails higher entry and compliance costs, it also renders such crypto assets safer and consequently attracts more investors with long term interests in the tokens.
Tokens issued in an STO are unique due to the DLT infrastructure that they use. For now the advantages that DLT confers are limited, owing to a number of factors among which the restrictive nature of trading and post-trading legislation, designed solely with traditional securities in mind, and the lack of infrastructural adoption by major stock exchanges and licensed intermediaries. Future technologically inclusive regulations could allow DLT securities to reach their full potential. It is certain that if this occurs, capital markets could undergo profound changes, thereby streamlining their procedures and increasing efficiency.
 INSIDER. 2017. ‘Market Manipulation 101’: ‘Wolf Of Wall Street’-Style ‘Pump And Dump’ Scams Plague Cryptocurrency Markets. <https://amp.insider.com/ico-cryptocurrency-pump-and-dump-telegram-2017-11>; see also European Securities and Markets Authority, 2017. ESMA Alerts Investors To The High Risks Of Initial Coin Offerings (ICOs). <https://www.esma.europa.eu/sites/default/files/library/esma50-157-829_ico_statement_investors.pdf>
 Ibid. ITSA Global. 2020.
 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on Markets in Financial Instruments and amending Directive 2002/92/EC and Directive 2011/61/EU, Article 4(1)(44).
 European Commission. 2019. Consultation Document On An EU Framework For Markets In Crypto-Assets. p.32. <https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/2019-crypto-assets-consultation-document_en.pdf>.
 European Securities and Markets Authority. 2019. Annex 1: Legal Qualification Of Crypto-Assets – Survey To NCAs. para.8. Available at: <https://www.esma.europa.eu/sites/default/files/library/esma50-157-1384_annex.pdf>.
 Oxford Business Law Blog. 2018. Initial Coin Offerings: Are Tokens Securities Under EU Law?. Available at: <www.law.ox.ac.uk/business-law-blog/blog/2018/09/initial-coin-offerings-are-tokens-securities-under-eu-law>
 CoinSchedule. Crypto Token Sales Market Statistics. Available at: <https://www.coinschedule.com/stats-geo/ALL?dates=Jan%2001,%202016%20to%20Mar%2028,%202020>
 European Banking Authority, 2014. EBA Opinion On Virtual Currencies. paras 19 and 21. Available at: <https://eba.europa.eu/documents/10180/657547/EBA-Op-2014-08+Opinion+on+Virtual+Currencies.pdf>; see also Directive 2009/110/EC of the European Parliament and of the Council of 16 September 2009 (Electronic Money Directive).
 ISSA, 2019. Crypto Assets: Moving from Theory to Practice, p 45.
 Ibid. ISSA, 2019. pp 15, 19 and 47.
 European Securities and Markets Authority, 2017. The Distributed Ledger Technology Applied To Securities Markets. para 11. Available at: <https://www.esma.europa.eu/sites/default/files/library/dlt_report_-_esma50-1121423017-285.pdf>.
 Ibid. ISSA, 2019. p 35-36.
 Ibid. ESMA, 2017. paras 12-14.
 Ibid. ISSA, 2019. p 10.
 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, Article 4; Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012, Article 3.
 For more information on setting up company ownership and governance systems through the allotment of DLT based depository receipts and the legislation applicable to such instruments please refer to: WatsonLaw, 2019. Tokenizing SME Equity: An introduction to the legal classification and the technological implications for issuing security tokens in the Netherlands and the EEA. Available at <https://watsonlaw.nl/wp-content/uploads/2019/03/Watson_Law_Infloat-STO-Tokenizing-SME-Equity.pdf>