Security tokens are created and issued by a company looking to raise money, just like an ICO. Unlike ICOs, however, security tokens are backed by real assets – whether equity, debts/loans, or investment funds, for example – similar to more traditional securities. As such, security tokens fall within existing securities laws and regulations.
The closer scrutiny afforded to security tokens makes compliance a little more complex. For example, KYC checks need to be thorough and identify the sophistication of the investor and you’ll need to conduct further KYC checks on the buyer as well as ongoing checks on investors.
STOs are a better choice for businesses looking to raise capital but don’t have a suitable platform for utility tokens (as used in an ICO). That’s because the value of security tokens is based on the value of the company or underlying asset, rather than on demand driven by platform use.
So, given these differences between an STO and both a traditional IPO or an ICO, what are some of the pros and cons of security token offerings?
Pros of security tokens
Low barrier for entry
Floating on a stock exchange or Alternative Investment Market (AIM) via a traditional IPO is a time-consuming and arduous process only available to large companies looking to target over £10m. It required lots of middlemen – including brokers, exchange fees, extensive due diligence, etc. – costing large sums of money.
In contrast, a major benefit of an STO is that it can be used to tokenize any asset or financial instrument relatively easily for trading online. This means smaller, early-stage businesses can raise large amounts of capital quickly without needing to pay huge fees.
As legal documentation becomes more standardised and more token protocols become open source, the cost of running an STO will only go down over time. This will lower the barrier to entry even further, helping more businesses and start-ups raise the required capital to make their ideas a success.
Greater flexibility for business owners
Listing your business also entails initial compliance checks as well as ongoing compliance work. Additionally, you often can’t run the business the way you really want. Instead, you’re tied to a single exchange and beholden to analysts’ recommendations, driving you into short, quarterly cycles rather than focusing on your long-term vision.
STOs provide much greater flexibility in terms of how you actually run your business – comparable only to a privately-held company. However, unlike a privately-held company, security tokens can be traded after the initial sale making them much more liquid investments.
Security tokens also have more transparent value based on the underlying assets, meaning your business is less likely to be shorted, even with a small number of large investors.
Attract global investors
Token standards are uniform across different regions, which means tokens can be easily bought and traded by investors around the world. In fact, security tokens tend to be much more liquid than privately held shares, which can be time-consuming and costly to trade.
As such, STOs tend to appeal to a slightly different investor profile than stock markets or the AIM. They often attract contributions from global investors looking to make a good return with greater liquidity, helping raise large sums quickly and to spread awareness of your business around the world.
Compliance can be hard-coded
Although compliance is slightly more complex with an STO than an ICO, compliance can be hard-coded into the security token through new standards developed on blockchains such as Ethereum.
The KYC checks I mentioned earlier, for example, can be coded in so only accredited investors can buy or trade them, essentially automating ongoing KYC checks. As these standards improve, it should make it virtually impossible to violate securities regulations.
Security tokens allow you to divide underlying assets into smaller units, enabling fractional ownership. This makes it more affordable for some investors to contribute to your STO and can also make the token easier to transfer on the secondary market.
Cons of security tokens
As I mentioned in the introduction, security tokens still fall under existing securities regulations. As such, companies running an STO will still have to comply with the same regulations as they would floating an IPO.
The slight benefit of STOs is in coding some of those compliance factors into the token and smart contract, making the token more easily tradable after issuance. The complexity of legal regulations over multiple jurisdictions still carries risk, however, so it’s important to get right.
As such, you need an experienced team with business backgrounds as well as experts in a range of fields, depending on what assets you’re securitising. Unlike an ICO, which relies more on the technology to create value, security tokens derive value from the business operations, so it needs to be a tight ship.
You’ll also need legal expertise covering every region you intend to sell your tokens to ensure compliance with local securities regulations. However, this is often provided by specialist STO platforms such as Tokeny.
Platform required to create and manage tokens
Unlike traditional securities, which have exchanges and brokers established around the world, you can’t simply call up your broker or NOMAD, if you’re listing on the AIM, and as them to create security tokens. STOs require you to create your own tokens as well as a platform to manage their sale. Get this crucial technological part wrong and you’ll end up in financial and legal hot water.
Creating a secure and suitable platform is a complex process, however, which means bringing a middleman in to manage the platform and tokens. Obviously, this will come with a cost. The benefit of using a trusted partner, however, is that you can avoid dealing with the complex technological framework involved and get on with creating value through your business.
A young market
The first STO was only completed less than two years ago, making this a very new space. As such, nothing has been extensively tested in the long-term, increasing the risk for both business and investor.
As such, there isn’t much legal precedent to rely on and regulators could change their minds at any time. Say, for example, an unscrupulous trader found a way of cheating a token sale – securities commissions could decide to enact new regulations, jeopardising your STO and limiting the liquidity of your tokens.
As it stands, there is no indication that regulators are planning to introduce new laws, so it should all be fine.