Security token offering

• 1. Introduction

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  Security token offerings were designed for a market that had lost billions of dollars to fraud. Initial coin offerings allowed companies to sell digital tokens to the public with almost no regulatory oversight. The resulting criminal activity ranged from terrorist funding to tax evasion. The STO was built as an alternative: a blockchain-based offering that operates within established financial law rather than outside it.

  Equities, fixed income, and ownership stakes in real companies can all be represented as security tokens. These tokenized digital securities are sold on security token exchanges and validated on a blockchain virtual ledger. That ledger records every transaction. The tokens carry the weight of actual financial instruments, subject to the same regulatory obligations as a conventional stock or bond.

  Bitcoin's central selling point was decentralization, meaning no government could influence or control the currency. By extension, ICOs shared that quality. When regulators began to push back, the central question was how to tell a utility token from a security token. By the close of 2019, that question had produced enforcement actions, national bans, and entirely new markets. The answers are still being written.

• 2. An Intermediary Model

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  Binance, Kraken, and Binaryx are among the cryptocurrency exchanges where both ICOs and STOs reach the general public. Their shared venue suggests they are the same kind of offering. They are not.

  ICO tokens are the offered cryptocurrency's actual coins. They are entirely digital and classified as utilities rather than investments. New ICO currencies can be generated without limit. Their value is almost entirely speculative, determined by what buyers expect the tokens to provide rather than by any underlying asset.

  Bonds and stocks are the closest traditional parallels to security tokens. Security tokens are actual securities, tied to a real company. Where an ICO asks buyers to believe in a project, an STO delivers a regulated financial instrument. That distinction is what places STOs under securities legislation rather than utility regulation.

  For small and medium-sized companies, the choice between an ICO and a full IPO has real cost implications. ICOs, because they bypass traditional exchanges, have offered a less expensive path to public funding than a conventional IPO. An STO on a regulated exchange, called a tokenized IPO, has the potential to deliver comparable efficiencies. Those gains come only after meeting the full requirements of securities law.

• 3. The Utility Defense

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  Kik, the messaging app, was sued by the SEC for over $100 million for selling what it described as a utility token. Telegram, another messaging platform, faced similar regulatory pressure and delayed its offering plans. Both companies discovered that calling a token a utility does not make it one in the eyes of the law.

  Legislation generally draws the line at passive financial return. If buyers expect a return on their investment without active involvement in the project, regulators classify the token as a security. That standard applies regardless of what the offering company claims about its own product.

  Some companies have deliberately exploited this ambiguity. Assuming a token is a utility has been used as cover to sell securities without regulatory compliance. If such an offering can later be proven to carry an expectation of financial return, the ICO becomes, in legal terms, an unregulated STO. Legal punishment follows.

  That line has been drawn differently in more than a dozen countries, with outcomes ranging from open regulated markets to outright bans.

• 4. A Global Patchwork

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  The European Union brought security tokens under MiFID II, the regulatory framework governing conventional securities markets across its member states. Newly issued tokens must meet the requirements of the EU Prospectus Directive. Germany issues MiFID licenses through the federal financial authority BaFin. The United States subjects security tokens to the SEC under the same laws as traditional securities. The United Kingdom's Financial Conduct Authority classifies them as Specified Investments.

  Switzerland placed security tokens under FINMA, applying the same laws as traditional securities. Singapore's approval process runs through the Monetary Authority of Singapore, requiring compliance with the Securities and Futures Act. Japan regulates security tokens under its Financial Instruments and Exchange Act. Hong Kong has its own framework through the Securities and Futures Commission. Canada, Brazil, Israel, and Malaysia each maintain separate approval bodies. Australia treats traditional and tokenized securities under different rules.

  China banned STOs and ICOs entirely, classifying them as illegal financial activity. The United Arab Emirates has no federal regulations for security tokens. Both the Abu Dhabi Global Market and the Dubai Financial Services Authority have provided guidance at the regulator level. South Korea set a 2027 target for full STO integration, through amendments to its Electronic Securities Act and Capital Markets Act.

  Thailand's Securities and Exchange Commission had already granted legal approval to ICOs, with STO application criteria still pending. Where frameworks had solidified, companies were already putting them to use.

• 5. First Tests

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  By the end of 2019, security token offerings had been deployed in three distinct scenarios. Stocks already listed on the Nasdaq were traded through the model. World Chess, FIDE's official broadcasting platform, used an STO for its pre-IPO. Singapore Exchange built its own STO market, backed by Japan's Tokai Tokyo Financial Holdings.

  Japan's Tokai Tokyo Financial Holdings brought institutional backing to Singapore Exchange's experiment. That the support came from a financial holding company, rather than a cryptocurrency startup, pointed toward a broadening of interest in the model.

  Whether that institutional interest would accelerate the STO's global adoption was, at the close of 2019, still unanswered.