This blog post is the second in a series of three, taken from our Ebook, The Differences Between Launching an ICO and a STO, by Tokeny COO, Philippe Van Hecke. The aim of these posts is to inform the reader, as the title suggests, on the key differences between the two offerings.
In the first article, we talked about the types of security tokens and some of the benefits included. This second article will focus on STO regulation and compliance.
Since securities tokens are essentially bearing the same characteristics as financial securities, they fall within the perimeter of existing securities laws. Those laws aim at protecting investors but also look to avoid money laundering or terrorism financing. So, unlike utility tokens, there are regulatory hoops to jump through to make your STO legal.
In Europe, some of the specific securities laws you would have to comply with, depending on the type of STO launched, include the Prospectus Directive, MiFid, AIFMD, UCITS. As such, there are a number of things to consider that may not be applicable in an ICO:
- Type of investors: Depending on the way they are structured, securities tokens might not be authorized for sale to any type of investor. They might be restricted to professional, institutional, ‘accredited’, or ‘well-informed’ investors.
- AML/KYC Check: AML and KYC regulations applying to security tokens are comparable to those applicable to other financial instruments. Therefore, regulations require stronger and more sophisticated (e.g. risk-based) initial KYC checks, ongoing KYC checks, and AML checks than for utility tokens, where in general no rules have been defined yet. However a principle of cautiousness should be applied in the case of ICOs as well.
- Prior authorization: Some securities tokens (depending on the region and structure) might require prior authorization by – or at least notification to – local regulator(s) as well as very strict documentation (e.g. prospectus, offering memorandum, KII, etc).
- Eligibility: If securities tokens are transferable after issuance, they will require the transferee to have gone through a KYC and eligibility process and to satisfy with the eligibility rules defined by the issuer.
- Long-term consideration: Compared to utility tokens, the issuer needs to consider what will happen with the tokens after issuance, besides the possibility of sale/transfers. For example, tokens may entitle the investor to a distribution of cash flows (e.g. dividends), voting in annual of general meetings and/or additional token distributions (dividends in tokens), and may entitle the company to offer ‘buy-backs’ at a later date.
- Tax: Tax schemes applicable to regular securities (e.g. withholding tax) should apply to securities tokens as well.
All of these considerations make running an STO and ongoing maintenance of tokens much more complicated than for ICOs. Actions like KYC compliance and transferability must either be embedded into the token (permissioned tokens) or embedded into the smart contracts used to issue the tokens.
Knowing Your Customer (KYC) is important for any token sales – it protects the company, protects investors, and reduces the chance of money laundering. That’s why Tokeny applies KYC checks to both ICOs and STOs.
At this stage, as a nascent type of asset, security tokens are generally purchased by sophisticated investors, corporate entities, and financial professionals. As such, these types of tokens are still unknown by common investors. We are at the very beginning of the security token journey. At this stage, they are only considered by professional or sophisticated investors who are expected to have a diverse portfolio and understand how to manage their risk on new types of assets and markets.
To ensure compliance from the issuance of security tokens to their lifecycle management, we use our proprietary T-REX (Token for Regulated Exchanges) infrastructure. This set of solutions allows the issuer to easily onboard investors, manage post-issuance corporate actions such as dividend payments, voting and announcements. The T-REX ensures continuity with regards to KYC and AML compliance checks, ensuring all participants are eligible for the investment.
This content is inspired by the ebook The Differences Between Launching an ICO and a STO. Click here to download.