Capital – the spine of any business entity. To embark upon a path of growth and development, capital is the lifeline that any company requires. For the longest time, we have regarded banks and other financial institutional loans as the traditional and conventional method of fundraising. Then came the advent of P2P fundraising. Whether through angel investors, venture capitalists, or IPOs, it became extremely convenient for businesses to acquire the required capital to run the show.

Now, with distributed ledger technology (“DLT”) and blockchain platforms, a new secured method of fundraising is available in the form of security token offerings.

Blockchain has upset the status quo of traditional financing methods, giving entrepreneurs and business entities the chance to directly connect to customers to raise funds in order to grow their business and meet market demands.

This article introduces the concept of security token offerings and their advantages in this blockchain era.

What is a token?

Before we begin defining and understanding the concept of security token offerings (“STOs”), it is important to understand the concept of tokens.

A token is a digital representation of assets, value, store, or utility, which companies usually give to their investors in return for funds.

What are initial coin offerings (“ICOs”)?

This is the most common and widely used method of raising funds based on cryptocurrency tokens. In ICOs, companies issue a limited number of tokens with the promise that the utility of such tokens will increase amongst the customers and that the valuations of the tokens will also increase, thereby reaching the ICO’s target as initially aimed for by the company.

In rare cases, ICO tokens have a fixed predetermined value. However, generally, the functioning of such a token is just like that of a stock offered in an IPO. The more people buy and invest in such tokens, the more the tokens’ value will increase.

Generally, ICO tokens are not considered securities. Hence, they remain unregulated and pose a substantial risk for investors. The question that arises now is: How does one categorize a token as a security? The answer was provided by the U.S. Supreme Court, which shall be discussed in the later part of this article. 

What are security token offerings?

Unlike ICOs, STOs are a digitalized form of securities that are backed by tangible, real-world assets such as stocks, bonds, debts, shares, real estate, etc. A security is basically a tangible, negotiable financial instrument with a stored monetary value.

Therefore, a security token represents digital ownership of an investment product or security on a blockchain platform.

How are STOs different from ICOs?

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STOs are backed by tangible securities or assets and are regulated by the regulations in the jurisdiction where the STOs are being offered. Meanwhile, ICOs are generally offered as utility tokens. Hence, they easily circumvent certain legal frameworks and do not have to be registered or comply with the strict governance of regulatory bodies.

Therefore, it is easy for a company to launch an ICO, while it is much more difficult to launch an STO. However, because STOs are regulated, they provide a higher level of security and assurance to investors. This is the main reason why we are witnessing a tremendous rise in the popularity of STOs.

How are STOs different from IPOs?

Although both are regulated offerings, IPOs are used only in private companies that want to go public. Through the IPO process, companies raise funds by issuing shares to accredited investors through traditional markets. With STOs, tokens that represent a share of an underlying asset are issued on the blockchain to accredited investors.

STOs are also more cost-effective than IPOs. With IPOs, companies typically pay high brokerage and investment banking fees to get access to a deeper investor base. While STOs require lawyers and advisors, they offer more direct access to the investment market and, therefore, typically don’t result in large fees paid to investment banks or brokerages. The post-offering administration of STOs is also less cumbersome and cheaper than that of traditional IPOs.

How are STOs regulated around the world?

United States of America:

The Securities and Exchange Commission (“SEC”), in its Decentralized Autonomous Organization Report, declared that a token that qualifies as an investment contract would be treated as a security token. Hence, it would be regulated by the SEC.

In the case of SEC v. Howey, the defendants had offered plots of lands for sale to investors with an option to lease back these plots to the defendants to carry out agricultural activities. The SEC sued the defendants on account of their failure to register the transaction with the regulatory. The Court held that the contract offered by the defendants was an ‘investment contract’ and, hence, should have been held as a security for the following reasons:

1. It is an investment of money;
2. The investment is made in a common enterprise/company; and
3. There is an expectation of earning profits from such investments.

The same principle, as laid down by the Supreme Court, has become a determining factor for categorizing a token as a security. If a token falls within the scope of the Howey Test, it is called a security token. Otherwise, it is called a utility token, also known as a gateway token, which gives the holder a right to a product or service.

United Kingdom:

The Financial Conduct Authority (“FCA”), in its Guidance on Crypto Assets, distinguished three types of tokens:

1. Exchange tokens- These are not issued or backed by any central authority and are intended and designed to be used as a means of exchange. They fall outside the regulator’s governing perimeter.

1. Utility tokens- These tokens grant holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by Specified Investments.

1. Security tokens- These are tokens with specific characteristics that meet the definition of a Specified Investment, like a share or a debt instrument, and are fully under the scope of the FCA’s regulations.

Switzerland:

The Financial Market Supervisory Authority (“FINMA”) issued its ICO Guidelines, which categorized and defined tokens in the following manner:

1. Payment tokens- Tokens are issued as a means of payment. FINMA does not treat such tokens as securities but will require compliance with Anti-Money Laundering (AML) regulations.

1. Utility tokens- Tokens that are intended to provide digital access to an application or service. These tokens do not qualify as securities if their sole purpose is to confer digital access rights to an application or service.

1. Asset tokens- These tokens represent assets that have underlying real-time assests. FINMA regards asset tokens as securities, which means that there are securities law requirements for trading in such tokens.

United Arab Emirates:

In 2018, ADGM and DIFC formulated its own rules and regulations regarding STOs or crypto assets. (In my next article(s) I will focus more on STOs/crypto asset regulations in ADGM and DIFC.)

