Tokens offered in a Security Token Offering (STO) are financial securities backed by things with real world value, such as assets, profits or company revenue, and offer legal rights including voting or revenue distribution. This is in contrast to tokens offered on Initial Coin Offerings (ICOs), which bestow no rights or obligations beyond providing access to a specific platform, network or service.

Aside from the fact that they confirm ownership through blockchain transactions and make fractional ownership possible, security tokens – also known as digital securities – actually function much the same way as conventional securities. They are subject to federal laws governing securities, thereby offering some protection to investors.  Security tokens are also programmable, with the blockchain system allowing for them to act in specific ways through smart contracts, without the need for a third party. Loans that are tokenized on a blockchain, for instance, can automatically make payments rather than rely on conventional intermediaries such as banks.

Regulations that affect STOs

Bitcoin is regarded as a commodity by the Commodity Futures Trading Commission (CFTC), an independent agency of the U.S. government. Meanwhile, the Internal Revenue Service (IRS) views it a property and the Securities and Exchange Commission (SEC) considers many ICOs to be securities.

Platforms that offer securities must register as a national exchange or Alternative Trading System (ATS), or otherwise apply as a broker-dealer, while commodities exchanges that provide spot markets or currencies do not require licenses as regular entities.

Firms involved in stocks, bonds, bank deposits, and other financial assets need to comply with the Bank Secrecy Act, USA Patriot Act, and consumer protection laws.

Benefits of digital securities

Under Regulations A+, D, S, and Crowdfunding, digital securities also tends to be much less costly and time-consuming than conducting ICOs. As in the case of owning shares of publicly traded firms, tokens that are classified as securities usually provide investors with alternatives for generating dividends as well as profits and voting rights.

? Cost effectiveness

Security tokens come with no administrative costs of buying and selling, unlike financial models for investment. This basically lets investors make significantly greater returns on investments.

? Speed

The buying and selling of digital securities to investors has a tendency to be faster, owing to the automation of checks.

? Worldwide trading

As security tokens are eligible for trading at the global level, being accessible to anyone around the world, they usually enjoy high levels of liquidity, which are further enhanced by increased adoption and their overall status as financial instruments.

? Round-the-clock trading

Security tokens can be traded at any time of the day, making them preferable over conventional models which have to factor in time constraints.

Disadvantages

Excessive regulations and limitations affecting those who invest in security tokens or participate in STOs can significantly impact securities liquidity and hinder mass adoption of digital securities.

Secondary trading of private securities tends to require intermediaries, such as brokers and exchanges, while the process for tracking trade activity is costly and tedious. Issuers also have the major burden of safeguarding against regulatory risks. Such inefficiencies can result in trade restrictions being imposed and private securities being rendered illiquid. The value of private securities is subsequently discounted to account for the lack of liquidity.

? Offering security tokens

Those seeking to issue securities will need to register them in a process that is complex, expensive and time-consuming. Projects can make use of the JOBS Act of 2012, which fits the needs of those issuing security tokens despite not being intended specifically for STOs. Those in the United States can apply for exemptions under Regulations S, D, A+ or CF.

? Regulation S

Regulation S is known as the “safe harbor” exemption and is only an option for firms outside the United States. Although it is not subject to the registration requirement under Section 5 of the 1993 Act, creators must nevertheless follow regulations specific to the country of implementation.

In order to clarify the application of registration requirements outside the United States and its territories under the U.S. Securities Act, the Securities and Exchange Commission (SEC) adopted Regulation S, which consists of five rules. Rule 901 sets forth the general statement that the U.S. registration requirements only apply to “offers and sales” of securities occuring within the United States and its territories. Rule 902 sets forth definitions for Regulation S, while Rule 903 provides safe harbor for transactions involving issuances of securities in compliance with Primary Offer Safe Harbor specified guidelines. For offers and sales made in the United States, Rule 904 provides safe harbor for offshore resales complying with Secondary Market Safe Harbor specified guidelines. Rule 905 provides equity securities of U.S. domestic issuers sold in compliance with requirements of the Primary Offer Safe Harbor and deemed “restricted securities” under Rule 144 of the Securities Act. They are subject to holding periods before they can be resold in the United States without restrictions.

? Regulation D

Issuers must work with Rule 506 (b), Rule 506 (c), and Rule 504. Rule 506 (b) and Rule 506 (c) have no limit for fundraising, but allow only accredited investors in the United States. Rule 504 has zero restrictions on investor status, while Rule 503 issuers are limited to US$5 million in raised capital and need to register the security with state regulators. Additionally, Regulation D allows for General Solicitation, through which companies can advertise their projects and fundraising.

? Regulation A+

For businesses seeking to raise under US$50 million while looking to solicit non-accredited investors, Regulation A+ is appropriate. Factoring the restriction for providing two years of financial statements, established startups would prefer Regulation A+, under which issued securities would not have restrictions on resale, thereby resulting in more liquid markets when compared to Regulation D.

? Regulation CF

Startups raising capital under Regulation CF can raise as much as US$1.07 million, intended primarily to fund small projects quickly in order to facilitate innovation, with a 12-month lock on secondary markets being the main disadvantage.