2018 was the year of the ICO. Everywhere you looked, crypto and blockchain companies were launching new tokens. The ICO market has slowed slightly in 2019. But there is a new crypto funding raising method: a Security Token Offering.
What is a Security Token Offering, and how does it differ to an ICO?
What Is a Security Token Offering?
A Security Token Offering is a cryptocurrency asset that derives value from an external, tradable asset. Any crypto token that passes the Howey test (more on this in a moment) is considered a security token.
Moreover, these tokens are deemed a security by the Securities and Exchange Commission (SEC) and can take advantage of certain exemptions that come with that status. On the other hand, they are closely monitored and regulated by the SEC.
An STO must register with the SEC before commencing the sale of tokens to the public. It is one way the SEC has added some regulation to the wild crypto investment and startup market. However, it isn’t compulsory and crypto startups and blockchain companies are free to approach fund-raising as they please (within the bounds of the law, of course).
The Difference Between ICOs and STOs
There is a fundamental difference in what an ICO and an STO offer in return for your investment. In the crypto world, there are two types of token:
- Utility: You receive a utility token in exchange for investing in an ICO. The utility token confirms that you can use the platform, whatever that is. Your token is essentially the price of admission. Some platforms and blockchains may offer additional perks to investing.
- Security: You receive a security token in exchange for investing in an STO. The security token is essentially a share in the crypto startup or blockchain project.
A security token, then, is a cryptocurrency token that offers investors the chance to receive a share of the business profits or a stake within the business. Also, note that there is no hard and fast definition of the Utility token. It is a term that has entered the common crypto lexicon.
There are other significant differences, too. To hold an STO, the company must register with the SEC. Registering requires the company to provide a detailed description of the company’s purpose, a description of the security token, detailed information on the company management structure, and a series of financial statements audited by an independent accountant.
Once registered, in the US, a security token must follow several SEC regulations, including:
- Regulation D 506(c): Requires verification that investors are accredited and that the information provided during the solicitation is “free from false or misleading statements.”
- Regulation A+: An exemption which allows the STO to offer the security to non-accredited investors through general solicitation (offering to the public, essentially).
However, the SEC is yet to approve a Regulation A+ STO, which cuts all but institutionalized investors out of the loop (in the US, at least). When a Regulation A+ STO is approved, you will be able to invest in and trade the token on the same day, unlike an ICO where you have to wait weeks for the token to even reach an exchange. That’s where the benefit of regulation comes into action.
How to Determine If a Cryptocurrency Is a Security Using the Howey Test
The Howey Test is used to determine if a non-traditional asset is a security or not. The name originates from a Supreme Court decision in 1946: SEC v. W.J. Howey Co.
The original lawsuit involved the Howey Company of Florida, which operated a large citrus farm. When Howey Co decided to lease half of its land to “finance an additional development,” it posed the question of whether the land itself could be considered a security.
The investors in the land possessed none of the “knowledge, skill, and equipment necessary for the care and cultivation of citrus trees” but expected a return on their investment. The speculators invested in the land sale on the assumption someone else would run their portion, and they would see a return on the investment.
The Supreme Court ruled that because the investors only saw value in the land with the prospect of others continuing the work, it was an investment contract rather than a land sale. Howey Co should have registered the investment contract with the SEC. As they hadn’t, it violated investment law.
The Howey Test is particularly applicable in the context of cryptocurrencies. As the crypto space continues to grow, the SEC wants to shape and define the limits of cryptocurrencies and their relation to security investments. If the SEC decides that a prospective crypto token is a security token, it must comply with SEC regulations. Alternatively, it must not sell any tokens to US investors, period. (The latter is why many ICOs and crypto projects do not do business in the US.)
Do STOs Make Cryptocurrency a Safer Investment?
The SEC stepping in to regulate and restrict what an STO can offer officially is a massive plus for investors.
The flourishing open market of ICOs was a sight to behold, and some would argue the true vision of a decentralized funding system. That lack of oversight allowed some projects to generate hundreds of millions of dollars of investment without regulatory checks. What many ICO investors want, though, is a massive investment turn around. Once an ICO token hits some of the big exchanges, investment profit margins can soar.
The STO wouldn’t do away with that potential. At least, not in its entirety. A regulated STO investment market would attract more institutional investors, in turn pumping more into the crypto ecosystem to help it flourish. Theoretically, the STO also cuts out the third-parties that prey on the ICO market, hopefully further decreasing price manipulation and other fraudulent investment practices.
Will STOs Replace ICOs?
In the short term, definitely not. The barriers for entry to an STO make it unappealing for the overwhelming majority of new cryptocurrency projects. Why artificially limit investment potential when the successes of the unregulated ICO are plain to see.
In the future, there is a strong chance STOs will gain parity with ICOs, especially if cryptocurrencies and blockchain technology continues evolving as it has done.
The involvement of the SEC and other regulatory bodies was always going to split opinion. For some, the lightweight oversight is welcome. There is no demand that each new token becomes an STO; it just wouldn’t work that way and the SEC knows that.
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