The explosive surge in ICOs during 2017 and early 2018 was unlike anything seen before, introducing a groundbreaking way to amass huge funds almost instantly. Yet, as numerous ICOs turned out to be fraudulent, failed to meet their commitments, or depleted their funds before launching a product, the heyday of ICOs significantly waned in the latter part of 2018.
Despite the diminishing appeal of ICOs, the potential of blockchain-powered tokens to innovate financial assets and tools remains strong. The decentralized finance (DeFi) movement is gaining traction, with several pioneering financial vehicles in the spotlight. collateralized debt platforms to decentralized prediction markets materializing left and right.
The DeFi space is keenly focused on transforming traditional financial securities into digital tokens housed on a blockchain.
'Security tokens' as they're widely known, are basically securities that signify ownership or liability, enveloped in a digital sheath to enhance the assets with a range of benefits and adaptability.
Following closely behind the ICO's legacy, Security Token Offerings (STOs) have captured the imaginations of investors, service professionals, exchanges, and others striving to stake their claim in a fast-growing market. Security tokens hold fascinating potential, with STOs serving as a vital method for firms looking to issue digital assets via blockchain.
What is a Security?
A conventional financial security is essentially a replaceable instrument carrying value that can exemplify either debt or ownership.
When securities represent ownership, they can symbolize stakes in a business (like stocks), giving stakeholders the chance to profit through capital growth of the asset or occasionally receive dividends. Holders of equity securities may have stakes in either public or private companies, generally securing some form of ownership in the firm.
Securities depicting debt are essentially representations of borrowed funds that necessitate repayment and encompass multiple lending conditions. There's a wide array of debt securities which includes varieties such as:
- Government bonds
- Collateralized Debt Obligations (CDOs)
- Collateralized Mortgage Obligations (CMOs)
- Corporate Bonds
- Certificate of Deposits
Holders of debt securities are typically granted the right to receive interest on the principal amount, which can be supported through methods like collateralization or otherwise.
Securities hold immense sway in the financial sphere and are highly pertinent to STOs due to their proficiency in capital raising. Companies can procure vast capital sums by engaging in Initial Public Offerings (IPOs) of equity when they opt to go public, while governments might issue municipal bonds to secure funding.
Public securities are actively traded on prominent stock exchanges and can be exchanged between investors in secondary markets as tradable assets.
Exploring the realm of Security Tokens and the nuances of Security Token Offerings (STOs).
There's a common misconception that security tokens differ markedly from traditional securities. However, despite being housed on a blockchain, they effectively function as securities governed by the same regulations and legal precedent as conventional financial instruments.
However, security tokens offer some unique advantages — specifically in improving liquidity in secondary markets, lowering compliance costs, automating trading restrictions, offering fractional ownership, and ensuring seamless asset interoperability.
STOs have flung open the doors for companies to acquire capital by issuing digital security tokens to investors while staying compliant with regulations. This approach benefits both investors and issuers, offering greater fraud protection than ICOs. Issuers span various sectors, such as commercial real estate, venture capital firms, and small to medium enterprises (SMEs).
There is discussion debate on what precisely defines a 'security token' or 'tokenized security,' but for most intents and purposes, STOs in this narrative revolve around launching new security tokens rather than tokenizing pre-existing financial vehicles.
An STO can be incredibly straightforward and advantageous for an SME in need of funding, especially when commercial banking services are inaccessible. Parallel to other emerging DeFi offerings, SMEs can explore open financial alternatives — issuing security tokens accessible to investors on the blockchain. This avenue significantly reduces entry barriers for retail investors while expanding financial possibilities for SMEs in local or regional territories where financial limitations have historically prevailed.
Moreover, SMEs issuing security tokens serve as a prime example of the multifaceted players within the security token ecosystem.
Read: Tokenizing Financial Assets
Delving into the vibrant ecosystem of Security Tokens and its numerous participants.