In my previous article, I wrote about the Draft Crypto Asset Regulations issued by the Securities and Commodities Authority (SCA) in the UAE. Please click on this link to read, in detail, about the draft regulations with respect to crypto assets. Hereinbelow is a brief explanation of how the draft regulation categorizes tokens:

1. Security Tokens or Security Crypto Assets -Tokens which are deemed to be financial instruments representing an interest in finance or investments such as stocks, bonds, debentures, commodities contracts, foreign funds, etc. and are traded, exchanged, or transferred in the form of a crypto asset. In simple terms, a token that represents an interest in a digitized form having an underlying financial instrument is considered a Security Token.

1. Commodity Token -The Regulation defines this as any token that is not a sScurity Token. The Regulation seeks to broadly encompass any and all types of Crypto Assets that do not fall squarely under the definition of a Security Token. In my opinion, a Commodity Token is a tokenized form of a tradable commodity with established markets such as gold, silver, oil and natural gas, etc.

Singapore:

The Monitory Authority of Singapore (“MAS”) has issued a Guide to Digital Token Offerings forming the basis of token regulation in Singapore.

Any token that offers capital market products such as shares, stocks, collective investment schemes, derivative contracts, spot foreign exchange contracts, etc. will be regulated and governed by MAS in accordance with the provisions of the Securities and Futures Act (“SFA”) and the Financial Advisers Act (“FSA”).

Every person including intermediaries (a corporation intending to apply for a license to trade in capital market products) operating or managing primary platforms (where different types of digital tokens are offered or issued) or trading platforms shall be regulated by MAS.

In addition to the above, this guideline gives extra-territorial powers to MAS for any platforms or digital tokens that have been issued or offered outside of Singapore but that engage or are intended to engage people who reside in Singapore; these will be governed by MAS and shall be deemed financial advisers in Singapore.

Malta:

Malta is considered the pioneer in crypto assets and tokens. Malta issued the Malta Digital Innovation Authority Act (“MDIA”) in 2018, when there was a lack of legal frameworks for security tokens around the world. The MDIA Act provides for the formation of the Malta Digital Innovation Authority and outlines its mission to regulate and promote the growth of the cryptonomic sector in Malta.

The Innovative Technology Arrangements and Services Act (ITASA) offers definitional criteria and guiding principles for Malta to become the first country in the world to hire blockchain developers to certify the quality and governance mechanisms of the distributed ledger software used by a company seeking approval to operate domestically.

The Virtual Financial Assets Act (“VFAA”) establishes a regulatory framework to govern entities that work directly or indirectly with virtual financial assets, including STOs and ICOs, exchanges, wallet providers, and crypto investment advisors.

A company offering STOs in Malta must submit a ‘white-paper’ (which is similar to a prospectus) to get initial approval from the MDIA. A company offering such STOs must appoint a Virtual Financial Asset Agent in Malta who must be registered and licensed by the MDIA to offer STOs.

Unlike the MSA of Singapore, the VFAA does not confer extra-territorial authority to MDIA to regulate digital tokens/virtual financial assets outside of Malta.

Estonia:

According to the Estonian Financial Supervision Authority’s (EFSA) interpretation, a token falls under the definition of security and is subject to the EFSA’s supervision if the token gives investors certain rights in the issuer company or has a value that is tied to the future profits or success of a business, especially if the security falls under the definition established in the Securities Market Act and the Law of Obligations Act.

The EFSA defines a utility token and a security token just like the laws passed by any other jurisdiction, i.e., if the token offers security to the investors, it shall be considered a security token.

To offer STOs in Estonia, a company must submit a prospectus to the EFSA. However, there are some exceptions to this:

1. If the offer is for only qualified investors (private placement);
2. If the STO offer is made to fewer than 150 investors except for qualified investors;
3. If an offer of securities is addressed to investors who acquire securities for a total consideration of at least 100,000 euros per investor, for each separate offer, or
4. If an offer of securities has a nominal value or book value of at least 100,000 euros per security, or
5. If an offer of securities has a total consideration of less than 2,500,000 euros per all the contracting states in total calculated in the one-year period after the offer of the securities.

Advantages of STOs

1. Regulated by a regulatory body;
2. Cheaper to issue for a start-up;
3. Fewer administrative procedures to be followed by the company offering STOs;
4. Middlemen such as banks or brokerages are circumvented, thereby reducing the listing cost for the company;
5. Smart contracts make it easier to transact with investors; and
6. There is an opportunity to deal directly with the investors.
7. Fractionalized ownership of assets: One major advantage for an investor is that it provides the opportunity for fractionalized ownership of assets, which traditionally could not be accessed by a mid-level investor. Using STOs, companies can tokenize hotels, major real estate properties, a big yacht, major infrastructural projects etc. Meanwhile, by investing in the STOs, the investor will get a fractional right or ownership of the underlying asset. 

Conclusion

It is evident that STOs are the way forward in terms of raising funds for companies. A token issued through an STO can grant its holder the right, under certain conditions, to receive regular payment distributions from the issuing company. However, in reality, very few companies have opted to issue STOs, as many regulatory bodies still lack the expertise to handle STOs in the real world despite the legal frameworks in place. Nonetheless, despite such shortcomings, in the long run, with an increased level of participation from start-ups and other entities, STOs will lead the fundraising industry to new heights.