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Security Token Offerings – STOs

Security Token Offerings – “STOs” – are currently one of the hottest topics in the blockchain scene. Some experts even claim that they are “The Next Big Thing” and predict that they will soon outgrow ICOs in number and investment volume. But is that actually true? Or is it more of a hype than reality?

In fact, more and more start-ups and larger companies consider conducting an STO. A lot of arguments speak for an STO, but there are also some downsides that need to be taken into consideration. In addition, the field is still very young and evolving, so that legal certainty and clear processes are still lacking.

We are also convinced that Security Token Offerings will fundamentally change the blockchain scene in the coming weeks and months. Therefore, we decided to dedicate a 3-part series to the emerging field of security tokens and STOs.

However, before we define Security Token Offerings in more detail, distinguish them from other forms of capital procurement and describe the procedure for an STO, we must first discuss what a Security Token is.

Wait a minute – “STOs”… What is a security token anyway?

The difference between an ICO and an STO lies in the type of token issued by an issuing entity. The term ICO does not provide any direct information about which token is issued. In most cases, however, this is a utility token. A utility token serves as the sole means of payment on the platform of the company concerned. Customers pay for the consumption of services with the token, while service providers are paid in the utility token of the platform. Important: the acquisition of utility tokens is not linked to the acquisition of rights or obligations; it is not a financial instrument. With a Security Token Offering, as the name already indicates, a Security Token is issued.

A security token is created by the tokenization of certain rights, such as the right to an interest payment or the repayment of a loan. Because rights are securitised, the security token is a financial instrument or a security according to the respective national legislation of the country in which the security token is issued. The event in the course of which a security token is issued is referred to as Security Token Offering – STO. The term STO has established itself in recent weeks and months because more and more companies and venture capital firms regard an STO as an attractive and inexpensive alternative to an ICO.

Advantages of Security Tokens

Just like every other types of tokens, security tokens have advantages and disadvantages. In the current somewhat hyped discussion, the advantages are emphasised in detail, but the disadvantages of this type of token should not be ignored.

A major advantage is that security tokens offer increased compliance with legal requirements. This is ultimately beneficial for investors, the executing company and regulators. In many countries, regulators are currently primarily reactive and spend a lot of time reviewing ICOs that have been filed or are already on the market for compliance with regulations in place to implement fundraising measures. In most cases there is still no clear legal framework for ICOs, as Malta has already developed, to determine whether a token is a utility token or a security token. Because smart contracts (see later section on smart contracts) enable the writing into code of laws and rules as well as their automatic enforcement, regulators can proactively ensure compliance by setting policies. For example, it is possible to use smart contracts to ensure that tokens can only be transferred to investors (more specifically, their wallet addresses) that have previously been approved through KYC processes. In addition, certain retention periods can be programmed into Smart Contracts so that tokens cannot be sold prematurely.

The issuing of a security token enables investors to get so-called “fractional ownership”. Because an underlying security is divided into a certain number of tokens, issuers benefit from increased liquidity and a much larger circle of potential investors. The large circle of potential investors and usually low minimum investment sums mean higher liquidity for the company, because tokens can easily be sold and bought. With appropriate marketing, the company can attract more capital from a larger circle of investors.

Security tokens are also extremely attractive for investors. Virtually every interested investor worldwide who has Internet access and a corresponding wallet can purchase Security Tokens. Through fractional ownership, investors gain access to investments in goods or markets that were previously reserved for large investors due to high minimum investment sums.

Security tokens offer another important legal advantage. Because the blockchain as a tamper-proof, robust database documents all transactions and changes in token ownership, regulators can easily track how tokens have changed ownership and who currently owns them. This enables efficient audit procedures and eliminates the risk of tax evasion, manipulation and attempted fraud.

Finally, security tokens overcome a common problem of utility tokens – high price fluctuations. Because security tokens are based on the tokenization of rights and real values, they usually lead to more stability. It is easier for investors and third parties to determine the real value of the tokens, which leads to increased certainty as to their value and a better basis for decision-making. Companies, on the other hand, do not have to fear sudden sales by a majority of investors and resulting, drastic depreciation of their tokens. This phenomenon, known as “pump and dump” in the behaviour of many speculators, can, however, already be prevented by specifying certain vesting periods in the Smart Contracts.

