A regulatory perspective: Are security token offerings a better system?
First published on Thomson Reuters Regulatory Intelligence on 7th February 2019
One of the most fascinating developments in the blockchain space since Bitcoin’s inception are Initial Coin Offerings (ICOs). The public understands ICOs to mean any type of token offering, when in fact they represent just a part of all token offering types. A token offering is the act of raising funds by selling tokens on a blockchain-powered platform. Funds are typically raised in the form of cryptocurrencies, such as Bitcoin and Ethereum, although this could be set to change as new projects emerge and evolve. In 2018 alone, over $21.5 Billion was raised through token offerings, which goes to show the disruptive nature of this emerging funding mechanism.
Token Sales, ICOs, STOs – what’s the difference?
In simple terms, both ICOs and STOs are types of token offerings. There is also a third type called UTO (Utility Token Offering) but we will not cover them in this article.
Initial Coin Offerings (ICOs) refers to the initial distribution of coins (sometimes called ‘Native Tokens’) of a new blockchain. Good examples are Ethereum, EOS and Waves, which are all blockchain platforms that have their own coin (i.e. Ether, EOS and Waves). Security Token Offerings (STOs), on the other hand, are tokens representing securities, created on top of an existing blockchain platform. There is no need to create a new blockchain in order to launch an STO, whereas you can only have an ICO by creating a whole new blockchain.
You may be wondering, why are token sales, and particularly ICOs, so disruptive? The crypto community seems to most strongly advocate the lack of barriers to entry for investors into a project, the lack of barriers to entry for entrepreneurs seeking funding irrespective of their geographical location or demographics, the ability for investors to trade their tokens 24/7 worldwide and, finally, the potential for a truly phenomenal return on investment (ROI). Despite their boom in 2018, token sales have struggled to come good on many of their promises. This is a result of both systemic and individual reasons (which fall outside the scope of this article). As a consequence, many perceive the current token sale system to be more or less dead with no possibility of revival.
However, many experts think that the concept of token sales for capital raising is still going to be prevalent in the future albeit in a new form – the Security Token Offering (STO), which is a new type of token sales yet to become popular. STOs are, at the present time, the closest thing the traditional financial world has come to integrating with blockchain technology and cryptocurrencies when it comes to raising capital.
The perceived benefits of STOs include, but are not limited to, the fact that compliance can be hard-coded into the token, their attractiveness to conventional financiers (for example, VCs) relative to other token sale types, fractional ownership of the underlying asset being represented by the tokens and a low barrier to entry for investors relative to Initial Public Offerings (IPOs).
In the UK, the recent report published by the Cryptoassets Taskforce (comprising HM Treasury, FCA and Bank of England) puts STOs right within the scope of FCA regulation. According to the report and the FCA’s Consultation Paper that followed, “security tokens amount to a ‘specified investment’, and may provide rights such as ownership, repayment of a specific sum of money, or entitlement to a share in future profits.” As a result, STO issuers will need to meet a range of requirements to avoid exposure. Publicly offered security tokens are very likely to fall within the definition of ‘transferable securities’, therefore, prospectus-related requirements would apply (i.e. publishing an FCA-approved prospectus prior to the offering). STOs of ‘transferable securities’ may, however, be exempt from the prospectus requirement if the tokens are marketed to a limited audience, comprising either ‘qualified investors’ or a ‘non-qualified investor’ audience of less than 150, or by setting a minimum subscription contribution of £100,000.
