What is a security token offering (STO)?
The advent of Bitcoin in 2009 made Blockchain mainstream. While cryptos and other blockchain-related financing garnered the reputation of being volatile and speculative, there is a broad consensus regarding the value of blockchain technology and other forms of distributed ledger technology in finance.
Large institutions across banking and technology, such as JP Morgan, Square, and Facebook, have already entered the blockchain space. Moving forward, we'll see more names as blockchain begins to play an ever-growing role in payments systems, including CBDCs and stablecoins, and the context of liquidity, via asset tokenization through security token offerings.
The word 'tokens' immediately evokes thoughts concerning ICOs, a method for raising capital for crypto projects and popularized in 2017, which is where we'll begin our journey.
What is an initial coin offering (ICO)?
ICO, short for initial coin offering, is similar in concept to initial public offering (IPO), as both allow startup companies and entrepreneurs to raise funds. While securities get issued in return for investment in an IPO, coins or tokens are offered to investors in ICOs.
The process by which a company ICOs is easy, but the lack of regulation within the US and abroad around ICOs has led to fraudulent crowd sales, illegal airdrops, and outright scams. The ICO craze in 2017 tarnished the reputation of blockchain and tokens for a brief period.
But through these turbulent times, blockchain's utility as a transformative technology remained strong. The distributed ledger and blockchain industry kept low, on the lookout for a better combination of technological benefits to bring new methods and value to legacy security offerings. The confluence of these two brought together innovative tokens in the form of a "security token."
What is a security token?
A security token is a unique token issued on a permissioned or permissionless blockchain, representing a stake in an external asset or enterprise. Entities like government and businesses can issue security tokens that serve the same purpose as stocks, bonds, and other equities.
What are the uses for a security token?
A company wishing to distribute shares to investors can use a security token that offers the same benefits one would expect from traditional securities like shares, voting rights, and dividends. Since the technology that underpins security tokens is blockchain, the advantages are numerous.
On a blockchain network, everything is auditable, including, sometimes, the identities of participants. Everyone can view the ledger to track holdings and issuance of specific fungible and non-fungible tokens.
Clearance and settlements are a central concern of investors looking to transfer assets. While trades are performed quickly, reassigning ownership can take days. On a public ledger, the process is automated and quick.
Existing financial marketplaces run per their schedules — typically only during business hours, as manual effort is required, and only for a fixed period. A marketplace that runs on a blockchain network, on the other hand, is active all the time irrespective of the time of day.
Asset tokenization opens up a plethora of investment opportunities for everyone, from large hedge funds backed by Wall Street to retail investors trading on Robinhood. For example, a Picasso artwork worth $10 million could be tokenized into 10,000 pieces — such that each piece is worth $1,000. Tokenization will democratize access to assets and offer superior levels of accessibility and granularity.
What is a Security Token Offering?
To better understand STOs and why we need them, we must first understand why ICOs were viewed as a blemish on the blockchain industry's overall image.
From 2016 - 2018, ICOs were in demand, — and investors didn't mind pouring their money into this new form of fundraising. In Q1 2018, over $6.3 billion worth of capital was locked into ICOs. The expectation was that these investments would appreciate over time. However, the bubble burst in Q4 of 2018, when the "market cap" of all cryptos fell by over $750 billion. The United States Securities and Exchange Commission (SEC) was still shy in implementing regulation around token offerings.
Soon after, regulatory bodies began making announcements around the topic of compliance. The most notable from SEC Chief Jayy Clayton: He declared all ICOs securities; Swiss FINMA also issued guidelines that classified tokens, as per the existing legislation, as securities. These and other pronouncements on ICOs led many blockchain founders to protest; they claimed their projects offered utility tokens and were not securities. The regulatory shadow hanging over ICOs pushed entrepreneurs and investors away from the market.
Regulators today want token offerings to remain compliant with the existing laws and rules around securities — hence, the Security Token Offering was born. STO is very similar to ICO but is compliant with securities legislation in the location where the token is being offered for investment. As STOs are compliant with related laws and rules, they create additional legal obligations for issuing equities in the company.
*The first firm to offer an STO was a US-based Praetorian Group, which registered the platform on 6th March 2018 with the SEC. The platform lists as a crypto real-estate investment platform.
Types of security tokens
Three different categories of security tokens are available in the market:
An equity token is similar to traditional stock, except for how ownership is recorded and transferred. Traditionally, the tracking of shares is logged in a database, with ownership of shares printed and certified on paper certificates. Instead, an equity token is recorded on an immutable ledger kept up-to-date by tens, hundreds, or sometimes even thousands of computers networked worldwide. Equity token holders are entitled to a portion of the firm's profit and have a right to vote. Equity tokens offer three main benefits to a company's decision making, financial outlook, and regulatory frameworks:
Investors can participate in voting while abiding by securities laws.
Startups have access to new and, potentially, more democratized fundraising models.
Regulators have a new and more transparent framework for evaluating the fundraising of a project.
A debt token represents a short-term loan on an interest rate, in the amount given by investors as a loan to a firm — it could be real estate mortgages, corporate bonds, or another type of structured debt. A debt token's price is dictated by 'risk' and 'dividend'; this is primarily because a medium risk of default can't be priced the same for a real estate mortgage and a bond for a pre-IPO organization. In terms of blockchain, a smart contract lives on the network, which represents debt security. Within that contract, repayment terms are included, dictating the dividend model and risk factors of the underlying debt.
Such tokens represent ownership of assets, such as real estate, art, carbon credits, or commodities. Blockchain, being secure, immutable, and transparent, enables a trusted record of transactions; it reduces fraud and improves settlement time, thereby becoming a natural fit for the commodities trade. Asset-backed tokens are digital assets with characteristics similar to any commodity, such as gold, silver, and oil, which, in turn, bring value to these traded tokens.
The growth and future development of STOs and STO platforms
Blockchain's value comes in the form of its role in permanence, security, and transparency — each of them is imperative to confidence, trust, safety, market efficiency, and soundness. It is already being incorporated into the new standard for public security offerings as the benefits are endless and more importantly, the infrastructure is in place. In 2020, Security token market cap observed a 500% growth and stood at $449 million. In January 2021 alone, Security token infrastructure companies raised over $30 million in capital. In another report, Plutoneo predicts a CAGR of 85% in the tokenized market in the European Union from 2018 to 2024. On the institutional side of security token issuances, the STO market saw the launch of 1X, issuance of a $33.8 million Bond-i by the world bank, transaction of a $20 million tokenized bond by Santander, and collaboration of Allinfra with Asia's largest REIT called Link REIT.
The emergence of security tokens does not stop with only liquidity and revenue distribution frameworks. Instead, security tokens open up multiple possibilities of investments. Small investors of specific security tokens could sell off either the dividend portion of full equity or a small part of their interest in a secondary market. Brokers, on the other hand, can bundle up the voting security tokens and sell them seamlessly. Decentralized autonomous organizations (DAOs) could include human shareholders coding voting choices into their smart contracts. The possibilities are only limited to the imagination.
But, it is to be kept in mind that the STO is still a relatively new concept as the infrastructure around security tokens is still in its infancy. Nonetheless, security tokens are here to stay, and there will undoubtedly be more security tokens launching soon. As blockchain technology attempts to revolutionize the financial space, the STO market is indeed one to watch in the coming days.