Disadvantages of Security Tokens

However, this also has some disadvantages, which primarily concern the issuing of a security token. A company might decide against using a security token, as with their acquisition, an investor also gets a legal claim against the company. This should be taken into account in the planning of legal and token economics aspects of the entire business model.

A further disadvantage is the fact that the field of security tokens is still so young and evolving that so far there is hardly any legal and technical experience or established best practices to follow. This raises another question: in which country or which legislation should the Security Token be issued and an STO take place? In addition to the possibility of competent legal advice, the decision should above all be based on the applicable laws, legal clarity with regard to crypto currencies and digital assets, and the government’s openness to the subject of digital assets and blockchain. One location that fulfils all these criteria is e.g. the Blockchain Island Malta.

Compared to issuing a utility token as part of an ICO, issuing a security token is a more complex legal matter. Due to the small number of STOs carried out so far, an ongoing exchange and close coordination with the financial supervisory authorities must take place in advance of the STO. Regulatory authorities must check the planned security token’s compliance with existing laws and give an explicit approval of the token. Only with this legal protection can an STO be carried out. Because such a review is complex and legally uncharted territory, interested companies must schedule a process lasting several months for the development and preparation of an STO.

So far for an introduction to the basics of security tokens and their differentiation from utility tokens. In the next, second part of our series on Security Token Offerings, we will look in detail at STOs and how they differ from IPOs and ICOs. In addition, in a forthcoming article we will look at the importance of smart contracts for the implementation of STOs. We will also take a closer look at the rapidly developing field of Security Token Exchanges and illustrate why Malta is a suitable location for conducting an STO.

Which rights can be tokenised

In the first part of our 3-part series on Security Token Offerings we dealt with the basics of security tokens and their advantages and disadvantages compared to regular utility tokens. In the second part of the series, we look at which rights can be tokenised as security. We will also define Security Token Offerings in more detail and differentiate them from IPOs and ICOs. Finally, we are going to describe the role Smart Contracts play in the implementation of STOs and the trading of security tokens.

Tokenization of rights on the blockchain: different arrangements possible

Important: Security tokens can be very different – a large number of rights can be tokenised to varying degrees. One possibility is, for example, the right to participate in the company’s profits or to receive a payment. Another possibility would be for token owners to have a right to repayment of a loan.

But voting and co-determination rights can also be tokenised. An STO of the company “Hydrominer” prepared in Austria, for example, gives token owners the right to participate in business decisions in addition to profit sharing, as well as a right of co-sale if a qualified majority of the owners would decide to sell their tokens.

It should therefore be noted that security tokens may resemble classic shares, but the concrete rights differ from case to case. As these are individual cases and depend on the design of the use case/blockchain venture, consultation with the supervisory authority at the planning stage is necessary and advisable in all cases. This is the only way to ensure that the legal structure and details of the token are such that the capital market prospectus is ultimately approved by the supervisory authority. Therefore, when selecting a location for an STO, it is particularly important to choose a country where supervisors are available to properly elaborate these aspects in advance of an STO.

Difference between STO and ICO

STOs are not only an attractive alternative to issuing shares (see section “Difference between STO and IPO”), but many start-ups and established companies compare them against initial coin offerings. The difference between ICO and STO is quite simple: Whereas it is typically a utility token that is issued for an ICO, in the case of an STO it is always the emission of a security token. Utility tokens are pure means of exchange on the company’s platform, securities regulations do not apply to them.

Until recently, practically all start-ups were busy demonstrating and convincing that their token was exclusively a utility token. The clear intention was of course to avoid the legal obligations arising with the issuing of securities – such as obligations to inform, publication of a securities prospectus, etc. – and partly to avoid having to face high legal penalties.

That’s about to change. The benefits of STOs are convincing more and more companies to seek an STO instead of an ICO. The main argument in favour of an STO is the increased legal security that results from the issue of a legally compliant security. Many tokens declared by companies themselves as “utility tokens” are critically examined by supervisory authorities. Time and again it has happened that authorities have classified a token issued as UT as security and the issuing company has subsequently been sued. This could ultimately lead to the company having to seise operations.

