Security Token Offering – An Outcome of the expanding body of Regulations in the Blockchain Space
Tightening the scrutiny of token issuances has made the crypto space more reliable for the participation of traditional investors
For a long time, the appeal of cryptocurrency and blockchain lay in the fact that it operated in a widely unregulated environment. The innovation was believed to be riding on principles recognized as libertarian and anti-establishment, and the prospect of it turning toward the regulated structure of the existing financial framework seemed like bit of an antithesis. This step had come to be necessary, given the scores of bad players who exploited the decentralized platform to raise money for unstable projects.
Contrary to the dread regulating the blockchain space had caused among fans, assimilating some degree of organization and accountability has propelled the evolution of blockchain forward. It has been instrumental in significantly mitigating fraud in the system of true peer-to-peer cross-border transfer of value, and innovative ways to raise capital or invest in projects with high potential, introduced by blockchain. One of the most notable outcomes of drawing up more in-depth regulations around this technology is the emergence of Security Token Offerings.
In the context of cryptocurrencies, regulations mainly refer to two primary concepts: Anti Money Laundering (AML) and Know Your Customer (KYC) regulations, and the regulations associated with the issuance and trading of securities. Unlike Initial Coin Offering which is mostly done for utility tokens, Security Token Offerings are done for security tokens which represent actual shares of companies. Regulations have laid the foundation for investors to put their money into tokens with the guarantee that their investment will be utilized by the company as intended or promised.
The debate over how to most efficiently describe a security is yet over, but the general consensus is that tokens which pass the Howey Test established in the United States are security tokens. According to this test, any money invested in a common company to earn profits exclusively through the labor of third parties is a security. Even up until late 2018, ICOs did not think it necessary to run a background check on their investors and left the door wide open for many to misuse business associations to siphon illegal money. Of late, many ICOs completely avoid jurisdictions which have clamped down on ICO laws, or, adhere to the set regulations and conduct the coin offerings as security token offerings.
The law in the United States regarding security token offering is similar to that for IPOs. Securities can be registered through either of the two processes – through an S-1 filing, or through an exemption (of which there are many). The processes are more complex and expensive when compared to issuing tokens through an unregulated ICO. In order to avail an exemption, the issuer needs to file a form with the SEC.
The transition from the ICO model to STOs has led to the shrinking of the pool of investors who could who were previously permitted to their money in such a form of fundraising. In the United States, a large percentage of private securities are limited to “accredited investors”, who is typically someone with a net worth exceeding $1M, or an ongoing annual income equal to or more than $200,000.
Previously in the lack of scrutiny from the SEC, holding ICOs were not a challenge. Tokens were launched, listed and sold on crypto exchanges swiftly and without much hassle. This has changed ever since most tokens have been recognized as securities, requiring issuance to pass through appropriate exemption. The tokens are now also subject to resale limitations.
Benefits of increased regulations and STOs:
The SEC was not very swift to adapt but eventually created rules with proper advantages in mind. The benefits of regulation of security token issuances can be segmented under three broad categories:
1. Investor Protection
The primary outcome of security issuance regulations is investor protection. Although it may complicate the process for legitimate projects, restricting the eligibility for investing in limitations on who can invest in unregistered securities offerings makes raising money less enticing for fraudulent companies. The lack of investor protection laws combined with the ICO craze of late 2017 enabled many companies with no plan or product to rake in funds riding simply on a catchy pitch or decent whitepaper. Greater regulatory scrutiny of ICOs would have averted most of these scams, and meted stricter penalties to the perpetrators.
2. Legitimized crypto across industries
The crypto industry is comparatively riskier than traditional capital markets. Because of this reason institutional investors, who are the largest players in the space, have been unwilling to participate in the market, despite it being fast moving and more accessible for investors and entrepreneurs both. The presence of traditional investors is important among crypto investors since it could potentially lead to a surge in demand and therefore increase prices.
3. Higher-Quality Issuances
Increasing regulation will impact the quality of token issuances. Issuers will have to conform to securities laws, raising the bar of eligibility to enter the token fundraising market. A highly scrutinized token issuance process will filter out fraudulent or weak projects from holding an ICO, improving the quality of security token issuances.
Institutions have welcomed increased regulation and see it as a necessary step before they can invest in crypto. To them, the financial risk increases multifold when dealing with money that belongs to other people, since they are liable to suffer not only financial loss but also become subject to further repercussions as a consequence of misapplication of fiduciary responsibility. These could include financial penalties and reputational damage. Overall it can be said that the risk posed by institutional crypto investment outweighs the reward and the most effective way to increase institutional investment while decreasing blockchain investment risk was by placing stringent regulations in place.