As originally published on medium.com
Why do so many people believe an STO (Security Token Offering) is the continuation of the ICO market?
Why STOs are unrelated to ICOs….
Look it is obvious when you think about it, Initial Coin Offerings so called ICOs came about for two reasons. Firstly the banks weren’t lending post 2008 and the VC flesh cost of capital remains high for entrepreneurs, and second, the Ethereum platform created the concept of a ‘token’ , something that could be created to be purchased as income capital and then sold as a speculative instrument, although technically not an instrument or anything…relying on uncorrelated price moves based on retail trading emotions, fuelled by the rise of Alts… Nothing more.
It was all down to Vitalik and his virtual transaction processing machine, the Ethereum protocol that provided the means behind this new process for raising capital and the genius of the piece this thing called the ‘token’. A network protocol supported by a programming language (Solidity) that enables simple move of a store of value to be coded as a Smart Contract and recorded on a distributed database. In fact 90% of Ethers’ value was related to ICOs, as the primary Use Case. A ledger based system which is the issue really, unlike Bitcoin that uses UTXO (unspent transaction output).
Oh yes then there is the smart contract where code as law, code is an instrument, code as a commercial agreement is in fact the only similarity between an ICO and STO in that both have a Smart Contracts. Although the ICOs versions are simpler.
We will come back to this point later…
STOs aren’t new
Look, anyone who thinks an STO is a continuation of the ICO madness is both a danger to themselves and to our Crypto Capital Markets movement.
Security Tokens are not only unrelated to ICOs they are a digitisation of what is already exists. A faster more up to date of Capital Markets without the hangers on, layers of useless intermediaries that add no value. Security Tokens are a manifestation of commercial rules and terms in software code, a digital financial instrument recorded as shares, bonds and asset based instruments. But this is when Blockchain works against you. These instruments are then able to be traded Peer 2 Peer, where the big issues begin for our community building new crypto capital markets infrastructure?
One could argue there is no actual STO market, merely the digitisation of financial instruments onto the Blockchain that opens to door for privately held companies to trade their assets on newly created security token exchanges…
STOs benefit from the use of Blockchain technologies in their native form as a genuine cost out solution removing friction, time, cost making it simpler and more efficient for companies to issue a financial instrument to raise capital. The game changer in Crypto Capital Markets has been security token concept offering the ability for stores of value to change hands cheaply and quickly on emerging secondary trading platforms giving Investors a way in and out of owning a stock in private businesses. STOs will go down in history as an important innovation, enabling smaller and or illiquid companies unable to afford or meet the criteria of a more expensive IPO (costing 8% to 10% total funds) and whilst not fully demarcating capital, makes it fairer, more transparent and accessible.
We are noticing many private companies and smaller public companies listed on less liquid smaller exchanges, are now turning to the STO process for capital raising in their own worlds they find it easier and traditional capital markets doesnt work for them, controlled and engineered by the Kleptocrats of Wall Street and the very dangerous FED, that has done a great job destroying the value of everything we own.
Tricky, Sticky, STO’s
If you are naive enough to think STOs are simple and easy then you have completely misunderstood their purpose. A security token offering, process, event whichever ridiculous acronym you come up is the engineering in software of a highly regulated financial instrument. Instruments that sit within existing law. Whilst we can debate whether cryptocurrencies sit in a SEC or CFTC driven regulated world, a security token is not a cryptocurrency. It is a digital representation of a traditional financial instrument on steroids, because you can do some really cool stuff.
The business issuing the security tokens are called Primary Issuers (normally a private company) may create a token to sell. The many service providers offering token issuances but do so often without knowledge or understanding of the need to cater for Secondary Trading requirements that comes with a commitment to be listed by an exchange or investors may end up owning a Security Token with no exit, the same as private companies today. So choose you primary issuer carefully and the protocol you choose and some will work against you at token listing time.
STOs are a really great concept but must be handled correctly and accommodate all the moving parts at the outset, as blockchain and especially smart contracts are not very good at being changed after the event!
My biggest concern, and one we come across all the time, are security tokens that are created using simple token protocols as scripts, the most basic and popular — ERC20. It may be great for ICO tokens but it aint much cop for STOs enabling the newly created digital asset to be sold once, and then via any compatible Wallet off-exchange, by-passing key compliance and regulatory functions. ERC20 doesnt have the essential properties to accommodate secondary trading (track and trace) and the requirements that go with monitoring and reporting on the movement of assets as financial instruments.
