Security Token Offerings (STOs) are the latest hype in the crypto community. Go to any conference and I guarantee you’ll hear one of the following statements.
I’m calling BS on all of it. Well, most of it, for now, anyway.
To be clear, I’m not anti STOs. I understand they could one day open up new untapped investment pools, bring more liquidity to the economy, make capital raising easier, faster and cheaper, and provide retail investors access to a new investment class.
That’s all great stuff, but people in the crypto community are running around acting like STOs are a workable, feasible and practical option today. Nothing could be further from the truth.
Hidden in plain sight are major structural challenges which put the viability of STOs and the benefits they are said to provide into serious question. Get ready because in 2019 this delusional STO hype is going to be met by a cold, hard, and highly regulated reality.
What is a Security Token Offering (STO)?
Let’s get on the same page about what we’re referring to here. A Security Token Offering (STO) is a regulated public securities offering of equity in a private company. When conducting an STO, a company issues equity tokens to investors which are legally binding investment contracts that represent the ownership of equity in a company, dividends, voting rights and more.
Rights are programmed into token smart contracts which are designed to enable the automated execution of these rights. This differs from an ICO utility token offering where contributors do not acquire any rights or equity in a company, rather future access to a product or service.
STOs do not beget liquidity
There are many people who seem to think that STOs result in the spontaneous, magic- like emergence of liquidity. In private markets, especially with small and micro-cap issuers, liquidity is very difficult to create. Not only will issuers have a tough time attracting investors but investors will also find their tokens have almost ZERO liquidity.
There are no secondary markets
No secondary markets exist to buy and sell security tokens, and this might not change for some time to come. Well, that’s not exactly true. There is a handful, but they have little to no volume which defeats the purpose of having them in the first place.
The reason for the lack of exchanges is that in most jurisdictions obtaining a license is difficult and compliance is a costly nightmare. Exchanges must adhere to rigorous and continual checks, reporting, KYC and much more. Meeting all the requirements is just too complicated, costly and risky especially when taking into account that several licenses may need to be obtained and different regulation sets adhered to in each and every jurisdiction of operations (national and international).
Traditional stock exchanges like NYSE or NASDAQ are not yet offering securities tokens because they lack the infrastructure for blockchain based digital assets. What’s more, in the US, these traditional exchanges are the only exchanges that enjoy a pre-emption of state blue sky laws. For the reasons listed above it would only make sense to set up a security token exchange on a national exchange or maybe an ATS that offers this benefit otherwise registration is required in each of the 50 states.
Adding to these complexities is the fact that other regulation sets may also apply in addition to securities regulations. For example, an exchange contemplating using security tokens denominated in cryptocurrency must abide by a whole different set of rules which apply to the transfer of cryptocurrency. In New York, this would be a Bitlicense.
With only a few exchanges that feature little to no trading volume, why would any investor want to purchase security tokens? For the possibility that maybe sometime in the future a market will exist with sufficient trading and demand?
There are no liquidity providers
Even if exchanges existed to trade security tokens that wouldn’t be enough to create adequate levels of liquidity. The creation of true liquidity also requires an infrastructure of liquidity providers. This is different to exchanges which can be thought of as trade facilitation platforms. Liquidity providers are the researchers, analysts, and salespeople who call customers to create buy orders to offset sell orders at the point in time they are required. They can be thought of as liquidity matchmakers.
“Tokenizing securities is not a magic recipe for liquidity. Tokens can be equally illiquid as their legacy digital or paper certificates. Tokens do not beget liquidity. Technology does not generate liquidity. Buyers and sellers create liquidity.” – Matthew Finestone
What’s important to understand here is that creating liquidity is a people-intensive endeavor. Doing an STO doesn’t nullify this fact which means that without liquidity providers equity tokens are highly illiquid.
Investor demand is probably overblown
One of the major selling points of an STO is that it enables global access to the holy grail of investors – the unaccredited retail investor. While this isn’t currently true, let’s pretend it is. Is there really a demand for security tokens on main street?
