While some blockchain projects have attempted to use the decentralized nature of the technology to avoid securities regulation, there are no guarantees that agencies such as the SEC, BAFIN, and FINMA will agree with claims of independence from jurisdiction. Initial coin offerings, which funded many early projects, remain unclear in nature as regulators continue to evaluate how opportunities for tokenization of securities can proceed within legal guidelines. The lifeblood of blockchain enterprises has been initial coin offerings, but questions linger around both their legal classification and consequences in different geopolitical environments.
The essence of blockchains and ICOs
Blockchain a ground-breaking disruptive technology with one unique aspect. Everything revolves around coded rules embodied in smart contracts widely known as “coins,” or “tokens.” Every transaction in a blockchain typically involves the transfer of coins or tokens—be it granting access to personal data, ownership of a game element, rewards for certain actions or monetary transactions. The coins are the building blocks of the blockchain platforms, and they have a utility in a decentralized internet-based ecosystem.
ICOs believed tokens would gain value like Bitcoin. This allowed startups to sell tokens early at low prices for initial funding.
ICOs presented a seemingly enormous opportunity for both founders and investors. They allowed the startups to raise millions within a short span of time, with nothing more than a whitepaper and a website. ICOs were not regulated, there was no control and they allowed anyone to effortlessly reach out to crowdfund their ideas. At the same time, the investors were eyeing the massive returns bitcoin had brought and were hoping the same thing would happen for them. Unfortunately, that did not happen.
Many ICO projects turned out to be scams, while many honest projects failed to deliver. Many countries stepped in to regulate ICOs, and many of them outright banned them.
But this created a dilemma; the Financial Securities Governing Authorities around the world are in charge of regulating securities–something many blockchain projects claimed they were not.
Whether certain blockchain project tokens are securities or utility tokens has been the subject of many debates. Some tried to confront the Securities Governing Authorities, claiming that the decentralized nature of blockchain essentially invalidates the security argument. On the other hand, some projects took a step forward and cooperated with the regulators and thus Security Token Offerings (STOs) were born.
What are STOs?
STOs differ from ICOs because security tokens are registered with agencies like FINMA in Switzerland. Or tokens pursue exemptions, usually making them limited securities.
In STOs, one is officially dealing with securities. This limits token utility or lessens it. Unlike ICOs, STOs are not restricted to in-project or ecosystem usage. Security tokens may go beyond blockchain to fractionalize real estate or artwork.
Conversely to utility tokens, security tokens including those on EDSX typically represent an underlying asset (digital or physical). For example, regulators consider a real estate token tied to the profitability of a certain property a security. It provides similar benefits to traditional equity or bonds as a financial instrument.
It is like bringing the benefits of ICOs to the non-blockchain world while removing the weak features. Digital securities offer investors various rights including equity, dividends, profits, votes, and buybacks. Security digitization creates these financial rights as digital assets using blockchain registration. The Swiss canton of Ticino permitted traditional firm shares to exist on blockchain, with shareholder records and transactions also on chain.
Security tokens stand out on many fronts, compared to IPOs or private investing. Unlike IPOs which require an arduous and expensive process with many middlemen and brokers, STOs are easy to pull off. The security tokens can be broken down and represent fractions of an asset, at sizes suitable for any investor. And unlike private investing, where investors need to wait many years until they see returns, security tokens are immediately tradable. As such, they are extremely more liquid.
The Good “downsides” of STOs
From a functionality standpoint, STOs are similar to ICOs. However, STOs carry significantly more compliance work. In all jurisdictions a proper KYC/AML (Know Your Client & Anti Money Laundering) process has to be performed including Switzerland which is taking the lead in developing the legal framework and in some jurisdictions such as the US, only certain qualified investors are able to participate in STOs although there are a couple exemptions to this. The regulatory framework in general creates an access barrier that slows down the STO process compared to ICOs.
During the ICO boom, exchanging cryptocurrency for new tokens was quickly and easily done. However, many illegitimate projects launched due to weak consumer safeguards, an issue regulators now aim to address. STOs add rules that limit investing but protect issuers from rule violations.
This adds to another traditional problem blockchain projects have suffered from: they only allowed tech-savvy people to use them. The user interfaces have, most of the time, been usable only from a Minimum Viable Product-perspective, rather than offering a solution for the average person. This has created a problem for mainstream adoption. Considering STOs go beyond the blockchain world, the technical requirements add to the complexity for regular users, which has motivated EDSX to focus on the development of UI for ease of use.
STO procedures incorporate compliance requirements like KYC and AML management. This ensures all regulations are followed correctly. It also improves security, a concern after hackers breached some blockchain project smart contracts.
Tailoring STO products to local laws is crucial. Regulations vary slightly between jurisdictions. Every security issuance has its own qualities. EDSX works with Swiss firms as that framework has been tested. However, other locations require legal analysis for each issuer and investor situation.
Will STOs pull off?
A large reason for ICO explosion was the lack of regulatory barriers for projects to release tokens. This is not the case in the security token context. Securities Governing Authorities compliance for STOs takes time for compliance filings, document execution, etc. Therefore, STO adoption will most likely be a slower build, rather than the substantial explosion we saw in 2017 with ICOs. However, STOs targets and challenges traditional financial sectors with a regulatory compliant financing opportunity, which could grow significantly over time.
The pipeline at EDSX alone is about 30+ companies lined up for STOs at different stages of readiness. Currently, some of the projects that involves ICOs flee to countries with more lax regulations but this cools down investor appetite. Others ban U.S. citizens from participating (and some do both). This can work for the crypto-space, but STOs reach far beyond that. The physical and digital asset industries will slowly adopt tokenization, and those industries are significantly larger than the current cryptocurrency market, which leads one to believe STOs will grow significantly over the next 2 to 4 years.
Based in Zug, the platform is fully compliant with all Swiss laws related to financial intermediaries, banking, anti-money laundering, and organized trading facilities. Among its core values, there are innovative solutions through blockchain technology, which ensures security and liquidity.
EDSX is the first platform in Europe with primary and secondary markets for both institutional and retails. EDSX is a pioneering platform that employs the world’s leading technology to globally list security tokens in both primary and secondary markets, listing digital securities of real financial instruments to the public with a decentralized peer-to-peer exchange. Our goal is to fully engage every aspect of the financial revolution.
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