Security Token Offerings: the Second Life of Initial Coin Offerings?

ICO, UTO and STO: a brief history of three acronyms.

2018 was the year of the peak of Initial Coin Offerings (“ICO”): the issuance of a new cryptocurrency exchanged for existing cryptocurrency (usually Bitcoin and Ether) or fiat currency.

The main object of ICOs has been the so-called utility tokens, which are a digital value, almost always compliant with the Ethereum ERC-20 standard, which gives the holder the right to purchase goods and services present on the platform of the issuing entity, expressly excluding monetary, speculative and participatory purposes.

ICOs have received a great deal of attention from regulators, and in many circumstances, utility tokens have been classified as security tokens, that is, real investment forms such as profit sharing, voting rights, and bond loans. With all that this entails in terms of sanctions. Therefore, the market has begun to perceive utility token offerings, or UTO, as a phenomenon, on the one hand, an expression of technological startups with blockchain solutions, and on the other, uncertain from a regulatory point of view, with consequent risks and costs in terms of legal compliance.

This generalized approach led the market to deepen, in 2019, Security Token Offerings (“STO”) in relation to which the regulatory context is clearer and more consolidated, applying, net of applicative peculiarities, the rules on the issuance of financial instruments. In addition, STOs do not require a blockchain project as an underlying asset: any type of company can theoretically exploit STOs as a fundraising tool.

For example, as early as the second half of 2017, the US Security Exchange Commission reclassified almost all UTOs as STOs (see the recent Telegram case), soon followed by the Canadian Securities Administration. Even the People’s Bank of China had a very severe approach: on September 4, 2017, it declared ICOs illegal.

A more open and optimistic attitude was registered by the Securities and Futures Commission of Hong Kong and, in particular, by FINMA (Switzerland) and the Monetary Authority of Singapore: both, by disseminating appropriate Guidelines to signal the discriminatory elements between UTO and STO, allowed these jurisdictions to become a reference point for many crypto projects.

An additional step forward was taken by Malta which, in 2018, approved the Virtual Financial Asset Act to regulate UTOs, and by San Marino which, in 2019, approved a delegated decree for the issuance of utility and security tokens.

On January 2, 2020, CONSOB published the Final Report entitled “Initial offers and exchanges of crypto-assets” following a public consultation that opened on March 19, 2019, and ended on June 5, 2019, which is a proposal for the regulation of UTOs.

Examples of STO

As mentioned, STOs involve the issuance of security tokens, which are financial instruments and products in the form of tokens on a blockchain. However, depending on the rights incorporated or represented, subcategories are possible, such as:

• Investment tokens: tokens with speculative purposes, such as participatory financial instruments;
• Asset tokens: tokens representing a tangible (diamonds) or intangible (song) asset or credit right;
• Debt tokens: tokens representing a debt, such as bonds;
• Equity tokens: tokens representing the share capital of the issuing company (known as Equity Token Offering or ETO).

In terms of classification, in 2019 we witnessed the first attempts to adopt STOs. The fintech company “20/30” raised £3 million through the issuance of six million equity tokens at £0.50 each, authorized by the Financial Conduct Authority and in collaboration with the London Stock Exchange, the first stock exchange to experiment with an STO through the Turquoise platform/market.

Neufund, authorized by BaFin (Germany), conducted an ETO with a minimum investment of €100,000. The tokens allow for the expression of voting rights through smart contracts.

Procedure

An STO typically consists of the following phases:

• Identification of the rights to be incorporated in the security token;
• Identification of the subjects to whom the security token will be offered;
• Legal classification of the security token within the various financial instruments recognized by the legal system;
• Choice of the blockchain platform on which to issue the security token;
• Preparation of documentation for regulatory compliance (e.g., informative prospectus);
• Drafting of a contract for the sale of the security token (investment contract, possibly in the form of a Simple Agreement for Future Tokens – SAFT);
• Publication of a Whitepaper describing the entrepreneurial project, the STO, and the security token;
• Private pre-sale of the security token;
• Public STO;
• Issuance of the token;
• Listing of the security token on dedicated exchanges.

Differences from UTOs

Aside from the characteristics of the aforementioned tokens, STOs present two peculiarities compared to UTOs.

First, as mentioned, STOs can be adopted by any company regardless of the business model. In this case, blockchain technology is used only to manage the issuance and transferability of the token, activities that can be managed through third-party providers such as Smart Valor and Polymath. For example, an industrial company could issue tokenized participatory financial instruments related to a specific business sector or dedicated assets. In other words, there is no need to develop a proprietary technological platform with specific tokenomics logic to exploit the potential of an STO.

Additionally, the tokenization of financial instruments and products allows for the creation of a more liquid secondary market than traditional exchange systems.

Conclusions

STOs are a fundraising tool that, leveraging an innovative technology such as blockchain, opens up new possibilities for established companies and startups with traditional or technological business models, all within known regulatory frameworks.

Of course, there are profiles of attention and sensitivity. First and foremost, it is necessary to approach the blockchain, understanding its most important positive and negative aspects with appropriate internal training. Secondly, it is necessary to be aware of the existing adoption limits in terms of market adoption, requiring pioneers to take the first steps. Finally, there are practical limitations that make an ETO currently unfeasible, as the Italian Business Register does not “read” the blockchain to verify ownership of shares and quotas; therefore, STOs of participatory financial instruments and bonds should be preferred.