TLDR: Security tokens combine the flexibility of digital assets and regulatory compliance as that of traditional securities. In this article, we take a look at some of the advantages of security tokens that make them stand out.
An STO or security token offering has been gaining ground as a formidable alternative to other ways of raising funds among companies from different industries.
It is a process similar to an initial coin offering (ICO) or initial public offering (IPO), where a company that seeks to raise money for its project issues tokens or shares of the company to investors.
For ICOs, these issued tokens are called utility tokens, for IPOs, what is issued are called shares, while for STOs, they are called security tokens.
Utility tokens use blockchain and promise the future use of a product or service, and generally give the holders special rights to the project that is being developed. However, they do not grant ownership stakes in a company, hence they are not considered investments and are not regulated.
Traditional shares of a company that are issued via an IPO, on the other hand, are units of equity ownership in a corporation. While they are highly regulated, they do not exist on the blockchain.
In the case of STOs, they take this process a step further by distributing blockchain-based security tokens that, as the name suggests, fall under the status of securities. Being securities, security tokens are considered to be a form of investment because they promise future profits and are regulated just like securities in traditional markets.
At its core, a security token is a digital representation of ownership of assets, such as gold and real estate or economic rights such as shares of profits or revenue.
One thing that sets STOs apart from other ways of raising funds is that it combines the advantage of being on the blockchain while providing a blanket of protection for investors because they are regulated and have to be legally compliant.
As a Deloitte report explained, STOs bring together the benefits of blockchain for financing but in a regulated environment, with the possibility of exchange-based and asset-backed structures increasing potential appeal.
To put everything into perspective, let us take a bitcoin mining farm as an example.
The company wants to raise more funds to expand their operations. Since they are already operational and their product has been launched, the farm comes to the conclusion that they have two ways to go about this – conduct an IPO or an STO.
In essence, IPOs and STOs share similar objectives, which is to raise capital in exchange for security, but they vary greatly in terms of the parties involved, structuring, technology used, and costs.
If the bitcoin mining farm decides to go with an IPO, they will essentially sell shares of the company to the public via a new stock issuance in order to come up with the needed funds. However, it is hardly as simple or straightforward as that.
In fact, going through an IPO is an expensive and time-consuming process that involves a lot of parties, steps, and strict compliance with numerous regulatory requirements in practically all jurisdictions.
Through the IPO route, the company will need to tap an investment bank to provide underwriting services, which includes preparing the necessary paperwork such as the registration statement, the red herring document, and the final prospectus that will be filed with the Securities and Exchange Commission (SEC).
The IPO will then be marketed in what is called a “roadshow” that, as the word implies, involves company executives, such as the CEO and CFO hitting the road to build enthusiasm for investors to invest in the IPO and to explain the company’s motivations for raising funds.
On top of it all, it is carried out in a non-digital form, which makes the whole thing more resource-intensive in today’s standards, especially for a bitcoin mining company – and a decisive factor why STOs have an edge over IPOs.
STOs tap into the power provided by blockchain technology, which automates processes and essentially removes intermediaries. While the specific processes vary in every jurisdiction, they are more straightforward, faster, and less exhaustive compared to IPOs.
One good example of this is Singapore’s CapBridge’s 1exchange public blockchain database integration with ACRA share registry via APIs in a public-private partnership.
1exchange is Singapore’s first regulated blockchain-based private exchange while ACRA (Accounting and Corporate Regulatory Authority) is the country’s regulatory body for business registration, financial reporting, public accountants, and corporate service providers.
With blockchain in the picture automating most of the cumbersome processes involved, the integration enabled significantly faster real-time private share transfers and filings for private market participants and the Singapore business community.
Another notable distinction that gives STOs an edge over IPOs is that several countries offer exemptions that allow an issuer to raise a certain amount of capital without having to issue a statutory prospectus, while several jurisdictions provide exemptions for fundraising initiatives such as STOs if the money raised does not exceed a certain amount.
In the US, a company is exempt from registering their STO with the SEC if it meets the requirements set under certain regulations, allowing them to save time and resources than if they go the IPO route.
Under their Reg CF (crowdfunding), an STO is exempt from SEC registration requirements for securities-based crowdfunding (subject to limitations) if the capital raised does not exceed $5 million.
In an article by EDSX, it is estimated that an STO campaign costs 40% less than an IPO due to the fact that it is carried out in digital form on a decentralized blockchain network.
Being on the blockchain means that smart contracts govern almost everything around an STO, including regulatory compliance, which enables more effective sales and exits by eliminating intermediary fees.
Smart contracts can also automate all token-related transactions, which makes turnaround times for STOs faster and cheaper compared to traditional IPOs.
In fact, Liqwith reported that with STOs, lead times for share transactions will be reduced from 35 days to 3 minutes, while cost per transaction will be reduced from €1500 to €15.
Unlike IPOs which can only be conducted in jurisdictions where the company operates, STOs are not restricted to a certain area as long as investors have an account with the exchange/platform that the STO is listed on and comply with the said exchange/platform’s legal and identification requirements such as KYC.
When it comes to accessibility, security tokens also have the advantage of being accessible 24/7 the whole year around. Their issuance, reporting, settlement, clearance, underwriting, exchange, registry, and compliance do not involve human intervention and they can be acquired or disposed of around the clock.
While STOs still have to comply with certain requirements set by the SEC and other regulatory bodies, they are considered to be a game-changer for the financial markets as they allow automated, speedy, and cost-efficient issuing and transfer of securities via the blockchain.
STOs are on track to disrupt IPOs because it democratizes access to investments on a faster and more cost-effective scale. Here is a quick look at what sets STOs apart from other fund-raising activities:
Going back to our bitcoin mining farm example, they can easily raise the funds that they need in order to expand their operations in a matter of days if they go for an STO instead of an IPO, not to mention that the former is the faster and more cost-effective option.
Provided that the funds raised will not exceed a certain amount (such as $5 million in the US under Regulation CF and may vary from country to country), the company will be exempted from registering the STO with the SEC. This is a huge load off any company’s back and means less paperwork, less waiting time for approval, fewer parties involved (no more underwriters), and less cost.
Since STOs are facilitated on the blockchain, this also means almost all processes and requirements involved can be programmed and will be governed by smart contracts. Whether it’s compliance, restrictions, lock-up period, management, etc., they can all be programmed into the security token making its issuance faster, easier, and cheaper.