How to launch a Security Token Offering (STO) is a series of posts taken from the ebook we published in January, Tokenized Securities. The ebook is a comprehensive guide that walks issuers through the main steps involved in the process of launching a STO.
Before we get into the operational process, it would be useful to introduce the topic area and define tokenization in this first article. Next, we will publish another article on the difference between utility tokens and security tokens.
2017 saw a huge rise in Initial Coin Offerings (ICOs). This has, in turn, created a new asset class that has challenged the traditional makeup of financial markets. ICOs presented an important innovation, providing new pathways and more efficient flows for capital from a significantly wider group of investors. However, as the technology of blockchain developed rapidly, the regulatory framework has not been able to keep pace. We have seen plenty of ICOs associated with scandal and fraud, which has naturally caused uncertainty from issuers and shareholders.
With ICOs in decline, 2018 has been called by many as the year of the shift to STOs. Security tokens are regulated and in most cases backed by underlying assets. They can produce a regular yield for their holders, while providing more stability and guarantees for the investors.
2019 will be a structuring year for the industry. Efficient technologies will be released, traditional security service providers will enter in the market, investors will onboard, licensed exchanges will open and regulators will move forward. The first complete use cases will start delivering value to their investors and step-by-step, tokenized securities will become more attractive than others.
What is a Security?
To start with the basics, a security is a fungible and negotiable financial instrument that holds some type of monetary value. It can represent ownership in a company’s stock, a creditor relationship with an entity through a bond or rights to ownership as represented by an option. To keep it simple, a security can be broken down into three overarching categories; equities, funds and debts.
Equity is an investment in stock issued by another company. The stock can be either private or public, and represents ownership of an entity. The entity could either be a corporation or a trust. Equity securities entitle the holder to some control of the entity on a pro-rata basis, via voting rights.
Debt represents money that is borrowed and has to be repaid. The issuer of the bond (or debt) owes the holders debt and is therefore generally obliged to pay them interest, and to pay the principal on the maturity date as stipulated in the offering documentation of the security. Typically, interest is paid as fixed intervals (monthly, quarterly, annually, etc).
An investment fund is a supply of capital belonging to numerous investors used to collectively purchase securities. Each investor retains ownership and control of their own shares. The same principle can be tokenized and the tokens can represent shares in the fund.
What is Tokenization?
Security tokenization is the process of materializing the ownership in a security through the issuance of a “token” registered on a distributed ledger technology (DLT) infrastructure. Therefore, tokenized securities can be equities, a bonds, or investment funds. It could also represent a securitized fraction of a real asset (e.g. a piece of art).
The DLT infrastructure used to issue the tokens can, depending on the legislation and the choice of the issuer, either be the “primary register” for the security or a representation in the form of tokens primarily issued on a different infrastructure outside of the blockchain.
For the purpose of this Ebook, we will refer to these tokens as ‘security tokens’ and we will detail how they work in the following section. Most players in this emerging industry refrain from calling these ‘digital securities’, as the term is too vague, and in fact, securities have been traded digitally for years.
Our world is full of these securities, but many are currently difficult to physically transfer or subdivide, so buyers and sellers instead trade paper or unsecured digital files that represent some or all of the asset. These systems are cumbersome, difficult to transfer and can be hard to track. The underlying assets can also lack transferability: For example, if the underlying asset is a piece of property, transferring the ownership of that asset requires it to be sold. Through tokenization, the rights of these assets can be shared almost instantaneously thanks to peer-to-peer trading. This is one advancement of many when applying blockchain technology in financial markets, other use cases are explained later in this Ebook.
What are Tokenized Securities?
Tokenized securities are representations of securities in the form of tokens that have been issued on a digital infrastructure, such as blockchain. Just like traditional securities, they can take the form of a range of different financial instruments, including equity, funds and bonds.
Therefore, to understand security tokens, it’s fundamental to understand securities. With securities, it’s mandatory to respect the relevant laws and regulation for every jurisdiction the assets are issued in, and in every jurisdiction the securities will be distributed. As you might expect, the exact same process is needed when issuing security tokens on a blockchain.
This content is inspired by the Ebook Tokenized Securities. Click here to download.