Security Token Offerings (STO). What you need to know. Next “big thing” in crypto, or simply the next logical step?

At first, it was the IPO. The Initial Coin Offering.

Now, it’s all about the STO. The Security Token Offering. The new shiny thing in the cryptoverse. Many call it “the next big thing”. In reality, it’s just what was supposed to happen, anyway. Let me explain.

In 2009, the first cryptocurrency (Bitcoin) performed its initial transaction. After that, other cryptocurrencies followed.

The initial purpose of Bitcoin, was pretty straightforward. Enable access to financial services, to the unbanked. To those, who because of circumstance or because they were simply born in the “wrong” country, didn’t enjoy the services and facilities a lot of us do.

Financial services. Without the need of a third party to act as a middleman. Without trust being an issue. Anonymously.

The utopia of decentralization.

But then, things got a bit more complicated. New technologies started exploding. Blockchains, Artificial Intelligence, Virtual Reality… Resources like computing power, storage, data collection and manipulation became affordable. So many projects, and not enough funding. Teams all around the world started looking for a solution to their funding problems. And then, someone had an idea!

“Why don’t we use code to create and sell a token. Those who buy our tokens, are going to get a piece of the profits we realize from our project”.

That was it. The birth of the ICO. Teams creating tokens, selling them without even having a prototype ready (most of the times), and promising a piece of the project’s revenues.

The ICO market then boomed! Billions of dollars exchanged hands (and still do) every year with the hope of buying a piece of the next “big thing”. A lot of projects failed. A few succeeded. And some were just scams.

Finally, governments and authorities decided it was time to intervene.

Money were made. Profits were promised. This sounds a bit more than just a simple token, doesn’t it?

The SEC said, “This sounds like a security!”. The ICO teams replied, “No, these are just tokens!”.

The difference between a simple “utility” token and a security one, is quite significant. That’s because when a token is classified as a security, it has to adhere to very strict compliance, legal, and financial regulations imposed by local, state, and federal authorities.

Suddenly, crypto companies were forced to return the money they gathered back to their investors. Others, saw their owners being convicted and/or face jail time.

It was time to separate token introduction into ICOs and STOs. To separate tokens into “utility” and “security” ones. (By the way, we’re mainly talking about the US market, because this is where the majority of ICOs take place, as you can see in the below chart; courtesy of inwara.com).

You see, there are lots of different token “flavors”.

There are tokens that grant you rights. By holding them, you can -for example- have the right to vote inside the particular cryptocurrency’s ecosystem.

There are tokens that allow buyers and sellers to exchange value. Get rewards for example, for completing specific tasks (like the rewards of an online game).

They can be used as toll payments. To pay a toll for example, in order to access better resources inside a project.

Tokens can be used to add functionality or extra features to the project. For example, pay with tokens in order to remove all advertisements from a blockchain-based web browser.

They can be (of course) used as a currency. A store of value that allows transactions inside and outside the project’s ecosystem.

Finally, they can be used as a means of earnings distribution of the project’s profits or as other financial benefits.

Too many uses to be ignored. So, the SEC decided to use the Howie test, to determine which projects should be classified as securities.

The Howie Test is a test (duh!) created by the US Supreme Court in 1946. The test determines whether a transaction is an investment contract, or not. If it is, then it is subject to the securities’ registration requirements.

To make things simple, if a transaction is (a) an investment of money, (b) the investment is in a common enterprise (more than one people participate), and, (c) there is an expectation of profit from the work of the promoters, or a third party, then it is classified as a security and it must meet all regulatory requirements.

And there were additional reasons that forced this compliance. For example, companies obliged to follow KYC (Know-Your-Customer) and AML (Anti-money Laundering) regulations, wouldn’t “allow” new competitors to enter without (eventually) forcing them to adhere to the market rules. If you want to operate in an advanced economy, you need to follow the rules. Other companies also had to protect themselves against possible ramifications. Like Visa for example, that banned a lot of projects and cancelled transactions involving crypto purchases in the past months. A lot of cryptoexchanges, crypto debit cards, and other crypto projects employ the services of Visa to deposit and withdraw funds. But, if you don’t know where the money is coming from, how can you be sure you will avoid possible money laundering charges? Better be safe than sorry.

So, token offerings were divided into 2 broad categories.

Utility and Security.

Hence the term STO; Security Token Offering. A security is any instrument (paper or digital) that proves you own rights to a debt or to the earnings of the entity that issued it. A token in our case is a digital representation of an asset. So in essence, a Security Token performs the exact same functions a traditional security issuance does. The difference is that it performs these functions by using blockchain transactions. Other than that, equity rights, dividend payouts, voting, they all remain the same.

The compliance and extra security features we find in security tokens, is the result of using multiple smart contracts. Unlike simple tokens where a single smart contract is enough for their creation, security tokens use multiple. In addition to the initial contract that manifests them, they use contracts that determine how they can be purchased, sold, traded, and whatever other feature is required by their use. (A smart contract by the way is a simple program –some code in essence- that executes as soon as a specific condition requires it to run).

Being the products of a blockchain of course, security tokens share all of the benefits of a blochain-based product. Immutable, transparent, and traceable transactions that make it very hard for Madoff wannabees to delete transaction records.

And there are even more perks for using a blockchain-based security token.

Let’s say for example that you want to buy into a commercial real estate opportunity. You only have a couple of thousand of dollars, and you want to put a little bit more next Christmas with your bonus. How can you do it in the traditional way? You can’t. You can’t buy 4 square feet this month and an extra three next Christmas. Ridiculous, right? Well, you can if the owners issue security tokens. They can issue a billion shares, and price them a cent a piece if they want to. So anybody can invest whatever amount they can afford.

The process can be used with other types of investments. An expensive diamond. Gold. Or a Van Gogh painting. You put your money, and you buy a percentage of the total securities issued.

Of course, the same idea works in the opposite direction, too. Let’s say you own a building and you need $20,000. You don’t have the time (or the credit score) to seek bank or any other sort of a loan. You can tokenize a percentage of your building, and sell the securities to the public.

Asset tokenization is an amazing tool, because it is very versatile. Unfortunately there are still issues that do not allow it to become a mainstream practice. For example, when you buy tokens of the building in our first example, you buy ownership of the asset. The security. You do not become a legal owner of the property. Blockchains are public, immune ledgers, and your transactions cannot be altered. You still have your rights intact. You enjoy your profits from the rise in the tokens’ value, and the profits from the building’s revenues. But that’s as far as your reach goes.

Let’s say now the owner of the building decides to sell it. You just own tokens, not the building. You have no rights over the property itself. You can see the problem, right? Smells like an expensive legal battle.

Then we have companies and their stocks. We can tokenize them and sell them, but not everywhere. A lot of countries do not allow the sale of fractional parts of company shares. It’s illegal. End of story.

So, security tokens are a very new, much more secure and versatile investment vehicle. They solve a lot of security, compliance, and trust problems that simple tokens and ICOs carry with them.

But, they have a long road ahead of them until they become mainstream alternatives. Countries have to adjust their laws. City, State, and Government bodies have to update their regulations in order to allow them to be defined, and operate legally.

Until then, we can only try to build better, more secure tokens. The good news is that the industry (and technology in general) moves so fast, that the governments have to work faster to keep up. Nobody wants to leave consumers exposed to bad products, incomplete services, and to the practice of fraudulent and money-laundering activities. It’s bad for us, and it’s bad for their re-election chances. So, let’s wait and see what happens!