Let’s remember that there is a market today where retail investors can invest in their favorite companies like Apple, Facebook, and Nike quite easily, yet most people don’t. If most people don’t even buy stock in the brands they know and trust, what would have us believe they will buy stock in a small private company they have never heard of?
STOs don’t offer easy access to a global pool of investors
If a project registers and adheres to securities regulations in one jurisdiction it doesn’t mean they can offer their security tokens anywhere in the world or even country-wide. It certainly doesn’t mean that retail investors can be sold to either.
An STO can only be registered and sold in jurisdictions that allow the crowdfunding of equity; otherwise, it’s illegal to do so. When dealing with a security, a company cannot even begin to transact until they have the regulatory licenses and provisions in place in each jurisdiction they wish to operate or qualify for an exemption.
Herein lies the problem. Regulations differ substantially from country to country making for nightmarish and costly regulatory upheavals. For example, most jurisdictions have tough restrictions on who can purchase securities. Tough and divergent regulations make it really difficult and costly to tap into a global pool of accredited investors and, for the most part, put retail investors entirely off-limits.
A US-based example & fragmentation in Asia
If you’re a US-based company and abide by Reg S, a US securities law that allows companies to raise funds in foreign jurisdictions without breaking any US securities laws, there is nothing in this regulation that says anything about foreign securities laws in overseas jurisdictions.
So, yes, while it’s possible to offer tokens in foreign jurisdictions, US-based projects will still need to understand and abide by local securities laws. There is a considerable risk that local laws will be violated by incorrectly assuming Reg S enables securities to be sold to any investors in overseas jurisdictions carte blanche.
There are also grey areas as to what it means to be outside US jurisdiction anyway. Even if you fall outside a jurisdiction, regulations in the US can be interpreted in different ways. For example, having an offshore issuer may not alone mean a project is outside the US for securities law purposes. In a recent case, a court looked at where the validation nodes were located among other things.
In Asia, regulations around STOs are fragmented and dependent on what country you operate in. Like in the US, there are no specific regulatory exemptions tailored to STOs so companies must go through existing securities frameworks or work within exemptions. In Hong Kong, institutional investors can invest in STOs that are registered and compliant with regulations. In Singapore, a strict securities regulatory framework exists supervised by the Monetary Authority of Singapore (MAS) which has its own set of rules and exemptions while in China STO activities are illegal.
It’s a regulatory jungle out there
Claims that STOs offer easy access to a global pool of accredited investors is not true. In fact, the reality may well prove to be the exact opposite for small and mid-sized companies because complying with each jurisdiction will prove way too costly and complex. These costs and complexities lead to risks that startups and even mid-sized companies cannot handle and frankly make the entire STO endeavor not worth it. There is no access to a global pool of retail investors either because regulations in many jurisdictions explicitly prohibit this.
Nobody knows what the future holds but there is no sign of anything close to a global convergence of securities regulations. We’re in the early days, so regulators will be evolving and playing catch up for many years to come.
STOs don’t make fundraising easier and cheaper
Beyond compliance which requires an extensive amount of investor protections, financial reporting, KYC, AML procedures, and other tasks, there are several stakeholders that security token issuers will have to work with such as bankers, lawyers, accountants, exchanges, and custodians (read money sucking intermediaries). These intermediaries do things like underwrite deals and solicit investor interest in a compliant manner.
Companies with minimal funds, experience, and know-how will find it almost impossible to conduct a compliant STO on any sort of scale because the more jurisdictions an STO is offered, the more intermediaries, regulatory complexities, and costs increase.
If this were not enough, there is a lot of regulatory greyness which increases the risks of doing an STO as well. Here’s just one example. Because the tokens offered are regulated securities, does that mean every time it moves on a blockchain it counts as a securities transaction? If this is true, do blockchains need to be registered as some sort of trading venue to facilitate all the securities transactions?
There is also the business side to consider. Who’s going to attract the investors to this new form of investment? What’s the value proposition? STOs are no different from any other method of raising capital in this regard. Companies will have to solicit within the laws and have marketing spend to attract investors in traditional ways. They will have to push a hard sell because most investors will only come when there is true liquidity which doesn’t exist at this time.
