Understanding Security Tokens: Learning the Language of STOs
Security tokens are emerging as the next major trend in crypto, finance, and asset management. As such, understanding what security tokens are, how Security Token Offerings (STOs) work, and the key legislative and regulatory bodies is vital for anyone wishing to capitalize on this nascent industry. The number of STOs is steadily growing, with over 120 completed to date, raising $512M.
Due to the unique terminology and technical concepts involved, the STO industry is harder to master than ICOs. It’s a space that includes numerous terms borrowed directly from the traditional stock market that have been appropriated by the crypto community. In this post, we will break down some of these terms and concepts to equip you with the lexicon you need to journey into this fascinating new area of the cryptoconomy.
The SEC’s official definition of a security is:
Any note, stock... future, bond, debenture, evidence of indebtedness, [any of a variety of certificates], transferable share, investment contract... [any of a variety of interests], any put, call, straddle, option, or privilege [of various kinds] or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
In short, “a security” refers to a wide range of interests or instruments attesting ownership of some form of property. The term is often used as a shorthand to describe the property represented by the document.
In very simple terms, security tokens are digital representations of securities or the digital securities themselves that can be housed on a blockchain. Legal definitions of a security token are, in many jurisdictions, still somewhat nebulous and are usually based on assessments of the extent to which a token conforms to existing securities regulations. In the US, definitions can be compiled from the DAO report, the “Munchee Order” [Securities Act Rel. No. 10445 (Dec. 11, 2017)], and the “Framework for “Investment Contract” Analysis of Digital Assets”. The UK’s Financial Conduct Authority offers a limited and subjective definition here, while Switzerland’s FINMA’s definition is here (p. 4).
Tokenization is the act of representing an asset or shares in an asset through a security token that exists on a blockchain. Tokenization facilitates the purchase and sale of fractions of tokenized assets on the open market, thus allowing even the smallest investors access to a percentage of traditionally inaccessible assets while also allowing the owners of the assets to raise funds against assets that are usually illiquid (e.g. a chain of bars, the rights to a hit song, a privately owned island).
A Security Token Offering. STOs are similar to ICOs in the sense that their purpose is the issuance of tokens as a form of fundraising. The difference is that STOs are conducted in strict compliance with the securities laws and regulations of the jurisdiction(s) in which they are offered. As such, they offer far greater protection to investors, encourage the entrance of institutional investors, and satisfy regulators.
STO issuance platform
STO platforms are protocols that manage the entire lifecycle of a security. This can include issuance, custody, KYC checks and secondary market trading. They can contribute to efficient issuance and transfer of securities at a low cost while avoiding counterparty risk. They facilitate the integration of the financial system, according to regulatory rules, under one common standard that provides synergies to all participants while also tackling the long-term liquidity issue that illiquid assets face by democratizing private assets and, thereby, improving market depth. For an in-depth view of STO platforms, see our recent article.
The Howey Test
A US Supreme Court test for determining whether certain transactions qualify as “investment contracts” (a form of security). As the SEC states, an investment contract exists “when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” If an asset fits this definition then it is likely that it will be recognized as a security. The SEC has frequently applied the Howey Test in its assessments of crypto tokens to judge whether or not they qualify as securities. The Howey Test was, for instance, instrumental in the SEC’s decision that “DAO Tokens Are Securities”. Though the Howey Test relates specifically to US determinations of securities under US securities regulations, since the US is such a dominant jurisdiction, the Howey Test can influence how other jurisdictions will classify a token.
Accredited investors are persons who legally qualify to invest money directly in private equity (unregistered securities). To qualify as an accredited investor by the SEC, you must:
- Have $1 million+ personal net worth or joint net worth with your spouse (not including the value of your primary residence).
- Have a yearly income exceeding $200,000 for the past two years or a joint income with your spouse of $300,000.
You can find the SEC’s official qualifications for accredited status here. Many STOs offer their tokens solely to accredited investors in order that they may be exempt from having to register their securities and completing the expensive and time-consuming regulatory filings that would this would entail.
Liquidity is “the interchangeability of assets and money” or, more simply, the ease with which something can be bought and sold with minimal slippage. Tokenization can render traditionally illiquid assets (e.g. real estate, art, a share in a private company) far more liquid by enabling secondary market trading, allowing smaller investors to purchase fractions of the asset and unlocking capital from global investors.
