The excitement that initial coin offerings (ICOs) have created in the past few years has been marred by an onslaught of scams, hacks, and critical mistakes committed by careless investors. As it turns out, one of crypto’s biggest appeals — limited oversight and regulation — has proven to be its greatest vulnerability.
But cryptoassets are already coming of age. With the arrival of the security token offering (STO), the crypto space is beginning to reach an uncharted level of legitimacy in the financial community. We are about to witness perhaps even more disruption in markets and society than we’ve been promised.
What exactly is an STO?
The STO is the safe, secure, and sensible answer to the ICO. The word “security” in the name says a lot: Security tokens have to be backed by a tangible asset, like a company’s profits or shares. On the other hand, ICOs involve “utility coins,” which have the potential to amount to little more than a promise or a souvenir.
STOs also require licensing approved by the SEC and other regulatory bodies. In other words, security coins have the features and protections of traditional assets, such as a share of company stock, while also leveraging the benefits of being a digital asset. And virtually any kind of physical asset — real estate, equity, etc. — can be “tokenized,” or used to back a security coin.
Here’s why STOs will matter for crypto investment:
Security tokens accelerate the democratization of venture capital
For decades, the world of private equity was reserved exclusively for venture capital firms and accredited investors — individuals with a net worth of at least a million dollars or with an annual salary of at least $100,000. But when Title III of the JOBS Act went into effect in May 2016, suddenly anyone could invest in private companies. It was a major win for everyday investors, and several equity crowdfunding portals opened up, showcasing many compelling opportunities in private equity.
Then 2017 happened. The advent of cryptocurrencies, blockchain technology, and smart contracts opened up an even more efficient way for entrepreneurs to raise capital without the use of a middleman, as well as the promise of a more equitable and democratized private equity landscape. While its ICO was accessible to the public, not just accredited investors, messenger app Telegram raised $850 million, marking one of the largest fundraising events in the history of tech.
Companies like Securitize, Polymath, and Harbor have become leaders in the movement to tokenize all kinds of traditional assets into security tokens. As a fundraising vehicle, security tokens allow companies to raise capital without having to lean on investment banks and stock exchanges as intermediaries. Spice VC, for example, is a tokenized fund, as is Blockchain Capital.
Given the oversight from the SEC and other regulatory bodies that security tokens are subject to, investors are able to invest in an opportunity without worrying about being scammed. Their only concern is the financial success of the company, as is the case with stock ownership. The financial regulatory framework in the U.S. creates a favorable landscape for STOs to thrive. The already corporation-friendly state of Delaware stands out in particular, as it now allows companies to write shares on a blockchain.
Above all, security tokens give companies an efficient way to raise capital from a broader investment pool than has ever been possible. This means innovation is accelerated and more people stand to benefit from a company’s success. Of course, easier access to capital creates a more competitive landscape, so companies that are doomed to fail will realize this inevitability sooner.
Traditionally illiquid investments are made liquid
As the old adage goes, it takes money to make money. But the advent of blockchain may do away with that notion. Before, several investment classes — including those with the highest and most bankable returns — had a prohibitively high barrier to entry.
Thanks to the technological breakthroughs of security tokens, this is no longer the case. Distributed ledgers enable the tokenization of otherwise illiquid assets, such as real estate and fine art. Security tokens allow fractional ownership, and the issuer determines how fractional that ownership is. This means virtually anyone who wants to own real estate in a place like Manhattan, for example, is able to. Even the most expensive piece of real estate, once it’s tokenized into a security token, can be divided into portions that anyone can afford. The same goes for fine art and other asset classes previously reserved for the super wealthy.
One might think this is comparable this to owning shares of a real estate investment trust (REIT), but becoming an owner of tokenized real estate offers far more flexibility, as you have more autonomy over the properties you own.
But everyday investors are not the only ones who win in this case. If you’re the owner of a multimillion dollar piece of property or a rare Cézanne and you want to turn it into cash, it can be difficult to find an individual with both the net worth and the interest to take it off your hands. By tokenizing whatever expensive piece of property it may be, the ownership can be divested to dozens or even hundreds of investors who may want to lay claim to it. That way, a valuable and expensive piece of property is no longer destined to sit around and collect dust.
The first known prominent example of this is the iconic Andy Warhol painting “14 Small Electric Chair” (1980), which was tokenized and offered for fractional ownership by the decentralized art gallery Maecenas. It certainly won’t be the last.
It’s still early days for STOs
We’ve seen remarkable progress in the development of security tokens, but there’s much to be done to broaden the scope and capacity of STOs. The very first exchanges specializing in STOs are just starting to go live. Companies like Polymath and Harbor are busy developing standard restrictions for tokenized assets and security tokens. Fully compliant exchanges such as Templum have obtained broker dealer licenses to host private placements (although these would only be available to accredited investors). Other compliant exchanges Open Finance and tZero aim to do the same.
But many challenges still persist when it comes to the broad adoption of STOs. For example in most countries, current laws allow only accredited investors to buy security tokens. Yet there are few mechanisms in place so far to ensure this kind of trading is possible only in wallets belonging to verified accredited or institutional investors. There’s also the question of verifying proper custody.
Believers in blockchain and cryptocurrencies should not be discouraged by the rampant fraudulent activity that has tainted cryptos and ICOs. Instead, it has only accelerated the rate of innovation to make the revolution of digital currencies and digital ownership safer, more equitable, and more secure. The present and future are both bright for security tokens. Should progress continue as expected, we are certain to see a more democratized investment landscape.