What is a Security Token Offering (STO)?

What is a Security Token Offering

The phrase “security token” or “security token offering” have been bantered about quite frequently in recent months. It has been stated that 2019 will be “The Year of the Security Token”. But, what is a security token, or security token offering?

Let’s discuss here what a security token is, and how a security token offering (STO) differs from initial coin offerings (ICOs).

If you remember, during 2017 and 2018 there was an ICO frenzy, where billions upon billions of dollars were raised to fund these so-called “projects”. This is what gave rise to the >2000 alt coins that came into existence within such a short period of time. Most of which are defunct now. I’ve really only heard news on the top 20, maybe most of the top 50-75 coins, yet there are over 2000 coins in existence (according to CoinMarketCap). Of the >2000 coins, with a total market cap of ~$120 billion, the top 10 coins compose 85% of that market cap (~$102 Billion), and the top 20 coins compose 90% of the market cap (~$108 Billion). This means that 10% of the market cap (~$12 billion) is spread out over 1,980 coins…

Anyway, I digress. The point is that the overwhelming majority of the ICOs that sprung into existence in 2017 were utterly useless and most were outright scams. Even if there were trying to be honest, they were simply inadequately prepared or inadequately skilled/determined to succeed.

In the news, you may have heard of the SEC (Security and Exchange Commission) make statements against the ICOs that they were unregulated securities offerings and that they would face penalties. Over 2018 and early 2019 the SEC has issued warnings and filed suits against the confirmed unregulated securities offerings masquerading as ICOs.

So what is a “security” to begin with?

A “security” in the financial sense has nothing to do with being safe/secure. A security refers to a stock/share or having a stake in a financial asset, company or investment vehicle.

The different types of securities:

  1. Stocks/ETFs
  2. Bonds/debt
  3. Real Estate
  4. Private, illiquid assets:
    • Gold/Silver
    • Art
    • Jewellery (i.e. diamonds, etc)
    • Historical Artefacts

Primarily I will be discussing the first three types of securities: stocks, debt (bonds), and real estate. Most particularly stocks, since they are the most applicable and easiest to understand when explaining security token offerings.

The Evolution of Securities Ownership

Originally, when a company issued stocks, it issued paper certificates, each representing a certain number of shares. A regulated custodian (regulated broker or Bank, or Trust) would hold the stock certificates on behalf of the owner.

As technology progressed in the 20th century the stock certificates were recorded on an electronic spreadsheet. This is how stocks and other securities are functioning today, similar to fiat money on electronic bank accounts. You can buy and sell stocks, bonds, and ETFs with your online stock broker. However, it still takes many days (at least 3-5 days) for the transaction to be settled and completed.

The next stage of financial evolution is the STO, security token offering. This is a digital token (digital asset), much like a cryptocurrency, on a blockchain. It is the digitization of stocks. Although, this has just been developing over the last 1-2 years and is not widespread.

Security Token

 

Setting the Stage for Security Tokens:

In order for security tokens to become widespread, there are a few prerequisites that must be met. The problem with the ICO frenzy in 2017 and 2018 was that >98% of them were unregulated security offerings (based on the Howey Test). Which means that for a Security Token Offering to function legally, it must register with the Security and Exchange Commission, file all the necessary paperwork and meet all security offering criteria and regulatory guidelines. It is essentially an IPO (Initial Public Offering) but a digitized version.

Additionally, the world will need:

  • Institutional custody solution
  • Licensed security token exchange
    • These solutions are already well underway. See more below!
  • Regulatory clarity (likely the easiest to achieve since STOs do not seek to change the definition of a security, but merely to change how they exist and are delivered).

Advantages of Security Tokens

It is important to remember the real function behind cryptocurrencies such as Bitcoin, Ethereum and XRP. They are networks of value (akin to the Internet being a network of information) that are programmable. Cryptocurrency as a medium of exchange or store of value is only the first, most basic application of this computer network program.

This brings us to some of the advantages of having security tokens. Security tokens are not merely stocks, ETFs, bonds, real estate, etc – they are programmable.