Although any type of security can be tokenised and offered via an STO, the prospectus-related restrictions seem to push STO issuers towards token offerings of ‘non-readily realisable’ securities (i.e. not traded in the primary markets) via the existing investment-based crowdfunding model. However, the fact that token offerings of non-readily realisable securities fall outside the framework for transferable securities does not mean that they circumvent regulations altogether. Such tokens will be offered via equity crowdfunding platforms which, in turn, are regulated as carrying on the activity of ‘arranging deals in investments’ or ‘making arrangements with a view to transactions in investments’. This limits STOs of non-readily realisable securities to investors who qualify as ‘high net worth’ or ‘sophisticated investors’, or to investors who will invest less than 10% of their net assets. Similar rules apply in the US, where STO issuers can offer unregistered tokenised securities under the SEC’s Regulation CF, Reg D, Reg A+ (‘mini IPO’), Rule 506(b), etc.
Today’s problem is that the above framework may only cover a sub-category of token sales. But what happens when tokens do not self-identify or are not readily identifiable as securities? This is the question regulators have been facing for the last couple of years, and they have only recently started hinting at what the answers might look like.
In the US, the SEC declared all token sales to be security offerings, vowing to crack down on all issuers that failed to register. In the UK, regulators have taken a more pragmatic approach by dividing token offerings into three categories: ‘exchange tokens’ used as a means of exchange or investment (i.e. Bitcoin); ‘security tokens’ (described above); and ‘utility tokens’ which can be redeemed for access to a specific product or service. FCA’s consultation paper (mentioned above) states that exchange tokens and utility tokens fall outside FCA’s regulatory perimeter. What’s more, it outlines a series of factors that are indicative of a security, i.e. do the rights and obligations of the token-holder exist by virtue of holding or owning that crypto-asset? Is there any entitlement to profit-share, revenues, or other payment or benefit of any kind? Any entitlement to ownership in, or control of, the token issuer?
Similarly, the European Securities and Markets Authority (ESMA), in its advice paper on ICOs and Cryptoassets, identified that “crypto-assets are diverse and many have hybrid features”, thus not allowing for “a ‘one size fits all’ solution when it comes to their legal qualification”. Closely resembling the distinction of the UK authorities, ESMA divided tokens into four categories: (i) ‘utility-type’; (ii) ‘payment type’; (iii) ‘investment-type’; and (iv) hybrids. ESMA surveyed EU member-state regulators, using a sample of six tokens reflecting each category (excluding pure ‘payment-type’ crypto-assets as “unlikely to qualify as financial instruments”) and asked whether such samples qualify as financial instruments. Results showed that 4 out of 6 samples could qualify as financial instruments according to the vast majority of the regulators. However, they also highlighted that Member States’ regulators “face challenges in interpreting the existing requirements and these may therefore not apply consistently across Member States” as the existing EU framework was not designed with crypto-assets in mind.
STOs: Going Forward
A quick Google search on STOs will reveal several links pointing to this year being ‘The Year Of The STO’, but why? Quite simply, STOs offer a degree of regulatory clarity that is unparalleled when compared with any other sub-category of token sales. There is obvious utility in this: entrepreneurs in the space want minimal exposure to regulatory risk, and STOs come with compliance guaranteed by technology.
However, from the perspective of people used to trading coins and tokens, the STO market does come with trade-offs – high barriers to entry for investors and entrepreneurs compared with ICOs, lack of STO infrastructure at the present moment and limited expected rates of return on investment (compared to historical ICO ROIs) to name a few. Consequently, those in the crypto community who are fully committed to decentralisation do not see STOs as a revolutionary funding mechanism, but merely as an optimisation of the legacy financial system.
Ultimately, though, it seems that token sales of all forms are here to stay. Each of them have trade-offs which must be thoroughly considered by both issuers and investors, as their utility varies depending on the specific requirements of the project. With clearer and more precise legislation being proposed and enacted all over the world, hopefully, in the near future, all forms of token sales can move out of the regulatory grey zone and into greater clarity. The lack of such clarity is the main obstacle standing between these funding mechanisms and what they were designed to do: disrupt the legacy financial system and open up alternative funding channels to entrepreneurs all over the world.
by Anthony Broderick and Tassos Repakis
DISCLAIMER: Opinions expressed by Coinschedule Blog contributors are their own.