In the United States, the Securities and Exchange Commission (SEC) has started issuing guidance on how to handle the cryptocurrencies being sold in ICOs. They’re working hard to protect the residents from fraudulent schemes. For any entrepreneur, the practical applications of Blockchain are perhaps the democratization of fundraising. Blockchain solution in a venture capital ecosystem enables entrepreneurs to tokenize the equity and bringing liquidity to venture capital and angel investors in return. In this blog, we will discuss how Security Token Offerings are outnumbering ICOs especially in US economy where the effect of new rules on efficiency, competition, and capital formation in regards to cryptocurrencies keep fluctuating.
ICO-A high-risk speculative investment?
ICOs lately has been a subject of speculation among the high-volume institutional investors. The fruits of the industry are starting to be borne—Nearly $400 million, or more than 10 percent of $3.7 billion raised in initial coin offerings, has been lost or stolen, Ernst & Young claim.
This boils down to the fact that participating in an ICO is perhaps not a preferred option for individual investors. For individual investors, it is hard to stay upbeat with the on-goings in the cryptosphere and they are most likely to be unaware of the token purchase price of seed investors or VC rates. Another reason surrounding the mistrust in ICO is that ICOs are not liquid like investments in public like stocks and they are not compliant with SEC regulations either.
The fact that the ICO terms might fail and the project is always a high-risk investment makes ICOs highly regulated especially in countries like the USA. Moreover, the DAO tokens following the DAO Hack failed to pass the Howey and other alternative tests and were deemed securities by the SEC. That’s when Security Tokens comes into the picture.
What are Security Tokens?
Unlike ICO where the token issues are dApp or utility token, the token hodlers gain governance voting rights or they get the profit-sharing rights then the token is considered to be a Security Token. They have the attributes of a security; the regulatory compliance can be applicable to both the investors and entrepreneurs on their respective sides. Furthermore, the following can be regarded as a security token:
- If the token offering is giving the right to equity shares in the enterprise
- If the token hodler gains the profit or ownership in the company, just like stocks
- If the token represents a kind of unit of a mutual fund, loan or any debt obligation
- If the token is backed by real assets such as landholdings
STOs are subject to federal security regulations in the states. Below are the regulations which when properly met can pave way for Security Tokens to attain the same reputation as the stocks.
For a thorough understanding of these regulations, you can also refer to this Medium publication.
Now, what makes token a security?
Before moving ahead, you must know that according to the government and regulating authorities any investment being done with an intent to make a profit is security. Usually, STOs look more like IPOs are they are somewhat similar in nature and offerings. Talking about the United States, understanding the purpose of the investment is of paramount importance.
The SEC and FINMA categorized tokens into two broad categories, i.e. Utility Tokens and Security Tokens. The centennial case that addressed this issue is the SEC v. Howey Co., 328 U.S. 293 (1946). The Howey test will answer these four questions based on which the type of token is decided:
- Is money or real-assets are involved in the investment?
- If yes, then are these investments are in a common enterprise?
- Whether the investors are expecting profit from the investment?
- Are there third-parties efforts involved in making the profit?
If the answer is ‘Yes’ to these questions, then the token sale is likely subject to the U.S. securities laws.
The token buyers can avail benefits like profit shares, dividends and voting rights. Moreover, the security tokens can also feature similar attributes as that of utility tokens. If an organization acknowledges that its token is a security, then it can be considered as an investment. For the buyers, security tokens bring more transparency in token economics.
To achieve the crowdfunding goals, is it important to launch an STO?
As mentioned above, the investors in an ICO do not need specific rights or company share where they are investing. In contrast, the STO investment is more about empowerment, here the investors gain more rights and own shares which is somewhat similar to that of a regular business intending to initiate an IPO. However, with STOs the decentralized nature of cryptocurrency is absent as there are governing bodies involved for the approval. Here are a few major reasons why people find STOs more legitimate than ICOs:
- They received an asset-backed token, basically a share in the company
- STOs require government compliance which means no scam projects
- Through blockchain, STOs will unblock trillions of dollars of illiquid assets
- Any company can tokenize its equity, STOs are not just limited to blockchain companies
- STOs provide global regulatory compliance, unlike ICOs they are not limited to Switzerland, Moldova or Singapore
STOs can effectively address the major issues faced with Utility Token Offerings — they offer corporate accountability and minimize the possibility of fraud.
- We have two legal structures of tokens: Security and Utility tokens
- Howey Test in the USA might be a good approximation to evaluate the secure nature of the token, there’s still a lot of uncertainty surrounding cryptocurrencies
- If there is some value associated with a token, this will not automatically prevent it from being qualified as a security token
- Security Tokens brings legal clarity for everyone in the ecosystem be it the company or the ICO contributors (although this is a speculation as of now)
- Only the licensed security trading platforms will facilitate secondary trading of security tokens
- Security tokens cannot be used as utility tokens, this means they cannot be used as a medium of exchange or trade
- Unlike ICOs, you cannot use security tokens to incentivize the users neither you can gain access to any platform with that.
- Security tokens differ from jurisdiction to jurisdiction, i.e. it is not necessary that what one platform consider as security would be the same for another platform.
- The security tokens are designed in a way that they will not convert to utility token once the business operations are live
- You as an investor must have a holistic look at both kind of tokens depending upon your investment.
EndNote – STOs are defeating its nemesis in the USA
Experts believe that tons of capital is expected to flow from Wall Street to security tokens in the coming years which will open up fractionalized investment. You can choose to offer security tokens by adhering to SEC guidelines and you will not be required to give up equity in the company or a revenue share. Despite the technical and regulatory hurdles, the token economy is moving forward and the token issuers must use the existing tools and shall not bet on these regulations to be modified.
DISCLAIMER: The purpose of this blog is to help potential token issuers understand how security tokens are regulated in countries like the United States. As a reader, you must conduct your own due diligence and seek consultation which provides a greater understanding.