Block chain-enabled fundraising methods are revolutionizing startup financing globally while offering investors new and exciting investment opportunities in the cryptosphere. However, unlike ICOs, STOs comply with regulations and, as such, afford investors similar rights, obligations, and protections that regulated assets have. In this article, I will discuss Security Tokens and STOs: A New Frontier for Block Chain and Securities Laws in this article.

“Almost any illiquid asset today lends itself well to moving onto the blockchain and becoming tokenized. It will create a deeper market with improved price discovery and should increase the value of those assets.” David Sacks, General Partner, Craft Ventures, Former COO, PayPal

For some years, the crypto space was the forte of anti-establishment investors, primarily because of its decentralized nature. Until recently, conventional financial institutions were wary of engaging crypto firms. Traditionally, companies utilized IPOs, venture capital, and loan facilities for fundraising.

The lack of financial services caused crypto startups to explore innovative ways of fundraising. The growth of the digital economy has introduced novel ways of raising funds, including Liquidity Generation Events ( (LGEs), launchpads, STOs, ICOs, and Initial Dex Offerings ( IDOs), among others. Indeed, necessity is the mother of invention.

Generally, transferring interests for assets like fine art, real estate, precious stones and metals is usually a strenuous task. Their transfer demands that parties contend with lengthy procedures, which are normally accompanied by colossal amounts of paperwork and bureaucracy. Fortunately, distributed ledger technology makes it possible to represent physical assets on a block chain as digital assets ( tokens), through a process known as digitization of assets ( tokenization).

A security tokenrepresents a holder’s stake in a business or asset. Security tokens are subject to security laws, as their value derives from external things. For instance, a security token issued in Kenya must comply with the Capital Markets Authority Act, among other regulations. Similarly, a security token issued in the US must comply with federal rules and regulations provided for under the Securities Exchange Act of 1934 and the Securities Act of 1933. Both enterprises and governments can issue security tokens.

Currently, numerous financial assets exist digitally. For instance, many economies worldwide are slowly transforming into cashless societies, where money exists digitally and is represented on electronic devices. In some parts of the world where security tokens are legally recognized, firms and startups issue investors with shares in the form of security tokens.

Security tokens are issued on a distributed digital ledger, which boosts, among other things, transparency and divisibility. Digitizing physical assets aids in unlocking their value, making it possible to transact them in real time. Block chain technology ensures the safe storage of ownership stakes. By coupling the transparency distributed ledger technology offers and the ease of transacting tokens, companies and governments can make previously illiquid asset classes available to markets.

STOs have emerged as viable crowdsourcing techniques due to several reasons:

Below is a brief overview of the various security tokens that are available for investors:

Generally, companies raise funds by taking out loans and issuing corporate bonds. Today, companies may issue debt tokens to raise funds. Debt tokens represent the debt a firm owes the holder. Typically, they accrue interest. Debt tokens are categorized into two: variable debt tokens and stable debt tokens. The interest rate attached to variable debt tokens fluctuates, while that of stable debt tokens remains stable.

In conventional markets, equity represents an investor’s stake in a company or asset. The same principle applies to equity tokens. Additionally, holders of equity tokens are entitled to a share of an enterprise’s profits, and subject to the terms of an offering, they may have voting rights.

Utility tokens are critical for crypto startups, firms, and project development groups, as they help secure funds for block chain projects. After the successful completion of the project, utility token holders may use them to conduct transactions with the issuer.

Asset-backed tokens represent physical assets on a distributed digital ledger. Assets on a block chain platform can range from real estate to commodities, vehicles to fine art, etc. These types of tokens allow fractional ownership and unlock previously illiquid assets.

Through an STO, companies sell security tokens via Security Token Exchanges. Security Token Exchanges enable firms that can not participate in an initial public offering ( IPO) to a fundraising opportunity within the confines of the law. Indeed, security token exchanges are controlled by the same rules and regulations that apply to conventional exchanges. For instance, they are required by the law to provide surveillance and oversight while upholding fair and orderly markets.

An enterprise looking to engage in a security token offering must comply with the securities laws of its jurisdiction. For instance, a company conducting an STO in the US must comply with the requirements of the SEC. The company must also follow prevailing anti-money laundering and Know Your Customer standards. Additionally, for the benefit of lay investors, issuers of security tokens must provide investors with intricate details about their offerings in plain English. Issuers satisfy this requirement by publishing a white paper.

Before issuing an STO, a company must contemplate the ramifications of regulations before going forward. For instance, under American laws, enterprises seeking an offering must register with the SEC or apply for an appropriate registration exception. Within the EU, companies looking to make an offering must register with the European Securities and Markets Authority ( ESMA).

In the EU, security token offerings fall under the purview of the Markets in Financial Markets Directive II( MiFID II). Companies offering multi-jurisdictional STOs must ensure they comply with all rules and regulations provided for under local laws. They must ensure they get authorization from local regulators before commencing an STO.

