Security Token Offering (STO) is considered one of the safest crowdfunding methods for blockchain and fintech companies. However, for it to be secure, there are quite a number of regulations that go along with it and anyone who chooses to use it has to adhere to all the regulations provided.
The entire scenario is complicated by the fact that there is no internationally recognized legal framework governing cryptocurrencies around the world. Therefore, individual countries are left to fetch for themselves as they race to feel the gap by establishing their own rules and regulations for cryptocurrencies together with anything else like STOs, ICOs, and IEOs that go along with them.
Generally, things have gradually changed with most governments accepting cryptocurrencies contrary to the past. For instance, when the first cryptocurrency, Bitcoin, was launched, it took some time for governments to accept it. At the time, governments were wary of digital currencies since criminals became too fond of them since they could enable them to transact anonymously.
The adoption of cryptocurrencies around the globe can be attributed to the various legal frameworks put in place by the various governments together with regional regulatory authorities.
Today, blockchain projects can almost flourish within any part of the globe. Most countries have accepted cryptocurrencies, with some even laying foundation for the development of their own state-owned cryptocurrencies. However, since blockchain technology is evolving fast, governments are now caught up with yet another handle, the regulation of the crowdfunding of blockchain projects.
To begin with, Initial Coin Offering (ICO) and Security Token Offering (STO) were among the first crowdfunding methods that were invented by blockchain developers. However, due to the fact that it was not easily regulated, scammers could easily get their hands on it to swindle funds off investors. That led some countries like China and South Korea to ban the use of ICOs in funding blockchain projects.
The embattled ICOs led to the invention of Initial Exchange Offering (IEO), which is simply an ICO run through a crypto exchange, so as to ensure that it was easy to apply some regulations to the crowdfunding.
STOs, on the other hand, were well regulated from the word go. Just as the name suggests, STOs deal with securities and governments already had certain laws governing securities within their borders. Therefore, it was easy to draft regulations for the STOs. Interestingly, these laws and regulations have made it quite difficult for developers to use it. Some fear the long process while others fear the strict rules that they have to adhere to in order to be allowed to conduct an STO.
What is an STO?
Before indulging into cracking the nut on the regulations and rules governing STOs, it is quite important to clearly understand what these STOs are.
An STO is a funding method that involves the selling security cryptocurrency tokens to potential investors.
The next question then becomes, what are these security tokens?
A cryptocurrency token can only be classified as a security token if it passes the Howey Test and is consequently subject to the federal regulations. Different countries have different regulations for STOs.
Holders of security tokens become part of the company behind the security tokens and are therefore entitles to some dividends out of the overall profit that the company makes.
There are four types of security tokens that a company could choose to use. These include:
- Equity tokens
These tokens are basically used to state the ownership of an asset like stock or debt for a certain company.
- Debt tokens
These are just like short-term loans to a company where there is an interest rate on the loaned amount.
- Utility tokens
These are the most common security tokens and they give users the ability to access the products or services of the project once the project becomes operational.
- Asset-backed tokens
These are tokens whose value is tied to a tangible or nontangible asset. For instance a company could have a security token whose value is tied to the value of real estate assets.
Reasons why security tokens stand out
- It provides an improved way of accessing real-world assets that have been digitized. Companies can digitize almost anything from debt, real estate assets to the parking fee.
- It provides investors with some degree of ownership and they are entitled to dividends out of the total amount of profit made by the company.
- Security tokens also provide increased liquidity.
- In comparison to traditional tokens, security tokens ensure that the founders or board members do not have to surrender board seats in Venture Capital deals.
- The regulations set in place ensure that there are no loopholes for scammers.
Steps of developing an STO
- Come up with a viable idea that entails solving a certain problem within the society/community.
- Carry out research on the probable solutions to the problem(s) that you intend to solve.
- Carry out research on other companies or projects offering solutions to the identified problem and identify key areas of improvement.
- Recruit a competent team for the development of the project and the STO. At this stage, you should also look for a competent legal advisor or a consultancy firm like Gravitas International to guide you through the regulatory handles. The regulatory mainly depends on your geographical location and you should ensure that you clearly understand what STO regulations are in place for your location.
- Identify the exact security within your project that you wish to tokenize. This tokenized security is what you shall offer in the STO.
- Choose a platform where you shall launch your STO. Examples of such platforms are Polymath and Harbor.
- Create a compelling website that clearly outlines your project goals and asset tokenization.
- Develop the security token with the help of your development team, and legal advisors.
- Market your STO in accordance with the set rules within your location.
- Launch your STO and offer the security tokens for sale to accredited investors in accordance with the set regulation within your location.
- Look for a good partner Security Token Exchanges where you shall list your security token.
Security token development
This is normally one of the hardest phases of STOs that make developers crack their heads. However, it is not as hard as people may think. All that is needed is the right team and legal advisor.
With STOs, you have to be careful to ensure that you stick to all the set regulations within your location from the word go. Normally, you should go for a consultancy firm that will help in auditing both the financial and legal matters concerning your project. The legal team should run jurisdiction checks on the security titles like credit ratings among others that you may specify for use.
STO becomes an exception when it comes to the type of tokens. Contrary to other crowdfunding methods that easily depend on Ethereum ERC-20 tokens, STOs do not use ERC-20 tokens due to the gas prices, protocol changes and network congestion that is associated with the ERC-20 tokens.
You could be wondering if Ethereum is not used, then what other platform is there for token creation.
Well, experts had to come up with platforms that could solve the issues with the ERC-20. Organizers and companies came up with new standards that enabled whitelisting and locking, which could enable tokens to comply with the required security regulations. These standards include ST-20, R-Token, ERC-1404, and ERC-1400. These standards still use Ethereum smart contracts, but they are improved versions that have an additional layer to accommodate regulations.
To make the process of creating security tokens, there are platforms dedicated to the creation of security tokens. Examples of these platforms are the Polymath, and Harbor platforms. These platforms provide an easy way of creating your security tokens.
The selected security token issuance platform should ensure that the value of the token is well scrutinized and in line with all the required regulations. It also takes you through all the remaining steps from setting the STO start or end date/time and payment acceptance.
The most important thing with STOs is that the required regulations have to be embedded within the smart contracts used for the STO.
What happens if your STO doesn’t meet all the requirements
- You will have problems getting your security token listed on security token exchanges. Normally, security token exchanges do not list STOs with legal issues. Worst, delisting from an exchange could greatly hamper your project brand.
- Failure to comply with the Anti-Money Laundering (AML) and Know-Your-Customer (KYC) requirements makes future relationships with banks a problem. In case you already had funds deposited in the banks, the banks could seize the funds.
- If you do not comply with all the regulations and laws set in place by the regulatory authorities within your location, the authorities could penalize you or even shut down the STO.