STOs and Security Tokens Explained (simply)

Summary

In this informative episode of Crypto Whiteboard Tuesday, Nate Martin from 99Bitcoins.com explores the concept of Security Token Offerings (STOs), positioning them as a middle ground between Initial Coin Offerings (ICOs) and Initial Public Offerings (IPOs). STOs involve the sale of security tokens, which represent tradable financial assets, to the public in a regulated manner. The video explains the differences between utility tokens, which promise a product or service, and security tokens, which promise profit. It also delves into the regulatory challenges faced by ICOs and how STOs provide a more secure and compliant alternative for fundraising. Martin discusses the various regulations that allow STOs to operate, including Regulation D, Regulation Crowdfunding, and Regulation A+, each with its own investor criteria and financial limits. The summary highlights the benefits of STOs, such as reduced risk of scams, access to a broader investor base, and the potential for asset tokenization across various markets. However, it also acknowledges the drawbacks, including limited access for non-accredited investors and the potential deterrents of compliance costs and lockup periods. The episode concludes by suggesting that STOs are an emerging opportunity for early adopters seeking regulated investment options in the cryptocurrency space.

Takeaways

• 📘 An STO (Security Token Offering) is a middle ground between an ICO (Initial Coin Offering) and an IPO (Initial Public Offering), offering a regulated way to sell tradable financial assets as tokens.
• 💡 ICOs were initially a way to raise funds by selling tokens for future use of a product or service, but they became notorious for scams and lack of regulation.
• 💰 Security tokens represent an investment in tradable financial assets like shares or bonds and promise future profits, as opposed to utility tokens that promise future access to a product or service.
• 🚫 The Howey Test in the US is used to determine if a transaction is a security sale, which includes an investment of money with an expectation of profits from the efforts of a promoter or third party.
• ⛔ The unregulated nature of ICOs led to many scams and manipulations, prompting increased regulatory scrutiny and legal actions against companies conducting ICOs.
• 🔒 STOs are designed to be compliant with Anti-Money Laundering (AML) requirements and securities laws, providing investor protection and reducing the risk of scams.
• 💼 STOs can be conducted under certain exemptions from SEC registration, such as Regulation D, Regulation Crowdfunding, or Regulation A, each with its own requirements and limitations.
• 🌐 STOs allow for a wider audience of investors and make it easier to market and transfer digital securities across borders, compared to traditional IPOs.
• 💵 Regulation D allows STOs to raise funds only from accredited investors, which may exclude smaller or non-accredited investors from participating.
• 🔒 There is typically a one-year lockup period for investors in Regulation D and Regulation Crowdfunding STOs, preventing immediate resale of the security tokens.
• ⏱ Regulation A+ offers a 'mini IPO' process with no lockup period, allowing for immediate buying and selling of tokens, but the offering is limited to $50 million.
• 🔄 STOs are still in the early stages, and as the market matures, more companies may consider tokenizing their assets to raise funds in a regulated manner.

Q & A

What is an STO?

An STO, or Security Token Offering, is a process where security tokens are sold to the public in a compliant manner with regulations, offering a middle ground between an ICO and an IPO.

How does an ICO differ from an STO?

An ICO (Initial Coin Offering) involves selling utility tokens for a project, often with little to no regulation and a higher risk of scams. An STO, on the other hand, involves selling security tokens that represent tradable financial assets and is subject to regulatory compliance.

What are the two main categories of tokens?

Tokens are divided into utility tokens and security tokens. Utility tokens offer future use of a product or service, while security tokens represent tradable financial assets and are meant as an investment.

Why is the distinction between utility and security tokens important?

The distinction is important because it determines the regulatory framework that applies to the token sale. Security tokens are subject to securities laws and require compliance, while utility tokens are not.

What is the 'Howey Test'?

The 'Howey Test' is a U.S. legal standard used to determine whether a transaction qualifies as an 'investment contract' and is therefore a security. It involves four main questions regarding investment, common enterprise, expectation of profit, and the role of a promoter or third party.

How do STOs avoid the lengthy process of an IPO?

STOs avoid the lengthy IPO process by using regulatory exemptions such as Regulation D, Regulation Crowdfunding, or Regulation A+, which allow for different levels of investor participation and fundraising limits.

What are the advantages of STOs over ICOs?