As mentioned earlier, security tokens represent various interests and assets. Before offering an STO, a firm must consider the underlying asset because different legal rules apply to different asset classes. Additionally, issuers need to consider issues related to governance and corporate structure.

For instance, before issuance, a company must ensure that its incorporating documents empower it to undertake such an activity. Additionally, issuers must consider how many token holders are allowed under a jurisdiction. For example, under US laws, only 99 residents can participate in an STO.

“The token market will be larger than the securities market, because in some way it will absorb the securities market. All the securities can be tokenized today. The beauty of the token is that you can represent anything, and not only securities, and that is what will drive at first the growth of the token.” Etienne Deniau, Head of Business Strategy, Société Générale Securities Services

Like traditional securities, a security token represents a stake in an asset or project. Just like conventional securities, security tokens must comply with the rules and regulations that apply within the jurisdiction they are offered. Generally, tokenization/ digitization of assets simplifies and automates the laborious and manual processes that issuers of securities have to go through to provide securities to financial markets.

Tokenization will help financial markets access greater liquidity and bigger pools of potential investors. The world is rapidly embracing token-based assets. Indeed, tokenization makes transferring certain assets within digital platforms happen faster. As geographic barriers are removed, opportunities for global trade increase tremendously.

As previously mentioned, digitization of assets will help markets unlock certain assets that have been illiquid for the longest time. Tokenization provides us with new ways of fractional ownership. Compared to traditional securities, a larger number of individuals can invest in security tokens due to, among other things, reduced investment costs.

Tokenization enables issuers of tokens to reduce friction in creating, selling, and purchasing tokens. Utilizing distributed ledger technology enables enhanced efficiency and minimizes errors during the creation, management, and issuance of security tokens.

The financial industry spends billions of dollars annually on compliance. However, block chain technology limits the possibilities of errors while making it easier and more affordable for financial companies to manage complex regulatory requirements by programming them in each token. In a nutshell, security tokens help to guarantee better compliance.

The use of block chain technology makes any form of corruption readily apparent. Block chain technology provides one source of truth to all parties. Any information added is available to all parties in real-time. This also helps minimize conflicts relating to record keeping. Users utilize shared ledgers and smart contracts to create fractionalized real estate, dynamic EFTs, etc.

Since time immemorial, governments and regulatory agencies have resisted innovative ideas. They generally tend to prefer legacy technologies. Despite this, the approval of regulators and governments is necessary for a token-driven economy to take root.

Despite the many advantages of tokenization, the digitization of assets has its risks. For instance, extensive regulations limit the flexibility of security token offerings. While extensive regulations may help legitimize STOs in the eyes of investors, highly stringent regulations may lock out the public. Surprisingly, while digitizing many types of assets is possible, analyzing their value may be problematic for investors.

The crypto industry is subject to widespread policy and regulatory changes; this may cause the value of STOs to fluctuate. Generally, market fluctuations usually cause losses to investors. The speedy and anonymous nature of tokenization may result in high compliance costs. Unlike traditional markets, which have had the luxury of years to create compliance infrastructure, the crypto industry has only been around shortly.

Creating a comprehensive infrastructure that inspects transactions for financial misconduct and criminal activity, like money laundering, takes a lot of money and time. STOs are susceptible to risks like money laundering and terrorist financing, causing costly compliance investments. Asset tokenization platforms rely heavily on open-source software for development purposes. This exposes tokenized assets to risks such as cyber-attacks, theft, and programming errors.

One of the greatest challenges to the establishment of token-based economies is security. Virtual assets are highly susceptible to volatility risks, further increased by crypto heists, cyber attacks, and regulatory changes.Block chain folksmay cause instability to digital assets, making it unfavorable for users as a medium of exchange.

Before issuing an STO, ensuring you have complied with all regulatory requirements is important. Due to the uniqueness of distributed ledger technology, securities agencies worldwide are developing more stringent rules on money laundering and combating the financing of terrorism. This is with good reason, as the crypto industry has become notorious for financial misconduct.

Tokenization promises to be a disruptive endeavor. It will cause the creation of novel asset classes and assets, leading to new primary and secondary markets characterized by minimum friction and low entry costs. Regulatory and government support will be vital if tokenization is successful. The potential of tokenization can only be fully realized if it receives full regulatory and government support.

Adopting new technology is normally difficult for most people. Surprisingly, institutions also need help to adopt new technologies. Most prefer legacy systems, which despite meeting their purpose, hinder growth. The primary reason why individuals and institutions find it difficult to adopt emerging technology is because of the inherent apprehension such innovative ideas elicit, and with good reason too.

The crypto industry is littered with incidents of rug pulls that have cost investors billions. A rug pull is a scam where crypto or NFT developers hype a product to raise funds and suddenly disappear with those funds. However, due to widespread demand by investors and governments, the crypto industry is pushing toward a merit-based direction, which has helped enhance innovation and credibility.