However, the process of an ICO and an STO is usually very similar. The primary difference is the increased time and financial expense incurred by an STO for regulatory review of the token and legal advice. However, the KYC processes required in the course of the STO are now also carried out by practically all companies in the course of their ICO for legal protection. While ICOs usually “only” publish a white paper, STOs must publish a legally compliant securities prospectus.

Difference between an STO and an IPO

We have already discussed that a security token resembles a classic security or financial instrument and must be legally classified as such. But how does the issuing of a Security Token (= STO) differ from an ordinary IPO?

Let us first take a look at the procedure of a classic Initial Public Offering. If a company plans to issue shares as part of an IPO, this must be notified to the relevant supervisory authority, such as the Bafin in Germany, the Securities and Exchange Commission (SEC) in the USA or the Malta Financial Services Authority (MFSA) in Malta. Part of the legal due diligence is the preparation and publication of a legally compliant capital market prospectus by the issuing company. The actual handling of the IPO is usually carried out by an investment bank. It usually takes over all shares to be issued, but also accepts responsibility for their sales as well as administrative procedures required.  For offering these services and assuming substantial risk, the investment bank charges a hefty commission. The bank places the shares on the stock market, investors then buy the shares on the stock market from the bank.

STOs also issue equity-like securities, but technical settlement is dramatically simplified by blockchain technology and smart contracts. Smart Contracts enable automatic processing of the issue and sale according to pre-defined rules. The resulting automation of transactions enables the elimination of intermediaries. There is no need for a bank to organise the placement and the initial sale. Instead, however, companies should rely in advance on intensive legal advice from a law firm specialising in cryptoservices. The elimination of an investment bank as an intermediary enables greatly reduced fees and faster order execution. Therefore, minimum investment amounts may be lower and the company’s security tokens may be made available to a wider group of potential investors. In addition, the financial institutions involved have no way of – possibly deliberately – influencing the STO process in their favour.

The Role of Smart Contracts in STOs

Anyone dealing with Security Token Offerings must take a closer look at a dominant technical phenomenon: Smart Contracts. They represent the technical basis for the issuance and trading of security tokens. But what is a Smart Contract? These are agreements programmed in code, the provisions of which are automatically implemented when certain framework conditions are met.

Smart Contracts are executed as decentralised apps (dApps) on Smart Contract-enabled blockchain protocols such as the Ethereum Blockchain. Practically all processes of a Security Token Offering are handled by Smart Contracts.

  • Specifically designed Smart Contracts control the transfer of investment sums from investors to the wallet address of the security token-issuing company.
  • Once the investment has been received and the minimum investment target (= soft cap) has been reached, the corresponding number of tokens is automatically transmitted to the investing wallet addresses on the specified date. Smart Contracts thus allow automated processing of the token issue and thus eliminate banks that act as clearing agents or intermediaries for IPOs.
  • Smart Contracts can be programmed with the logic provided depending on the application. Common examples are so-called “whitelisting”, which means that only explicitly permitted wallet addresses and their owners can receive such tokens. Also, a contrary procedure – “blacklisting” is possible: here some wallet addresses are provided to which no tokens may be sent. Other examples of rules programmed in Smart Contracts are vesting periods, but also co-determination rights.
  • Smart Contracts also enable the automated payment of profit shares at the end of a fiscal year – corresponding to the dividend payment for classic shares.
  • Trading on Security Token Exchanges – as described in more detail in the next section – is also only possible through Smart Contracts.

In the next, third and last part of our series we will deal with the role of Security Token Exchanges as a secondary market for Security Token. In addition, current efforts to establish Security Token Exchanges in Malta are presented and why Malta is currently probably the most attractive location for STOs.

Security Token Exchanges

In the third and last part of our series on Security Token Offerings we deal with Security Token Exchanges. We describe the emergence of security token exchanges as a secondary market for security tokens as a result of the ongoing STO trend. We then report on current projects to establish Security Token Exchanges in Malta before showing why Blockchain Island is a particularly attractive location for conducting an STO.