STOs offer regulatory compliance, reduced risk of scams, and the ability to trade on verified exchanges. They also allow for a wider market of investors and easier cross-border transfers of digital securities.

What are the potential downsides of STOs?

Potential downsides include a focus on accredited investors, which may exclude smaller investors, the lockup period which restricts the sale of securities for a year, and the costs associated with compliance.

What is the role of the SEC in STOs?

The SEC (Securities and Exchange Commission) plays a crucial role in overseeing STOs to ensure they comply with securities laws. Companies conducting STOs must fall under specific regulatory exemptions to avoid SEC registration.

How does the lockup period in STOs work?

The lockup period, as required by certain regulations like Regulation D and Regulation Crowdfunding, mandates that investors must hold their security tokens for one year before selling them. This is to prevent pump-and-dump schemes and protect other investors.

What is the future outlook for STOs?

STOs are in the early stages, and as the market matures, more companies, including those outside the crypto space, are expected to tokenize their assets to raise funds in a regulated manner.

Why were ICOs initially popular but later faced regulatory scrutiny?

ICOs were initially popular due to their ease of raising funds without the need for extensive regulatory compliance. However, they later faced scrutiny due to numerous scams, frauds, and the lack of investor protection, leading to increased regulatory oversight.

Outlines

00:00

🤔 Understanding STOs and Their Role in Cryptocurrency

This paragraph introduces the concept of Security Token Offerings (STOs) and contrasts them with Initial Coin Offerings (ICOs). It explains that ICOs involve selling tokens to raise funds, with investors hoping for a return if the project is successful, exemplified by Ethereum's sale of Ether. Tokens are categorized as utility, which provide access to a product or service, or security, which represent financial assets like shares or bonds. The paragraph also touches on the regulatory issues that arose with ICOs, the lack of oversight, and the resulting scams and frauds. It sets the stage for a discussion on the 'Howey Test', a standard used in the U.S. to determine whether a transaction is a security sale.

05:02

🚨 ICOs vs. STOs: Navigating Regulatory Challenges

This section delves into the regulatory aspects of ICOs and the rise of STOs as a more compliant alternative. It describes how the 'Howey Test' is applied to determine if tokens are securities, and the consequences ICOs faced due to regulatory scrutiny. The paragraph outlines the characteristics of STOs, which are sales of security tokens to the public that adhere to regulations, including Anti-Money Laundering (AML) and securities laws. It explains the exemption mechanisms in the U.S., such as Regulation D, Regulation Crowdfunding, and Regulation A+, which allow STOs to operate under specific conditions. The summary also discusses the advantages and disadvantages of STOs, including investor protection, market accessibility, and the limitations imposed by regulations like the lock-up period and compliance costs.

10:02

🌟 The Future of Fundraising with STOs

The final paragraph discusses the potential and current state of STOs in the financial landscape. It suggests that STOs are suitable for early adopters who seek investment opportunities with some regulatory oversight. The speaker anticipates that as the concept of STOs matures, more companies, including those outside the cryptocurrency sector, will explore tokenizing their assets to raise funds. The paragraph concludes with an invitation for viewers to ask questions in the comments and an encouragement to like, subscribe, and enable notifications for the channel to stay updated with new content.

Keywords

💡STO

An STO, or Security Token Offering, is a type of fundraising method where companies sell security tokens to the public. It is a regulated process that aims to tokenize tradable financial assets, such as shares or bonds, and offer them to investors. In the video, STOs are presented as a middle ground between ICOs and IPOs, providing a more secure and compliant alternative to ICOs while avoiding the lengthy and costly process of an IPO.

💡ICO

An ICO, or Initial Coin Offering, is a method used by companies to raise funds by selling cryptographic tokens to investors. These tokens often represent a future use of a product or service. The video explains that ICOs became notorious for scams and lack of regulation, leading to significant financial losses for many investors.

💡Utility Token

A utility token is a type of cryptocurrency token that provides access to a product or service. It is not intended as an investment but rather as a means to use the product or service offered by the company. In the script, a Starbucks gift card is used as an analogy for a utility token, where the holder of the card expects to use it for a future cup of coffee, not to sell it for profit.

💡Security Token

A security token represents a tradable financial asset, such as a share or a bond. It is designed as an investment that may pay dividends, share profits, or pay interest, with the expectation of future profit. The video emphasizes that security tokens are different from utility tokens as they are meant to generate financial returns for investors.

