While some projects have tried to rely on the decentralized nature of blockchain to fall outside the jurisdiction of securities regulators, there are no guarantees that the regulators such as SEC of US, BAFIN of Germany or FINMA of Switzerland will agree with those claims. ICOs, which have been the lifeblood of many blockchain projects, are still under uncertainty as to their nature and legal consequences.
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 of tokens or coins circulate around the idea that these instruments would be more valuable over time, similar to what happened to Bitcoin. Thus, startups could sell them in an early stage of their lifecycle at a discounted price to the public, in return for early funds.
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?
Security Token Offerings are different from Initial Coin Offerings in that security tokens are either registered with a Securities Governing Authority (e.g. FINMA in CH) in the jurisdiction where the tokens are offered, or the tokens are filed under an exemption, which typically makes the tokens restricted securities.
In STOs, one is officially dealing with securities. While this means that the utility-part of the tokens are either entirely removed or lessened, it also means that—unlike ICOs—they are not bound to a specific in-project or ecosystem use of the tokens. Security tokens can go beyond blockchain projects or ecosystems and represent a securitized fraction of a real asset, such as a building or a piece of art.
Conversely to utility tokens, security tokens including those on EDSX typically represent an underlying asset (digital or physical). For example, a real estate token tied to the profitability of a certain property is considered a security because it is a financial instrument providing similar benefits to traditional equity or bonds.
It is like bringing the benefits of ICOs to the non-blockchain world while removing the weak features. Digital securities provide an array of different financial rights to an investor such as equity, dividends, profit share rights, voting rights, buy-back rights and more. Security digitization is the process of materializing any of the above financial rights in security through the issuance of a digital asset registered on the blockchain. The Commercial Register in the Swiss canton of Ticino even allowed traditional shares to exist on the Blockchain with the shareholder register maintained on the Blockchain and negotiability and transferability happening on the blockchain.
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 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.
In the booming ICO days, one only had to exchange our cryptocurrency for the newly minted token, and the process was extremely fast and efficient. However, while this was beneficial in terms of access, a lot of illegitimate projects were able to take off due to a lack of consumer protection, which is motivating the focus of governing bodies currently addressing cryptocurrencies. In the current regulatory environment, STOs certainly present a double-edged sword that constrains participation, but ensures a token issuer is not subject to regulatory 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.
In addition, the compliance requirements for STOs (such as KYC and AML management) are incorporated in the procedure, ensuring nothing is missed. This also ensures the tools have higher security—a threat looming over blockchain projects as many of them had their smart contracts hacked.
Specifically, when it comes to STOs, tailoring the product to local laws are important since the laws in those jurisdictions are similar but not exactly the same, and every security issuance is unique. EDSX for example is willing and ready to take on board Swiss companies as the legal frame has been sandbox tested but requires particular legal research and structuring when other jurisdictions are involved be it on the issuer or investor part of any STO.
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.ch 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.