This entry is part 1 of 3 in the series Security Token Offerings

Security Token Offerings or STO’s have long been a part of the crypto narrative but 2019 and beyond will see them take centre stage. This three-part series will attempt an overview of the characteristics, advantages, and drawbacks of this new form of offering. Part one focuses on the possibilities raised by STO’s. Part two focuses on the very real possible drawbacks for crypto, in general, and investors, in particular. The last post attempts to give a fair overview of STO’s for the following year.

To be clear from the onset, STO’s are very unlikely to offer the spectacular returns of ICO’s in early to late 2017. That gold rush is done and as it turns out there was a lot of fool’s gold in the mix. Security Token Offerings for a plethora of reasons I’ll go into in the next post are, at least in the first wave, very unlikely to match the x10+ returns of their ICO cousins. In fact, many of them will prove to be underwhelming long-term investments. Please bear this in mind for when the STO hype machine ramps up and ramp up it will.

What is a Security Token Offering?

A crypto token that passes the Howey Test is deemed a security token. While many ICO’s strive to avoid being labelled a security. STO’s from the outset seek this designation.

Under the Howey Test (1946), a transaction is an investment contract (security) if:

It is an investment of money.

There is an expectation of profits from the investment.

The investment of money is in a common enterprise.

Any profit comes from the efforts of a promoter or third party.

Source: FindLaw

Source: International Business Times

Security Token Offerings are the intermingling of blockchain with traditional assets such as stocks, bonds and property. In essence, STO’s are equities – they are a share (stock) in a company (or a portion of ownership in property) that (likely will) offer regular dividends and perhaps voting rights. To stick with the direct stock comparison – one STO will be equal to one share on a traditional market but now in blockchain form with all that comes with that digital and immutable format.

While ICO’s typically only offer access to a network in the form of a utility token, STO’s offer some form of ownership in the project itself. As such they are governed by the same laws that apply to stocks and bonds where Know Your Customer (KLM) and Anti Money Laundering (AML) procedures are a prerequisite to purchase. It will not be possible to own an STO and remain anonymous as has frequently been the case with ICO’s.

Advantages of STO’s

Diffused Ownership and Liquidity

STO’s will allow, and indeed, encourage fractional ownership. As it stands, there are many assets and asset classes that lie entirely outside the means of a typical retail investor but STO’s will solve that access barrier by allowing fractional ownership. Investing in prime real estate is currently a very expensive endeavour generally open only to accredited investors. Tokenisation raises the possibility of many thousands of people of more modest means gaining access to such investment opportunities. The risk remains, but so too does the opportunity. Another clear example is fine art – today buying a painting by Degas or a scripture by Rodin is the sole proviso of the rich. However, the tokenisation of such art will allow many hundreds, indeed, thousands of people to become part owners of a single piece of art. Those tokens may then be freely traded on an exchange.

STO’s, therefore, will very likely lead to greatly increased liquidly for a range of traditional assets classes such as real estate and art. Currently, these are largely restricted to high-net-worth individuals and corporations. The number of buyers and sellers is therefore quite limited. Tokenisation may open the floodgates to a massive injection of liquidity from retail investors.

Much Cheaper Access to Liquidity

In the US an Initial Public Offering (IPO) on a stock exchange costs at least 3 million dollars. The range of fees is impressive and exorbitant for all but the best-capitalised firms. This means only the very largest firms can afford to list. Only a very small fraction of companies ever go public – well under 1%. STO’s will incur a fraction of the cost to set-up and roll-out, thereby greatly increasing mid and small-sized companies access to external funding. The likely outcome is that many, many more medium to small companies will utilise STO’s to raise funds.