Security Tokens will:

  • Unlock liquidity 
    • Global (not regional) markets, near instant settlement, within seconds (compared to 2-5 business days).
    • Fractionalize large assets such as real estate to allow for deeper liquidity. Rather than selling the entire property or taking a mortgage loan you could sell a fraction of your property. This can give someone time to buy up a property without having to incur debt and gives the owner the ability to access liquidity in their home without having to sell or mortgage.
  • Open 24/7 
  • Transparent
    • On an international, open blockchain you can see all transactions, how many dividends were paid out to whom; who owns how many shares of each company/asset etc.
  • Faster and cheaper to make trades/transactions
  • Programmable
    • Easier to pay out dividends to owners
    • Voting and corporate governance can be automated, or made easier with shareholders being able to participate online via their security tokens.
    • Programming security tokens to enforce regulatory laws regarding who can sell or buy shares in what timeframes (i.e. corporate board members, or insiders), to avoid insider trading.
  • Bearer assets – if you hold your own private keys to stocks you could potentially be a true bearer owner of the shares. This would not work the same with real estate or other assets such as art or jewellery particularly well, but it does for stocks.
Security Tokens Will Dominate

 

Current Security Token Platforms:

There are a number of companies in the cryptocurrency industry that are, or are becoming, regulated platforms to buy and sell tokenized securities much like how stocks, bonds, ETFs, derivatives etc are bought and sold today.

  1. tZero
    • Enables investors to trade security tokens via a digital securities brokerage at Dinosaur Financial Group.
    • I believe that it will utilize its own tZero token as the blockchain on which the stocks are tokenized, however, I cannot find further details on this, at this time.
  2. Templem
    • Has received US$10 million in funding from Japan’s SBI group, which is heavily invested in Ripple and XRP. While I cannot confirm, I would expect that the Templem platform may tokenize securities on the XRP blockchain.
  3. Polymath
    • Using the Ethereum Blockchain to create security tokens on an ERC20 platform.
  4. OpenFinance Network
    • States to be an open, interoperable trading platform for secondary markets (typically less liquid, must be accredited investors or businesses, basically trading security tokens of large private business with shareholders [i.e. Ripple]). Uses an “R-token” Standard which is an extension of the Ethereum ERC-20 tokens and compatible with all ERC20 wallets.
  5. Securitize
    • A company that follows regulations to assist corporations in tokenizing assets or initiating an STO. It is also a platform to help corporations manage the digital tokens (i.e. dividend issuance, votes/governance, etc).
    • Utilizes the Ethereum Blockchain, as well as the XRP blockchain. I believe that securitize will work with multiple blockchain platforms for creating securitized tokens.
  6. Abra
    • A mobile, non-custodial wallet app with a trading platform that allows users to invest in 30 cryptocurrencies and 50 fiat currencies.
    • Currently allows you to invest in tokenized stocks such as Alibaba, Alphabet (Google), Apple, Amazon, Coca-Cola, Exxon Mobile, Netflix, Facebook, and many more, based on Bitcoin smart contracts (crypto collateralized contracts, C3s).
  7. DX Exchange
    • A fully European Union regulated digital exchange.
    • Allows you to buy and sell cryptocurrencies, fiat, and digitized stocks. The stocks are bought based on prices from world-wide leading exchanges such as the NASDAQ, NYSE, Hong Kong Exchange, and Tokyo Stock Exchange. The bought stocks generate smart contracts and ERC-20 tokens (that now represent each stock).
  8. World Markets
    • A peer-to-peer blockchain marketplace for cryptocurrencies, tokens and tokenized securities. Already live, it allows you to invest fiat, cryptocurrencies and to purchase real stocks with Bitcoin (prices are even quoted in BTC).
    • The smart contracts of the underlying security token (stock) is powered on the Bitcoin blockchain.