Security Token Exchanges (STEs) as secondary market for Security Token

Security Token Offerings combine the strict requirements and legal protection of classic securities with the decentralised, smart contract-based nature of blockchain technology. With the advent of security token offerings, a new type of exchange is also emerging: Security Token Exchanges (= STEs).

While all types of tokens (primarily utility tokens) can be traded on normal crypto exchanges, STEs are designed exclusively for the trading and sale or purchase of security tokens. This is necessary in order to best suit the special properties of security tokens. With the sale of the token at the STE, the tokenised right is also transferred to the new owner of the token. Security token exchanges therefore represent the secondary market for security tokens. The greater the number of security tokens issued, the more important STEs will become.

As this is also an industry that is still in its infancy, it remains to be seen how the market will actually develop. One possible scenario is that the increasing number of security tokens issued will force existing market leaders such as Binance, OKEx and other crypto currency exchanges to integrate the functionality of a STEs into their service portfolio.

An alternative scenario is that, due to the different requirements for trading security tokens, specialised trading platforms on which only security tokens can be traded will prevail over conventional utility tokens and establish themselves on the market. It is undisputed that they will contribute to making security tokens increasingly attractive as an alternative to traditional securities, because the former can be traded more easily, quickly and cheaply. Finally, the ownership of the token serves as proof of ownership and entitlement for any rights associated with the token.

Several Security Token Exchanges planned in Malta

Already in July this year, Neufund, an equity-based token platform (a special form of security token), announced a collaboration with MSX, a Fintech-specialised suborganisation of the Malta Stock Exchange. The aim is to create the first regulated, decentralised global stock exchange.

So-called tokenised securities as well as other digital assets are to be listed and tradable. By the end of 2018, this parties want to have jointly tested this in a pilot project. Equity distributed on tokens is issued via new funds as the primary market. Neufund and Malta-based Krypto-Exchange Binance have also formed a partnership. The equity token issued as part of the pilot project will then be tradable on Binance as a secondary market.

The 3 companies share a long-term vision of a complete ecosystem in which token-based securities can be issued and traded using blockchain technology, all of which will of course be legally compliant and legally binding.

However, the Malta Stock Exchange would like to explore further potential with its MSX accelerator. Together with Binance competitor OkEX, which is also based in Malta, the company is also working on the development of its own exchange on which security tokens can be traded.

A Memorandum of Understanding (MoU) between the two parties was signed in July 2018. The platform is called OKMSX and is expected to go live in the 1st quarter of 2019 and serve clients worldwide. According to its own statements, this will also primarily be a trading platform for security tokens at the institutional level.

Malta has recognised which way the wind is blowing. Exchanges, in particular, will play a key role in a future in which blockchain technology will transform many industries sustainably and permanently.

Malta as a location for STOs

When it comes to selecting a location for a Security Token Offering, Malta is at the top of the list. As the above examples show, the Maltese government and the Malta Stock Exchange are already preparing for the first wave of security token offerings and the establishment of security token exchanges. In fact, no other country can currently compete with Malta in terms of attractiveness and popularity as a potential location for an STO.

Since joining the EU in 2004, Malta has made a name for itself as an international financial centre. The technology-friendly Maltese government is open to blockchain, digital assets and tokenised securities. Proactively, conventions are being organised to promote the establishment of blockchain companies, which find here a clear legal framework for the licensing of digital assets.

Tax aspects also speak for the Blockchain Island Malta. Companies that have collected crypto deposits benefit from the advantageous and favourable corporate income tax rate. Investment income and capital gains generated by crypto-funds are tax-exempt. In addition, personnel and operating costs are below the level of Western European EU countries, giving another reason for locating the company on the sunny Mediterranean island. Through the EU internal market, STOs that have been classified as regulated and legal by the Malta Financial Services Authority can become active and attract investors in all EU member states.

Positioned as “Blockchain Island”, Malta has become an international hub for the crypto scene. More and more companies, founders and developers have followed industry giants such as Binance and OKEx and contribute to the flourishing blockchain community in Malta. All signs indicate that we will see a rapid increase in the implementation of security token offerings in the coming months. The Blockchain Island Malta offers ideal framework conditions and is prepared for the upcoming STO boom.

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