Assets that can be Programmed

At the moment, you buy a share, it’s value goes up/down or stays the same. It pays a dividend or not and infers a voting right of some sort. With tokenisation, the range of options expands dramatically. Say you invest in a piece of art, housed in a national gallery – programmed into that ownership might be free access to the museum or entry to the annual gala or whatever the marketing team can conjure up. Buy tokens in a premier hotel – preferential rates as standard. Invest in a mining company, reduced cost to store precious metals with a third party. Length of ownership might be rewarded on a scale, so holding a set number of tokens over an extended period of time would automatically result in some benefit. The list of options is quite literally endless. OK, so at heart, many of these benefits of ownership may simply be loyalty points but the appeal is obvious. This nuanced reward for ownership greatly exceeds what is currently on offer to stock or bond investors and may be the primary driver towards the tokenisation of current traditional assets.

Compliance by Design

Security token offerings can be coded to be absolutely and automatically compliant to the laws that apply to them. From day one they can adhere to whatever set of laws deemed necessary. Know your customer (KML) and Anti Money Laundering (AML) compliance is just the tip of the iceberg. Third party verification can be baked into the smart contract that controls the token. In fact, a buy-sell contract won’t even take place until each and every coded requirement is satisfied. This has immense benefits for regulatory authorities as much of their remit is carried out by the token itself. Where disputes arise – the record keeping function of blockchain transactions would likely greatly simplify conflict resolution. Preventing certain entities from investing in certain projects could be literally coded into the token as could limits on individual investments and so on.

Harmonisation of Assets

As all STO’s are tokens and therefore may be traded on exchanges (24/7?) the movement between one asset and another would become much easier. Property could be traded for art, art for commodities, commodities for a stake in a small food franchise and on. These assets could be stored in one portfolio or one cold storage wallet and thus be very easily interwoven and exchanged. Of course, some STO’s may not be so liquid – that would depend on how they were designed but the flexibility remains an option.

Even at this early stage, the immense opportunities afforded by STO’s are clearly identifiable. In the next part of this series, I will examine the very real concerns and limitations ‘baked into’  the STO model.


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Responses

  1. Zeus69

    Great series start CD, will be good going forward. Very interested in the STO’s, sounds like a viable option in preference to ICO’s. Thanks for sharing, I will post this on.
    Regards,
    Mark (Zeus69)

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  2. miti

    Ottimo! E’ davvero fantastico poter avere una panoramica così approfondita sulle STO e se le altre due parti che pubblicherai saranno come questa, non vedo l’ora di leggerle!
    If I could give you just one note, the acronym for “know your customer” should not be KYC instead of KLM as you said?

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    1. CryptosDecrypted Post author

      Perhaps the more common and valid application will be medium-sized businesses – offering tokens (shares) in the same way as an IPO but without the massive associated costs. I think Polymath estimate the cost to launch an STO in the region of $10 to $15k.
      The Howey test notes ‘a common enterprise’ so your house without a business associated with it might be difficult to pass as a security.

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  3. Brandon Holsey

    Seems STO’s might make warrants and restriction of shares much more efficient via smart contracts for companies that hold debt/equity rounds and so forth. However, with easier access to funding – prepare to see a propelled rate of failure amongst the industry. It simply propels the speed of failure as 90% of the startups will inevitably fail (statistically speaking). I think it will bring both positive and negative impacts on these young, most ambitious projects. Time will tell us, later, what we wish we knew now Great article. Looking forward to the remaining parts.

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  4. Adil Elias

    Very informative post as usual @cryptosdecrypted! I have a question that might be a little outside of this post (but I started wondering while reading LOL)… Do you think EOS being registered in the Cayman Islands would be protected a bit from the SEC? Or do you think that wouldn’t necessarily stop the SEC?

    Maybe it’s a stupid question haha. Anyways, awesome post man! Insightful as always.

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    1. CryptosDecrypted Post author

      That’s actually a really good question. The SEC could absolutely judge EOS a security though Block.one took certain precautions against this (https://news.bitcoin.com/eos-raises-700-million-despite-tokens-affording-no-rights-uses-purpose-or-features/) – the SEC could still view EOS tokens as passing the Howey Test. Being registered in the Cayman Islands helps but the SEC can pursue a case against foreign registered companies if they choose to do so..given the global clout of the USA…However, the fact that Coinbase is considering listing EOS suggests a brighter outcome.

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