💡Howey Test

The Howey Test is a legal standard used in the U.S. to determine whether a transaction qualifies as an 'investment contract' and thus is considered a security. The test involves four parts: investment of money, in a common enterprise, with an expectation of profit, solely from the efforts of others. The video uses this test to explain why many ICOs were later found to be selling securities, despite initially classifying their tokens as utility tokens.

💡

💡Regulation D

Regulation D is a set of rules under U.S. securities law that provides exemptions from the registration requirements for certain securities offerings. In the context of the video, it allows STOs to be conducted without registering with the SEC if they are limited to accredited investors, who are individuals with a net worth of $1 million or more, or with an annual income of $200,000 or more in the last two years.

💡Regulation Crowdfunding

Regulation Crowdfunding is a rule that allows companies to raise a limited amount of capital (up to $1,070,000 annually) from both accredited and non-accredited investors through online platforms. The video mentions this as one of the regulatory frameworks that enable STOs, with a one-year lockup period to prevent pump-and-dump schemes.

💡Regulation A+

Regulation A+ is a U.S. regulation that allows companies to conduct a mini-IPO, which is a public offering of securities that bypasses the normal requirements of an IPO. Once qualified by the SEC, it allows anyone to participate in the STO, with a limit of $50,000,000 and no lockup period. The video presents this as a way for companies to conduct STOs with broader participation and immediate liquidity.

💡Anti-Money Laundering (AML)

Anti-Money Laundering (AML) refers to the legal procedures in place to prevent and combat money laundering, the process where the proceeds of crime are legitimized by removing or disguising their illicit origins. The video states that STOs are intended to be compliant with AML requirements, which is a key factor in distinguishing them from the unregulated ICOs.

💡Lockup Period

A lockup period is a restriction that prevents investors from selling their securities for a specified period of time after an investment. In the context of the video, STOs under Regulation D and Regulation Crowdfunding have a one-year lockup period to protect other investors and prevent market manipulation. This contrasts with Regulation A+, which has no lockup period.

💡Tokenization

Tokenization is the process of representing a real-world asset or a financial instrument in the form of a digital token on a blockchain. The video discusses how STOs allow for the tokenization of various asset classes, enabling a wider range of investments and providing a new avenue for companies to raise funds.

Highlights

An STO (Security Token Offering) is a fundraising method that involves selling security tokens, which represent tradable financial assets.

STOs are positioned as a middle ground between ICOs (Initial Coin Offerings) and IPOs (Initial Public Offerings), providing a regulated alternative to ICOs.

ICOs involve selling tokens for a project with the promise of future use, whereas STOs offer tokens that are considered investments, potentially paying dividends or sharing profits.

Utility tokens promise a product or service, in contrast to security tokens which promise profit.

The ICO market saw a peak in 2017 with billions invested in projects, many of which failed to materialize, leading to significant investor losses.

The lack of regulation in the ICO market led to numerous scams and manipulations, prompting increased scrutiny from regulators.

The 'Howey Test' is used in the US to determine if a transaction should be considered a security sale, which has implications for ICOs.

STOs are designed to be compliant with Anti-Money Laundering requirements and securities laws, offering a more secure investment environment.

STOs can be conducted under certain exemptions from SEC registration, such as Regulation D, Regulation Crowdfunding, or Regulation A.

Regulation D allows STOs to raise funds from accredited investors only, with no limit on the amount that can be raised.

Regulation Crowdfunding permits participation from both accredited and non-accredited investors, with an annual limit of $1,070,000 for STOs.

Regulation A+ requires SEC qualification, similar to a mini-IPO, with a participation limit of $50,000,000 and no lock-up period.

STOs aim to reduce the risk of scams and fraud through regulation and oversight, providing a safer environment for trading compared to ICOs.

STOs have the potential to tokenize almost every asset class, opening up larger markets for investors.

Critics argue that STOs may exclude smaller investors due to regulations like Regulation D, which is only open to accredited investors.

The lock-up period and compliance costs associated with STOs may deter some investors and companies from participating.

STOs are considered more suitable for early adopters looking for investment opportunities with some regulatory oversight.

As the STO market matures, more companies are exploring the tokenization of their assets to raise funds in a regulated manner.

Transcripts

What is an STO?

Is it “the new” ICO?

What’s the difference between a security token and a utility token?

Why is it even important?

