It’s no secret that in the last couple years ICOs, or Initial Coin Offerings, have quickly grown in popularity to fund a wide range of projects. In fact, in the first three months of 2018 alone, ICOs successfully raised roughly $6.3 billion, which was already 18% more than the entire amount raised in 2017. Yet despite the increasing popularity of ICOs, there are still several concerns over their lack of regulation or liability on the part of the issuers.
Consumer protection continues to present a significant challenge in the world of crypto asset investing. For example the Centra ICO, which was publicly backed by world famous boxer Floyd Mayweather and music producer DJ Khaled, was found to be a fraud. The two founders of Centra have since been charged and arrested. Or we can look at the PlexCoin ICO, which was halted by the SEC in December of 2017 when the founder, Dominic Lacroix, was jailed for ‘defrauding American and Canadian investors’ claiming astronomically high returns of 1354%.
While many projects considerings ICOs prepare for regulatory scrutiny, the two largest crypto assets, Bitcoin and Ethereum, were recently ruled out of the security classification by the US SEC. The reasoning was quite straightforward. With many ICOs, there is a centralized third party with purchasers and an expectation of return - which sounds an awful lot like a security. Conversely Bitcoin and Ethereum were seen as sufficiently decentralized with no central party playing a determining factor in the enterprises’ success. Further, Bitcoin was designed specifically as an alternative currency to compete with fiat or gold vs. a structure that could parallel a security offering.
In response, many ICOs under the spotlight have been quick to point to the ‘utility’ of their tokens. Utility tokens essentially provide users with access to a product or service rather than an investment. For example Filecoin, which raised $257 million from their ICO, provides a decentralized cloud based storage service that takes advantage of unused computer hard drive space. ICO contributors received tokens that will give them the ability to purchase storage space from Filecoin once the service is launched.
Since the total supply of these tokens are fixed, the price would likely appreciate over time if the demand for the product increases. However, if ‘utility tokens’ are advertised or marketed by startups as an investment, they can expect regulators to follow.
Since institutional and larger accredited investors have been held at bay because of these concerns, projects are turning to a new token offering model: “STOs”, or Security Token Offerings, as a bridge between ICOs and traditional securities.
What exactly are Security Token Offerings?
If global regulators continue hammering down as expected, STOs are positioned to potentially replace - or at least provide a more consumer-friendly alternative to - ICOs. While security tokens are similar to ICOs in that their sale allows companies to efficiently and quickly raise funds, their key similarities end there.
The core difference is that instead of ‘utility’ applications, the tokens are explicitly tied to elements associated with traditional securities - i.e. portions of the company’s revenue, dividends, voting rights, etc. As such, STOs are not just crypto tokens associated with a startup, but much more clearly defined equity and backed by tangible assets. The this security+coin hybrid structure could bring a wave of new investors who have stayed away from ICO investing. 7pass for example, a “hybrid investment company focused on the emerging global legal cannabis market,” is one of many security token offerings leverage this investor interest.
Considering an expectation by many of inevitable regulatory oversight, there has been increasing recognition from industry leaders that ICOs should morph into STOs. Since they are theoretically far more consumer friendly by meeting regulatory criteria upfront, companies could avoid many of the pitfalls ICO issuers and investors have experienced to date.
Are STOs the next "mega trend?"
STOs do in fact have the potential to eliminate much of the risk associated with ICOs. Since STOs can represent real or synthetic equity in a company, they could provide increased legitimacy to the crypto landscape and bring a massive influx of investors along for the ride.
If ICOs do come to be fully regulated as genuine securities, we could see a rapid shift in companies trying to play by the rules and an entirely new landscape for token investing emerge - think new tokens, issuers, investors, regulatory processes, etc. Otherwise we could witness a continued tug-of-war between STO issuers the crypto purists who want to see ICOs and the entire landscape free of any regulatory entanglement.
One indicator that may paint a picture of what's to come are the number of industry leaders preparing for an influx of STOs. Overstock.com’s blockchain subsidiary tZero for example not only raised $134 million via their ICO designed to comply with SEC requirements, but recently raised an additional $270 million from Chinese private equity firm GSR capital to expand their STO-focused exchange among other asset tokenization offerings. The list doesn’t end there. Polymath, Blockchain Capital, Swarm, and Airswap are just some of the active players in the quickly growing STO space.
As an investor, you may find yourself asking - if STOs are going to be valued and regulated like traditional securities, why do we need tokenized securities at all?
Most STO evangelists contend that buying and trading this new class of asset-backed tokens is cheaper, faster, and generally more advantageous than its traditional security counterpart. Tokenized assets aren’t limited by the restrictions that surround traditional investing: they allow for fractional ownership, help to democratize investing, and are more convenient and cost effective for companies to launch.
For the issuers, they key advantage is unprecedented access to a global pool of capital. As these tokens can be sold and traded internationally (when compliant with regulations), they become more fairly priced and, therefore, more attractive to investors.
While many in the crypto-verse seem to be on board, these are still brand new investment vehicles and adoption will follow their innovation and appeal. With a limited number of market makers and licenses to trade these assets, overall infrastructure is also a key hurdle. As such, the growth of projects such as tZero will be telling.
But if the regulatory trends continue, you can expect to see far more STOs issued - bringing regulation craving institutional investors to the table for the first time and likely renewed, rapid growth of the entire crypto investment landscape.