Regulatory exemptions don’t necessarily ease the pain
Companies conducting an STO will no doubt target an exemption to ease their regulatory burdens. Exemptions do offer benefits, but they come with challenges as well. For example, in the US, tokens can be issued under Reg D, Reg A+ or CF. Reg CF caps the amount that can be raised and the amounts each investor can contribute. Reg A brings higher disclosure burdens, and a stricter qualification process and Rule 506 of Regulation D has an accreditation threshold.
Many exemptions also have a lock-up period for up to 12 months which can cause significant challenges for investor liquidity and thus the attractiveness of the investment in the first place. Offering the tokens in multiple jurisdictions also requires qualifying for multiple exemptions which require a deep understanding and the correct navigation of foreign regulation sets.
The point is, offering security tokens come with a whole lot of follow on implications and challenges, whether a project qualifies for an exemption or not.
Technology stacks might be incompatible with regulations
Thus far, for the most part, the majority of teams in the tokenized securities industry are building on top of the Ethereum blockchain as it is the most well known smart contract platform with decent levels of functionality. They are adding layer 2 solutions with different privacy features.
This approach may backfire because these solutions need to work around the limitations of the base protocol which are already built with some kind of concept in mind. Ethereum is an open and transparent ledger which is a problem as confidentiality is often a significant requirement for regulators as well as businesses. The blockchain infrastructure used by a project must adhere to confidentiality and accountability requirements set out in securities regulations to have any chance at offering a compliant STO.
If one of the main goals of putting securities on a blockchain is to take out the intermediaries in the heavily regulated securities market without losing regulatory approval, can this be done with current platforms like Ethereum? Do newer security token platforms understand the regulations? What if they break securities laws, who gets the blame?
Some projects are working on unique blockchain infrastructures to launch regulation-compliant tokens but which regulations will they base their platform on? How will they enable global STO offerings which must comply with different securities laws? How can a blockchain platform adhere to divergent securities regulations and what happens if/when these rules change?
There are also issues about how to regulate and verify a systems-based response to the acquirement of an asset. This is not just about immediate and once off verification. It’s about ongoing compliance and showing this compliance. How will this be built into a blockchain? How will intermediaries and regulators interact with these systems?
With regards to smart contracts, regulators are going to want to know what kind of testing has been done and is this testing being done on an ongoing basis? These are just two of the most straightforward questions surrounding the application of the technology. And what about the question alluded to previously. If a token is a security, does that mean every time it moves on a blockchain it counts as a securities transaction? If this is true, do blockchains need to be registered as some sort of trading venue to facilitate all the securities transactions?
There are simply too many unanswered questions that will take time to resolve. However, it would be reasonable to conclude that projects will need to have the technology stack that facilitates their STO approved by regulators prior to an STO launch. Taking all of these complexities into consideration, do we really think 2019 will be the year of the compliant STO?
A cold, hard, and highly regulated reality awaits
Many proponents of the security token offering fail to consider a seemingly obvious fact. STOs do not exist in a vacuum. Instead, they must fit in with a highly regulated financial world built up over decades. A world that features lots of moving parts, legacy systems, intermediaries and powerful incumbents with vested interests all of which have been designed around these established sets of regulations.
It is precisely these realities, the infrastructure of entangled, technologies, regulations and supporting human elements that make changes, especially significant changes, so hard to realize. And it leads me to my sobering outlook on the viability of STOs in the near term.
“We always overestimate what we can accomplish in one year and underestimate what can be accomplished in 10 years.”
Of course, the existence of these regulatory and technological challenges won’t stop the STO hype train from ratcheting up another gear or prevent investment from flowing in. The crypto community loves a good dose of hype and will no doubt continue to underestimate the cold, hard, regulated reality that awaits.
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Anthony is the head of content and research at Intrepid Ventures. He has spent the past several years researching and analyzing technologies and working with a diverse mix of blockchain companies to help them gain insight and develop authoritative content.
Also published on Medium.