Well stick around,

in this episode of Crypto Chiteboard Tuesday we’ll answer these questions and more.

Hi, I’m Nate Martin from 99Bitcoins.com and welcome to Crypto Whiteboard Tuesday

where we take complex cryptocurrency topics, break them down

and translate them into plain English.

Before we begin don’t forget to subscribe to the channel

and click the bell so you’ll immediately get notified

when a new video comes out.

Today’s topic are Security Tokens and Security Token Offerings

or STOs for short.

But before we dive in, we first need to understand what ICOs are.

An Initial Coin Offering, or ICO for short,

takes place when a company sells cryptographic assets known as tokens

in order to raise funds for its operations.

The tokens being sold play a role in the project

and those who buy in early are getting them at a discount,

assuming the project succeeds.

The company usually opens the sale of tokens for a limited time frame

until the money they need to raise is reached.

A good analogy for an ICO would be selling $1 casino chips at 80 cents a chip

in order to build the new casino.

If the casino comes to life the investors made a wise investment.

A good example of an actual ICO would be Ethereum,

where Ether - the token used to power the Ethereum network -

was sold to investors before the network launched,

in order to fund the project.

Tokens in general are divided into two categories -

utility tokens and security tokens.

Utility tokens are tokens that promise the future use of a product or service.

They aren’t meant to be an investment, they have a utility.

One example that might be considered a utility token of sorts

would be a starbucks gift card.

If you buy it at a discount,

you’re not really expecting to make a profit by selling the gift card.

Effectively, you’ve prepaid for, and expect at a later date,

a cup of coffee.

Security tokens on the other hand,

are tokens that represent tradable financial assets,

for example a share or a bond from a company.

Security tokens are meant as a form of investment,

they pay dividends, share profits

or pay interest in a way that promises future profit.

Put simply, utility tokens promise a product or a service

while security tokens promise profit.

While ICOs started out with good intentions,

people quickly started seeing the opportunity for easy money

and used this mechanism to fuel their greed.

In 2017 the ICO frenzy reached its peak.

Billions of dollars were invested in so called utility tokens

that had as little as a piece of paper describing some obscure future venture.

Of course the overwhelming majority of these projects

never saw the light of day and a lot of investors lost their money.

Back then the ICO field was completely unregulated

and quite the number of scams and manipulations emerged.

Investors pumped up the price of specific tokens just to dump all of their holdings

once everyone else bought in.

Other cases included companies that just completely vanished, along with the money,

once the ICO ended and the money was raised.

Instead of a creative way to raise capital,

ICOs quickly became a workaround to avoid regulation.

Companies that wanted to avoid the long, expensive regulatory path

toward the traditional Initial Public Offering or IPO

just conducted an ICO instead.

Nobody asks for permission to run an ICO,

you just set up a website, some tokens and start selling them to the general public.

Also, unlike an IPO,

you’re not giving away any control over your company or profits

since you’re supposedly selling tokens

that only promise future use of your currently non existing product.

As things got out of hand, public complaints increased,

companies like Google and Facebook

banned all ICO projects from advertising on their platforms

and regulators stepped in.

The regulators wanted to investigate whether these so called tokens

shouldn’t be in fact considered as securities.

And if so, are the companies behind them

meeting the requirements to allow them to sell securities.

You see, in the US there’s a simple test called the “Howey Test” that is used to decide

if what someone is selling should be considered a security.

It states that a transaction is considered a security sale,

if a person invests his money in a common enterprise

and is led to expect profits solely from the efforts of the promoter or a third party.

We can break this long and confusing sentence down to four main questions:

One - Was there an investment of money?

In the case of ICOs the obvious answer is yes.

Two - Was this investment done in a common entreprise?

Since ICOs raise money for a company which is considered a common enterprise

the answer is also yes.

Three - Was there an expectation of profit?

Well, this is a very interesting question,

since a company can always claim that its tokens were meant for utility only.

However, when you look at the token market

you can clearly see that people are buying tokens in the morning

and then selling them in the afternoon.

Meaning tokens are bought in order to sell them for a profit.

So depending on the specific case this could be a yes or a no.

And four - are the profits connected directly to efforts of a person or entity

who are not the investor?

This question is a bit confusing, so here are some other ways to look at it:

“Is there a person, that isn’t the investor,

who is in charge of making this venture succeed?”

You could also ask “Is this a passive process for the investor?”

