The boom of initial coin offerings (ICOs) in 2017 and 2018 brought a new and unprecedented way for fintech firms to raise funds in minutes without going through the traditional route of initial public offerings (IPOs).
But the boom brought along a bust as the majority of these ICOs turned out to be scams, white paper ideas that never saw the day of light, and projects that ran out of money without quite kicking off.
It’s not long ago that the ICO model went bust but it was the first iteration of the crowdfunding model that will likely last for decades to come as decentralized finance (DeFi) takes center stage.
We are moving into an era where startups are tokening real assets in an attempt to raise money from the masses. However, these companies must comply with securities laws laid by the US Securities and Exchange Commission (SEC).
The SEC has ruled that all crypto assets – save for Bitcoin and Ethereum – are security tokens. And this is why the next step in this kind of crowdfunding is the Security Token Offering or STO for short.
What is an STO?
An STO borrows some of its properties from initial coin offerings. Just like an ICO, an investor receives a security token or coin as a representation of their investment. Unlike ICOs, the security token offers an investment contract backed by real-world assets such as stocks, bonds, or more.
In the traditional world, a security is a representation of company ownership with physical monetary value.
A security token represents ownership of an investment contract but recorded on the blockchain. When you buy shares or stocks of a company, you are given a document to authenticate your ownership. The same goes for security tokens, except that there is no paperwork involved but the blockchain.
In essence, STOs bridge the gap between the wild west of initial coin offerings and the more regulated traditional world of initial public offerings.
Differences between ICOs and STOs
STOs are backed by real-world assets and are in good standing with regulators. On the other hand, the majority of ICOs are utility tokens that give investors the privilege to use a specific platform or smart contracts.
ICO issuers argue that the tokens are not designed for investment purposes and as a result, are able to circumvent regulation.
This makes it very easy for ICOs to raise funds from almost any member of the public because of the lack of regulatory compliance. It is a different case for STOs as they have to offer their tokens under strict securities laws. This means that they have to sell their tokens to accredited investors.
A company that wants to issue a security token needs the support of the following stakeholders:
- Legal – STOs need to work closely with lawyers and those in the legal industry as they have to comply with securities laws in the jurisdictions they want to operate in. Failure to do so would result in securities regulators taking action against the projects. This is why too many ICO projects ran into legal battles with regulators in 2018.
- Issuance platform – an STO project needs to work with leading issuance platforms in order to gain the trust of investors.
- Custodial services – STO projects need third parties to store their tokens. These could be exchanges or issuance platforms.
- Exchanges – security tokens can only be listed on regulated tokens. We will likely see more exchanges getting regulatory licenses in preparation for listing security tokens.
Why STOs are good for the ICO industry
Now that the ICO bust is becoming a reality, there is solid evidence to believe that security tokens are important for the future of the industry. Here are the reasons why.
STOs comply with security requirements. This means that investors have to spend less time figuring out if the people behind the project are legit. Their only job will be to research how sustainable and profitable the business model will be.
A new direction for the industry
The crypto industry has long been seen as a wild west propagated by anarchists and people with nefarious intent. However, security tokens will likely change that as regulation attracts institutions and accredited investors who will give the sector a new image. The inflow of institutional capital will stabilize the industry and give it more credibility.
Investment for everyone
ICOs were lauded for allowing people of limited income to invest in startups with the potential for heavy profits in the future. STOs have the potential to continue that torch and allow people of low income to invest in startups and exciting technologies. This is an advantage for companies as well as they have a large pool of people to raise funds from.
Tokens become securities
Security tokens can be traded as securities. This affords investors voting rights, ownership, and more. This will take the industry mainstream. It will no longer need to push for adoption from the shadows as it did in the past decade.
Higher success rate
ICOs were mostly doomed to fail because it was only a team with a white paper and no working product that raised millions in seconds. STOs have a higher chance of success rate due to increased scrutiny.
Ownership of real assets
Investors in ICOs did not own anything more than the promise that the token would be used as a core driver of the blockchain platform being developed. In security tokens, investors have an ownership or real or physical assets.
Innovation and new products
A regulated environment will give the industry more credibility, leading to more research, and capital flow to support new ideas.
This fanfare around security tokens should not make us blind to its immediate drawbacks for the majority of the stakeholders. For example, companies are still trying to figure out how to navigate regulatory requirements for issuing security tokens.
This could affect exchanges that don’t know how to treat security tokens. And most importantly, STOs may close the investment door for retail investors – the same people who made the industry what it is today.
Despite these drawbacks, STOs are the future now that the ICO boom has hit a dead end. There is a lot of bullish sentiment when it comes to security tokens. The recent activities in the industry such as Facebook’s Libra project have just made people realize that this industry is too big to go unnoticed.
It took the ICO industry a number of years before reaching its peak in 2017 and 2018. The same will likely happen for security tokens, except that they will likely last longer at their peak than ICOs did.