So how do you identify the next holder of the asset?
All of this could be fine should the custodians decide to take on the tracking and movement of your new assets, handling payments, dividends and reporting. Which if they do, you won’t be to affordable as fees. It is all very well management mentioning in passing our token will be listed on exchanges, maybe more than one, demonstrating they are not only ignorant of the liquidity issues, but also the token may not be able to engineered to comply with the exchange functions.
And forget Initial Exchange Offerings (IEO) as this is exactly the same as an ICO and wont help you, a last gasp for the larger exchanges before they are closed down by the regulators. Could you launch an STO on the exchange, if you have sufficient capital and confidence maybe, but liquidity isn’t there yet.
Exchanges that focus on supporting STOs will generally choose the best tokens, issued by companies with a good story, those businesses with natural momentum and understand the need to communicate progress through effective PR to reach the investor community, itself quite traditional that encourage the traders to make markets for the tokens and the takers to be attracted.
Many operating in STO-land would have you believe doing an STO comes with less regulatory strings and obligations. That they are easy, similar to an ICO process. This is entirely wrong!
I have even seen White Papers where the world ICO has been replaced with STO… Astonishing and dangerous.
Any company issuing a financial instrument, the purpose of which is to raise capital from investors (retail and institutional), has to follow current Capital Markets Regulations, from the perspective of jurisdiction of the Issuer and the local of the Buyer. Key documents have to be created, an Investor Deck, Sale Agreement and a detailed Information Memorandum, a white paper is not one of them, and usually a data room is available with the deeper level of information to support the thorough investor due diligence process. The focus is less tech, not about the token, more how the instrument works for the investor and how management will protect investors interests, deliver the returns promised and service the yields.
The wider problem are endless intermediaries jumping onto STOs because they think it is the place to be. The older ICO advisory community are trying to cross the chasm without realising actual knowledge of capital markets, software engineering and Blockchain smart contracts is required to avoid another train-wreck situation. It is too tempting for advisors to jump on the money making bandwagon once fuelled by retail profits, without realising they are adding an extra layer in the process, and more friction, time cost, the very reasons for digitising assets in the first place.
As you may know by now, I am not fan of regulation because most of it is poorly thought through and doesnt work for the people. Just look at 2008 regulation and regulators didn’t protect the public from the banks in 2008, the genesis of the Bitcoin journey. Offering people new hope and a decentralised, tamper resistant, immutable path. It is entirely warranted to have protection for investors, given banks continue to steal from the people, insurers sell failed products, pensions that leave you poor in old age, savings plans that yields less than you put in, and pretty much every financial product has been mis-sold. An industry created to feed all those useless empty suits because they are unemployable anywhere else.
Problem with Ethereum, with Blockchains
The people that think they understand STOs without being involved at the ‘coal face’ is the bigger risk. Everyone bangs on about STOs using ERC20, ethereum’s protocol for tokens from the position of a Primary Issuer. Sounds straight forward if you are designing a ‘numpty token’ and not a financial instrument as mentioned earlier.
It looks easy, you write the smart contract to create a set of genesis tokens, sent to the smart contract address, where the contract terms, price and yield, the conditions of use and the terms for exchange of assets is deployed. Allowing said tokens to be sold as part of an STO with some for of KYC on the buyer. Sounds amazingly easy!
The flaw in this approach, is the Primary Issuer is often not thinking of Secondary Trading or about how the custody of assets will work, how to manage liquidity, and identifying owners as they are traded. In Ethereum you cannot track and trace because unlike Bitcoin it is ledger based, and you cannot validate where the asset came from, even Ether. Remember in a Bitcoin world you can track and trace on the Blocks where the Bitcoin came from and where it is going to.
The entirety of the process from Issuance to Exchange Trading and involves the essential tracking the assets as they change hands must be engineered at the outset. Some exchanges create a new token, their standard (because there is no global exchange token standard) with which to pair your ERC20 security token to other functions including Registry and Compliance. The problem with this approach is it wont be used by other exchanges and for me this also add complexity, friction and still doesnt solve the big issue.
The Big Issue:
How to pairs tokens with current holders KYC as trading happens… Yes you heard it here.