When an SME — let's call it Company A — wishes to distribute security tokens representing equity in its operation, they can do so by collaborating with several key market entities, including:
- Issuance Platforms
- Exchanges
- Custodians
- Broker-Dealers
- Legal/Compliance
Company A can issue their security token to investors via a dedicated issuance platform. Some of the well-established issuance hubs include Polymath and Harbor , which provide seamless integration with required services like custodians, broker-dealers, and legal/compliance bodies to ensure a secure, regulation-adherent procedure.
Developers working with such platforms also refine standard token interfaces (like ST-20 for Polymath or R-Token for Harbor), embedding regulatory parameters directly into the token architecture, such as stringent trading restrictions. These standard interfaces for security tokens also enable asset compatibility, enhancing secondary market liquidity and minimizing token trading frictions.
Read: Our Guide to Polymath
Custodians uphold a strong reputation for safeguarding digital tokens in extremely secure offline storage — particularly crucial for institutional investors. BitGo ranks as a frontrunner among digital asset custodians, often collaborating with exchanges or issuance settings.
Trading platforms permit investors to exchange security tokens, thereby providing improved capital access, boosted liquidity in secondary markets, and an equitable investor entry point into securities. tZero has made headlines as a notable exchange, recently launching with support from Overstock. Security tokens from Company A can freely trade on exchanges like tZero, where investors undergo necessary Know Your Customer (KYC) and Anti-Money Laundering (AML) verifications. Remarkably, a few exchanges can function as issuance platforms concurrently.
As an SME, Company A's security tokens can be extended to retail investors who otherwise find SME investment opportunities out of reach due to restrictive entry criteria. Yet, by democratizing access to security tokens, SMEs gain momentum by pooling investments within local communities, ultimately fostering growth in small enterprises and nurturing the development of local businesses.
Open financial frameworks like Mt. Pelerin is also exploring the creation of SME marketplaces, enabling entities like Company A to discover comprehensive, open-financial services on the blockchain.
Distinct applications for security tokens are already materializing, such as investment funds in commercial real estate (think of REITs ) which bring down exorbitantly high investment minimums and even usher in innovations like fractional ownership. Harbor has already hosted successfully managed an STO for a property in South Carolina, drastically reducing minimum investment requirements relative to prevailing standards.
STOs vs ICOs
Overall, STOs negate the fraudulent tendencies associated with ICOs and provide credible securities to an expanded investor base with improved efficiency, asset compatibility, and market liquidity when compared with traditional securities. STOs are anchored by tangible assets, unlike ICOs initially championed as 'utility tokens' lacking real collateral and unprotected by securities legislation.
Contrary to IPOs, STOs provide a cost-effective alternative and can untangle a broader spectrum of assets — from fractionalized ownership investment funds in treasured art collections to various forms. Launching an STO involves significant fee reductions in banking and brokerage as a consequence of process automation in comparison to traditional IPOs.
It's vital to understand that despite STOs falling under securities laws in the U.S., introducing security tokens carries legal intricacies since they're derived from emerging technology. Several nations outside the U.S., including China and South Korea, have preemptively banned STOs.
Within the U.S., substantial financial investments are pouring into the budding security token space as participant roles continue to take shape. Examining which markets will shine at the dawn of security tokens is pivotal to understanding which sectors the STO model optimally serves. Undoubtedly, both SMEs and Real Estate Investment Trusts (REITs) epitomize straightforward applications of STOs, but numerous other practical, regulatory-friendly, and economically viable security token ventures exist.
Conclusion
ICOs introduced an outlandish trend, sparking a flurry of activity around altcoins at the tail end of 2017. However, the industry has grown more discerning since then. As ICOs lost steam, security tokens emerged as a judicious application of blockchain technology, marrying traditional financial tools with digital assets.
With DeFi making significant inroads, security tokens are positioned to significantly influence the major shift towards a universally accessible financial landscape.
1Comment
A good one for the crypto newbies.