The transition from Traditional Stocks to Security Tokens

Currently, when you purchase the digital version of a traditional stock, the shares are bought on a traditional exchange and wrapped in a cryptocurrency smart contract that then is a digital token representation of that electronic (old school) stock (all of this work is done in the background so no need for you to worry). Much like how electronic records/copies of paper certificate stocks were made decades ago to transition paper stocks to electronic versions.

What is a Security Token Offering

Moving forward, I believe that the norm will be that STOs will replace IPOs and corporations will now initially issue security tokens that originate on the blockchain as opposed to being backed up on the blockchain. All security tokens will be forms of smart contracts. This may take 3-5 years before widespread adoption (2022-2024), but hopefully sooner.

Security Token Offerings on Different Blockchains.

As you may have noticed above, the various security token exchanges or digital stock exchanges utilize a specific blockchain. The only ones mentioned above were Ethereum, Bitcoin and XRP (indirectly)… and tZero token. There were no smaller cryptocurrencies mentioned (i.e. Litecoin, EOS, Tron, NEO, Monero, Zcash, Stellar, etc), … other than tZero.

The development of security tokens based on the top three blockchains will only further increase their value for two reasons.

  1. The value of these markets will “pass through” the cryptocurrency network. This is like owning the only train station into town. Everyone will have to use your train, so you will have a very valuable business. Another analogy is like being the only internet provider in town; likewise, everyone will need to use your internet network services, making your internet service very valuable. Similarly, if trillions of dollars of stocks (~$30 Trillion) will pass through the top 3 cryptocurrencies, this will GREATLY increase their network value.
  2. Increases the network effect. Like Metcalfe’s Law that I mentioned in one of my other posts. The larger the network of something, the greater its utility and value. This 100% applies to cryptocurrency.

Other Implications of Security Tokens?

  • Potentially could make stocks bearer assets and hold them privately on a hardware wallet.
  • Could theoretically be paid in stocks, just like you could be paid in cryptocurrency.
  • Could theoretically use tokenized stocks as payment for things – although like not practical as this would lead to a capital gains (or loss) event.
    • I.e. using Apple stocks to buy Google stocks… instead of selling into fiat or cryptocurrency first. Totally possible, but likely not implemented yet.

Markshire Conclusion on “What is a Security Token Offering”

Of the cryptocurrencies mentioned above, Ethereum seems to be being utilized the most and will be used to tokenize securities on: DX Exchange, Securitize, Polymath, and OpenFinance Network. Bitcoin is being used on Abra and World Markets. XRP is suspected to be used by Templem, backed by Japan’s SBI holdings as well as Securitize. Although I bet that there are other platforms working with Codius/R3 or Xrping to bring more security tokens on the XRP ledger.

It is too early to tell which cryptocurrency will control the largest volume of transactions or dollar value of securities being traded over their respective blockchain networks. Even though Ethereum seems to have the most number of exchanges utilizing them, it comes down to volume and value being transmitted over the blockchains, as well as the ability for the cryptocurrency to handle the volume transactions.

I personally believe that all three of the top cryptocurrencies will be massively successful. It is a VERY large market out there and there are plenty of assets to be tokenized. Over US$30 Trillion in stocks, even larger bond market and global real estate market of ~US$217 Trillion.

Moreover, once tokenized, I highly suspect that the securities will be able to cross platforms in some form of interoperability ledger/network.

Additionally, the current stock arena is highly regulated to prevent fraud and insider trading and protect the average investor and large institutional investors.

I believe that the STO revolution will allow digitized stocks to be traded without the NEED for a trusted third party, and perhaps there will be some decentralized platform to help censor insider traders/fraudsters.

However, there will definitely be a certain degree of government regulation in the stock market space. Which, to be honest, I am not entirely against. I’m a pretty innocent investor so I would hate to be scammed or played by a bad actor.

Well, that was certainly an interesting topic. Please let me know if you would like to add anything, as a question or make a comment in the comments below! I would love to hear from you!

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Author: Markshire Crypto

Millennial cryptocurrency investor, writer and marketplace researcher. Founder of Markshire Crypto. Mark has been involved in the cryptocurrency industry since 2017, following the industry daily and creating content.

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