And yes there are no token standards across current platforms, primary issuance and exchanges. None at all. Ethereum, EoS, Stellar, Bitcoin, Cardano and others, literally any protocol that offers options for tokenisation with a native smart contract language will face the same issues.
But what about ERC1400 and 1600 I hear you say, doesnt matter. Problem remains.
Where and who does the KYC matters to the regulator. The issuance platform, the bank, the exchange, the custodian it is time to work this out and how the assets is tracked against the owner…
Play these out for me…
Scenario: So you have issued an ERC20 based equity token, that entitles the holder to non voting shares (a Pref or B share) and you have sold them to Investors. You collect KYC and AML information (accreditation checks) with passport and ID address checks. The buyer signs the sale agreement and accepts the terms, sends the money and receives the tokens that are the equivalent to digitised equity, seen and recorded along with all the other buyers onto the Blockchain, a sort of public cap table and share registry. All good then.
No not good at all. As you have learned the ERC20 protocol allows any Wallet holder to transfer (sell) there new digital assets to another Wallet? Blockchain is after all based on Peer 2 Peer which is now the problem.
You would be amazed how many experts and ad advisors have no understanding of this fundamental issue. And dare I say several exchanges that have also built stuff that doesnt work.
This stuff is complex, you are designing capital market instruments, to be issued and then traded to meet the investors needs, the needs of the issuer and the regulator, as these assets are traded and change hands everyday. And the platforms are also new…
So you still want to give it a go…ask this — what makes you qualified to work on a new security?
My recommendation to management of projects is to get some Officers & Directors Insurance fast, because you may need it when you find your new security token cannot be traded at all because it doesn’t meet the needs of the business and investor, or worse cannot be traded.
There are only a few handfuls of people that can handle the complexity of engineering STOs…
Scenario. So, let remind ourselves. You have sold your tokenised equity to Fred because he passed his KYC/AML and he is both and accredited, self certified and/or sophisticated investor.
The new digital asset is finally listed on an exchange, assuming it has ben created properly to be engineered onto an exchange. Yes more software coding. Fred opens an account on the exchange passing KYC and wants to sell his new asset to Joe. Fred soon realises that he can avoid paying transaction fees by sending the digital asset to Joe directly at the price quoted or a different price? ERC20 Wallet to Wallet!
Boom well that was easy thinks Fred.
With us so far? Fred’s digital assets are where exactly? Has Fred sold the title to the asset or merely passed the digital balance to Joe, giving him access to the address holding the account token balance? Not really a test moreso asking the questions. Where are the assets? On exchange in hot Wallet still, of off-exchange Cold store to the extent of reasonable daily trading and liquidity is known and planned for. How does Joe redeem the securities? Joe is not a member of the exchange and hasn’t done KYC? He is unregistered. Are these assets now stranded? Whos responsibility is it to check Joe? Because Fred has moved access to his assets off-exchange or has he?
Scenario: Mary has an account on an exchange and holds 50,000 equity tokens of a company that issued 500,000, e.g. 10%. She loses her private key? What happens now? Are the assets stranded, how does she or anyone else get access, how does this impact overall supply if 10% cannot be traded and what of price as there are now 450,000 in circulation. What will the regulator say when Mary complains she cannot access her entitled asset as the legal rights holder?
Scenario: Alice has received twice as many tokens from the exchange by mistake. Can the exchange re-call the tokens?
Scenario: Fred now want to sell the equity tokens on the exchange and Joe has now registered. The exchange now has to pass the KYC and ID checks of Joe to the token, that used to be links to Fred’s tokens and update the Cap Table and be visible in all the other reports around daily trading, periods and the asset register itself. How is Joe’s entitlement to dividends handled?
Scenario: The company wants to change the dividend policy from 8% paid annually to 10% paid bi annually? The investor (token holder list) the corporate actions have to update the shareholder register for the company and the new terms voted by the board. Is this possible once the smart contract is deployed? Whos role is this? The exchange, the custodian of the primary issuer, whos?
Then you have payments to and from investor and broker accounts, to the and with the exchanges themselves for the individual account holders (investors) to move their assets, for institutions and day traders, to transfer values and receive proceeds from trades net of fees and charges, and want too cash out. In the USA using ACH accounts, in Europe virtual IBAN accounts in the UK connected to the banking systems. Then there is FX a whole topic by itself and if you mix crypto and fiat currency then this gets even harder.