Settlement is the confirmation of a payment of account (i.e. the delivery of an asset and the reciprocal payment). In traditional markets, settlement can take a number of days following the initial trade agreement. This period comes with significant counterparty risks (e.g defaulting). Due to their automated nature, security tokens allow for extremely short settlement periods and, as a result, limit counterparty risk.
A broker-dealer is an entity (broker-dealers can range from giant firms like LPL Financial and Ameriprise Financial down to sole proprietors) that purchases and sells securities either for itself or on behalf of its customers. Broker-dealers are subject to a great deal of regulatory oversight and stringent legislation. Broker-dealers are relevant to STOs because, while non-security tokens are tradable commodities, the trading of any token that is recognised as a security is heavily restricted. Registered broker-dealers can, however, offer securities to their customers.
The SEC’s DAO report declared that the DAO ICO had violated federal securities laws since “DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).” This report is significant as it marks the beginning of the SEC’s oversight of the cryptoconomy and alerted many to the danger of tokens being recognized as securities. The DAO report is considered by many to be the genesis point of STOs.
The US Securities and Exchange Commission. An agency of the US federal government that is charged with the creation and enforcement of federal securities legislation and regulation of the industry. Since security tokens are simply a form of representation of an underlying security, their oversight falls within the purview of the SEC. More details can be found on our recent article.
The U.S. Commodity Futures Trading Commission. The CFTC aims “to foster open, transparent, competitive, and financially sound markets, protect market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act (CEA)” As an entity that pursues market integrity and polices the industry for abuses, the CFTC often has jurisdiction over crypto assets.
The US Internal Revenue Service. A bureau of the Department of the Treasury tasked with collecting taxes and enforcing the Internal Revenue Code. The IRS has released extensive guidance on taxation of crypto assets which you can read here.
The US Financial Industry Regulatory Authority, Inc. is a private, not-for-profit, self-regulatory organization authorized by Congress to ensure the broker-dealer industry operates fairly and honestly. FINRA works to protect investors from fraudulent broker-dealers and scams.
The Swiss Financial Market Supervisory Authority is the Swiss government body responsible for financial regulation. FINMA is significant in the space due to the significance of Switzerland as a hub of crypto assets and blockchain. FINMA’s guidelines on crypto asset regulation can be found here.
The UK Financial Conduct Authority. The FCA is an independent financial regulatory body tasked by the UK government with the regulation of UK financial firms and the maintenance of the integrity of domestic financial markets. The FCA’s crypto assets guidelines can be found here. See particularly the UK Cryptoasset Taskforce report.
As the SEC states, “The federal securities laws require all offers and sales of securities, including those involving a digital asset, to either be registered under its provisions or to qualify for an exemption from registration.” The costs associated with registering a token with the SEC can be extremely high. Exemptions provide exclusion from registration requirements. If the team/project/token can fulfil certain criteria, they can qualify for an exemption and, in doing so, save themselves a lot of time and money.
The majority of security token offerings that have so far sought an exemption have done so under the Reg D filing. There are a number of different rules that a security can file for under Reg D.
Under Rule 506 (b) there is no capital raising limit but only accredited investors and up to 35 sophisticated investors can take part. The fundraisers cannot undertake general solicitation.
Under Rule 506 (c) there is no capital raising limit but investment is restricted to accredited investors only. The fundraisers can, in this case, undertake general solicitation.
Under Rule 504, while there are no investor restrictions, a capital raising limit of $5M is enforced. Again, fundraisers are free to undertake general solicitation. Rule 504 does not preempt state regulations, meaning that it must also comply with regulations in each individual state it sells securities.
Often referred to as the “mini Initial Public Offering”, Reg A+ allows fundraising of up to $50M over a 12-month period and is open to non-accredited investors. However, it is believed at the time of writing that no Reg A+ STO has yet been passed by the SEC.
Regulation CF or regulation crowdfunding is designed to allow startups to quickly raise up to $1.07 million in funds. It allows general solicitation and preempts state regulations. However, a Reg CF must be conducted through a registered platform only, and there remains a 12-month lock-up on securities after purchase.
Regulation S is a safe harbor exemption for securities sold to non-U.S. investors. It can be used in combination with other exemptions. There are a number of categories of Reg S filings that you can read about here.
For a more in depth analysis of exemptions see our recent article.
There are many more native and esoteric terms that apply to the world of security tokens, some of which we’ll address in a follow up to this blog. In this post, however, we’ve defined what a security token is, and covered the Regs and regulatory acronyms you’ll commonly hear. To learn more about how these agencies impact security token issuance within the EU, check out our recent article Everything You Should Know Before Launching an STO in Europe.