Security Token Offering (STO)

WebTalk

A Security Token Offering (STO) is an event at which digital securities are issued.

For an STO definition, one must first ask oneself: what are security tokens? They are considered the second generation of crypto tokens . While  ICOs  are referred to as utility tokens these days, security tokens are fully regulated and tokenized investments with an investment focus. Essentially, security tokens are blockchain -based digital assets that generally comply with the regulations of the respective securities regulators.

What is an STO (Security Token Offering)? ICO vs. STO

After the ICO bubble burst at the end of 2017, the token-based collection of venture capital was over in the medium term. The problem at the time: the token economy was still in its infancy, there were hardly any mature business models and the lack of regulation tempted fraudulent companies to scam.

Are security token offerings legal? This is exactly where the difference to ICOs lies. Because security tokens grant investors the same rights as traditional financial market issues. For this reason, securities regulators must first approve security token offerings – just like capital market products from the traditional financial sector. Once this is done, executing an STO is legal. In contrast, the legal status of utility tokens is still unclear.

Security tokens pursue a funding goal; the prospectus must clearly define what the value of the investment is based on. In contrast to utility tokens, security tokens are officially approved securities in token form.

Digital vouchers vs. digital securities

While utility tokens are a type of digital voucher, STOs are funding methods and are clearly labeled as such. The reasons for ICOs can be varied. Most of the time, companies link dedicated services to utility tokens, such as the right to use a platform.

On the other hand, the reason for performing an STO is to generate equity or debt. Security tokens are not tied to usability on the respective platform, but pursue a funding goal. The advantage: While ICOs are usually reserved for companies that are already active in the blockchain ecosystem, STOs can be carried out by any company.

Medium-sized companies in particular, which have so far been denied access to the stock exchange, have a tried and tested means of raising capital with STOs.

Where are STOs traded?

During the token sale, investors can buy the tokenized securities directly from the issuer. There is no need for any sort of intermediary like in traditional IPOs. The purchase is therefore peer-to-peer.

Secondary market for STOs

As with stocks and bonds from the traditional financial sector, there is also a secondary market for STOs. Because security tokens are regulated financial products, the exchange operators must be regulated. Crypto exchanges like Binance are out of the question for a secondary market.

However , security tokens are fungible instruments, and the signature is made using a private key. Accordingly, private resales away from the stock exchanges are already possible.

In addition, there are regulated exchanges in other European countries that are approved for trading in security tokens .

A distinction must be made between regulated state exchanges such as the Gibraltar Blockchain Exchange and regulated private exchanges. While there are already individual examples of the latter, investors will have to wait a little longer until state STO exchanges are launched. Investors are particularly excited about state token exchanges. Finally, STO-compliant state exchanges would legitimize the funding vehicle.

STO vs. IPO

But what is the difference to the traditional IPO?

Advantages of STOs over IPOs:

  1. efficiency

The appeal of STOs is that the fundamental capital markets vehicle of tokenized corporate finance holds promise for both investors and entrepreneurs. Since companies can sell securities without the help of intermediaries such as stock exchanges, Security Token Offerings (STO) offer immense potential for liquidity.

STOs are significantly “leaner” in their structure than IPOs. Because issuers cut out a number of middlemen, STOs are significantly cheaper than IPOs. The big advantage: Due to the peer-to-peer character of crypto tokens , companies no longer even have to set up a stock corporation. Medium-sized companies can also take advantage of this means of increasing capital.

STOs therefore lower the barrier for small and medium-sized companies to bring in capital – an enormous use case of blockchain technology.

2. Exchange Trading Hours

Order placements on the Frankfurt Stock Exchange are only executed during the trading hours between 8 a.m. and 8 p.m. All placements placed by brokers after 8 p.m. are not matched until the following trading day.

The blockchain , on the other hand, is always “open”. Traders can trade security tokens 24/7 and 365 days a year. Information is therefore priced in much faster and should lead to a more efficient market.

3. Fractional Ownership Claims

Asset classes such as real estate, works of art or shares sometimes have high unit costs. They are often so high that private small investors have little access to these markets.

The situation is completely different with STOs. Security tokens allow high-priced assets to be scaled down into individual tokens . In this way, even investors with less deep pockets can claim fractional ownership of stocks, bonds or valuables and thus gain access to markets that were previously closed to them.

A single share of Alphabet Inc., for example, cost over 1,050 euros at the time of writing. A possible use case of fractionation can be shown with high-priced assets like this one.

4. Fast processing

While transferring ownership of traditional assets usually takes several days, security tokens can change hands almost instantly. This is only limited by the block times of the underlying blockchain .

5. Cost Reduction

STOs offer a significant cost advantage for both issuers and investors. On the one hand, STOs can be made cheaper by the provider than IPOs. And on the other hand, investors save costs for intermediaries such as banks or brokers.

This is the advantage of the token economy: middlemen are gradually becoming obsolete due to the peer-to-peer nature of cryptocurrencies .

6. Investor Protection

It is true that STOs do not individually protect against the total loss of deposits. However, the regulated environment of STOs makes exit scams, which occur again and again with ICOs, unlikely. After all, the supervisory authorities (in Germany the BaFin is responsible) must first agree to a prospectus that has been submitted. That doesn’t mean it’s a risk-free investment or that bubbles can’t develop. However, fraudulent perpetrators can be identified much more easily.

Investing in STOs involves the same financial risks as traditional investments.

7. Compliance

With rights come responsibilities. The practical thing: security tokens are programmable assets. This has the advantage that issuers can design tokens in a way that automatically ensures compliance with legal regulations.

For example, investors must identify themselves before making a purchase; one speaks of so-called know-your-customer regulations (KYC).

Token Standards

Similar to ICOs, there is also a token standard for STOs. The well-known ERC-20 standard  is out of the question for security tokens. Finally, the official requirements also include compliance with the current KYC guidelines. ERC-20 cannot afford that. An STO-compliant token standard must be able to reliably exclude certain groups of buyers (so-called black listing). The following token standards with STO compliance already exist:

1.ERC-1410

ERC-1410 builds on ERC-20 and ERC-777. The aim of this standard is to build an optional fungibility. This means that a part of the circulating set can be equipped with properties that only this subset has.

2.ERC-1404

This token standard is designed to be as easy to use as the ERC 1400 standard. Above all, the issuer can control two restrictions:

  • detectTransferRestriction : Issuers can use this to control transfer restrictions. Investors on so-called black lists can, for example, be excluded from token sales.
  • messageForTransferRestriction : This function informs investors about the reasons for the transfer restriction.

3. ST-20

The ST-20 standard is the security token standard from Polymath. Based on ERC-20, it expands the functionality of the widespread ERC-20 standard to include compatibility with STOs. Compliance requirements can be adapted to the respective token using a modular system.

4. R token

The last one in the bunch is also based on ERC-20. However, issuers retain control over the token transfers.

Conclusion on Security Token Offering

Token sales as a funding vehicle are experiencing a revival after the ICO debacle. And that’s good news. Because the basic idea of ​​circumnavigating the army of intermediaries between suppliers and buyers of assets is promising. Since Security Token Offerings reduce friction losses, they are the (cost) efficient alternative to traditional financial market issues.

On the supplier side, they offer small and medium-sized companies an attractive means of generating capital. On the demand side, promising opportunities for capital investments in medium-sized companies, apart from the DAX and Dow Jones, should arise in the future.

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