Regulatory Position — Listing Security Tokens
The regulators will expect the same rights, operations and protection for Investors and traders on new exchanges that list Security Tokens. Exchanges will generally not hold the digital assets on exchange, they will manage treasury operation to control supply monitoring all activities in real time. So managing the movement between Hot and Cold wallets, ensuring the right amount of tokens are available to support daily trading volumes, to make provision to insure on-off-exchange assets. And doing this in the US, EU, GCC, South East Asia and Asiana as investors and traders will wants access to their assets 24/7 anywhere.
So before you announce your STO to the world please explain in your investment deck where you intend to be listed and how your service provider will deal with the scenarios above. Taking over someone else’s tokenomics for me isn’t desirable as I want to see how the valuation is done, the purpose of the security instrument and how the use of funds will increase the value of the underlying business, and hear from management how they have a plan to deploy the capital. Given we have a solution to the above issues, and while we accept the issues with ERC20 we have to navigate, we don’t necessarily like it.
One of the primary roles of any exchange is to track trades as they happen, ensure the market for traders (investors) is safe, secure and monitor all trading activities, to make sure there is no funny business or market manipulation. Where the fiat currency comes from? Where the crypto comes from, before going onto the exchange. So the token has to have certain innate properties and track and trace of underlying crypto is key. Bitcoin you can check. Ether and other crypto you cannot.
Each security to be listed has to pass through a listing process, for on boarding onto the regulated exchange, which will depend on the local capital markets rules in each jurisdiction, Malta, Gibraltar, USA, Singapore etc. Which starts with a statutory due diligence process and then has to meet the needs of the investors for current liquidity provisions and those of the exchange itself, because at the outset there is no market for your token, average daily trading volumes are zero, and you need to reach the makers and the takers.
What tends to happen is the new Security Token holders are bound by terms that intent to drive hold behaviours, but there will always be those that want to sell after the ‘hold period’ which varies. Tokenomics engineering to change the security tokens state from a convertible, to pref or equity is a consideration as each manifests in an instrument for investors who demand different things. To enable some to get in and get out in short time horizon, and others to hold for the longer term expect to be rewarded for their loyalty. Hybrids are emerging.
In the early days primary issuers collecting capital for selling securities will be expected to help make the markets and provide liquidity support themselves, to report on the progress of the business, after the initial capital raise, and to drive the interest in the business, their proposition and their token.
We are seeing more and more established business entering the STO market, wanting to raise growth capital. In fact some of our clients are group Holdings companies that have asked us to tokenise the Holding group, where the new security is linked to the underlying performance of a diversified portfolio of companies, and activities. Yes it is complex and very useful given pending doom of global recession where investors are looking to insulate asset performance from impending decline.
Early stage companies. Pre revenue and no working product will find it almost impossible to get an STO away. You cannot sensibly value a pre product and revenue business on the strength of a great idea, signed partnerships and maybe a good market response to a MVP test.
Investors are savvy, and with STOs founders are entering their turf, which for securities is traditional. Traditional valuations, multiples and DCF apply. But you would be surprised how founders, encouraged by advisors, come up with ridiculous valuations and cannot explain why. Whilst on the other hand there is a premium on Blockchain tech, getting to a decent valuation is tricky.
It is quite traditional. Early money is higher risk. Value today pre money is easier with customers and revenues, value post money after deployment and the path the exit, requires broad analysis of the business case and how effective the management team will be at increasing the value of the business. The the reality hits that serving an 8% annual cost of money (dividend) for a few years will require the business to be on a growth path with some serious momentum already.
STOs are here, they are brilliant, they will deliver essential capital to private companies, although we are seeing public companies listed on smaller markets come forward. STOs are costly to get away, but cheaper than an IPO’s. STO are very complex to work out and engineer. There are no guarantees there is a pot of gold at the end of the rainbow as there may not be makers and takers for your security token to give your instrument trading life.
STOs are traditional approaches the raising capital with a twist or two. The digitisation of assets, the creation of new assets that can be bought and sold, visible on the Blockchain is a great idea. Difficult to engineer you bet.
Author: Nick Ayton Founder & CEO Chainstarter Group
Chainstarter has built a live Crypto Capital Markets infrastructure comprising Primary Issuance Platform, Secondary Trading Exchanges linked to Custody, Payments and the Investor community. Boasting the latest BIOmetric KYC and AML login and portable Identity.