In most cases the answer to these would be a solid “Yes”

as the investor’s involvement in the project ends

usually once he or she invested funds and got tokens in return.

Bitcoin, for example, doesn’t fall under this category

since there’s no one person making the decisions.

Many open source projects can have the benefit of the doubt

since you can’t say that there is one person calling the shots,

it’s more of a group effort

and that disqualifies them from the fourth question.

So while most companies classified their token as utility tokens

in order to avoid security regulations,

when they were reviewed by the authorities,

almost all of them were said to be selling securities.

As a result many ICO companies were subject to legal actions

including hefty fines and even jail time.

Today, most ICOs aren’t open to the public because of the fear of regulators

and are privately funded by small groups of investors.

So there you have it,

on the one hand we have ICOs -

A completely unregulated form of raising money from all around the world,

that’s fast and easy to execute and is filled with scams, frauds

and just plain negligence.

And on the other hand IPOs -

A long, expensive, exhausting road of raising money from investors

by vetted, legit companies.

But today,

there’s a new type of offering called a Security Token Offering or STO.

A kind of middle ground between an ICO and an IPO.

Let me explain.

An STO is the process of selling security tokens to the public

while avoiding the long exhausting process of an IPO.

There are no utility tokens in STOs

and everyone participating is considered an investor.

STOs are intended to be compliant with Anti Money Laundering requirements

and securities laws.

You might be wondering how are STOs possible?

How can you sell securities without regulatory oversight?

The answer is through exemption.

In the US for example,

you’re exempt from registering with the SEC if you fall into one of three regulations.

Regulation D, Regulation Crowdfunding or regulation A.

Regulation D means that STOs are exempt from registering with the SEC

if they raise money only from accredited investors,

meaning anyone with a net worth of $1 million or more

or with an annual income of $200,000 or more in the last two years.

The company can raise an unlimited amount of money

in this manner.

Regulation Crowdfunding states both accredited and non-accredited investors

can participate in the offering,

but there is an annual limit to how much an STO can raise -

and that's $1,070,000

Both regulation D and regulation CrowdFunding have a one year lockup limit.

This means that investors need to wait for one whole year

before selling their security.

This is done to prevent pump and dump schemes and protect other investors.

Regulation A+ means the offering must be qualified by the SEC,

sort of a mini IPO.

Once it is approved,

everyone can participate in the STO, which is limited to $50,000,000.

There is no lock up period for a Regulation A+ exemption.

You could buy and sell your tokens in the same day

just like you currently can with cryptocurrencies.

So, once a company falls into any one of these regulations,

it can sell security tokens as part of an STO,

with no threat from the SEC coming down on it to shut it down

and throw the proprietors into jail.

So are STOs a good thing?

STOs have a lot of advantages.

For starters,

they remove the threat of scams

through the implementation of regulation and oversight.

While ICOs were traded on shady and unregulated exchanges,

STOs are traded on verified exchanges.

Also, STOs open up bigger markets for investors

since almost every asset class type can be tokenized.

From the fundraiser’s perspective,

a wider audience of investors can be reached,

as digital securities are easily marketed and transferred across borders.

Of course many people think STOs are a bad thing since in some cases,

regulation D for example,

they offer the investment to accredited investors only.

This seemingly excludes the Main Street investor

while allowing only the rich to benefit.

On top of that,

the lockup period and cost of compliance

may deter many investors and companies from participating in STOs.

In the end, STOs have various pros and cons.

I believe that at this point in time,

they are more suited for early adopters,

who are looking to invest in something new and exciting

while still subject to some oversight,

which offers a certain degree of investor protection.

These are just the early days of STOs

and as we move forward,

more and more companies, not just crypto related,

are thinking about how they can “tokenize” their assets

in order to raise funds.

Well, that’s it for today’s episode of Crypto Whiteboard Tuesday.

Hopefully by now you understand what Security Tokens and STOs are -

A way to tokenize tradable financial assets and offer them to the public

in a responsible regulated process.

You may still have some questions.

If so, just leave them in the comment section below.

And if you’re watching this video on YouTube, and enjoy what you’ve seen,

don’t forget to hit the like button.

Then make sure to subscribe to the channel

and click that bell so that you’ll be notified as soon as we post new episodes.

Thanks for joining me here at the Whiteboard.

For 99bitcoins.com,

I’m Nate Martin, and I’ll see you… in a bit.