Securities represent fractional ownership of an asset and form the basis for the multi-trillion-dollar global market. As the backbone of industrialized economies, securities markets tend to be highly regulated by the Securities and Exchange Commission (SEC) and other government or industry bodies, making it relatively difficult to disrupt with new technology.
Despite these challenges, security tokens are quickly disrupting the securities markets by lowering costs for both investors and issuers. While initial coin offerings (ICOs) got off to a rough start, security token offerings (STOs) are quickly becoming a viable alternative to conventional securities and enjoy support from a growing number of regulators.
Let’s take a look at how INX’s recent STO changed the game for security tokens and where the industry may be headed over the coming years
What is a Security Token?
A security token is a unit of value issued by a company. If the tokens are unregulated, they are issued through an initial coin offering (ICO). If the token is regulated, they are issued through a security token offering (STO) that’s blessed by the SEC, FINRA and/or other regulators. The latter has the potential to disrupt a much larger market for conventional securities.
While utility tokens provide future access to products or services offered by a company, security tokens derive their value from an external asset that can be traded. For example, Filecoin raised $257 million through the sale of utility tokens that users could use to access its decentralized cloud storage platform, but don’t provide a stake in the company or its profits.
A common test that regulators use to differentiate between utility and security tokens is the Howey Test, which asks two simple questions:
- Are the token holders allowed to provide funding for the company’s capital and receive a portion of the profits?
- Does the fundraising effort of the ICO entail investment in the project where profits are generated entirely from the effort of individuals other than the creators or founders of the project?
If the answer is “yes” to either question, then the token is considered a security token.
INX Undergoes SEC Approved IPO
INX is a Gibraltar-based startup that recently completed an SEC-approved initial public offering of up to 130 million INX Tokens at 90 cents a piece with a $1,000 minimum investment. Built on Ethereum, the tokens provide holders with a share of the company’s profits rather than a percentage ownership, making them different from a conventional stock.
The company will provide token holders with 40% of adjusted operating cash flow, excluding the initial tokens and including any future tokens. In addition, 75% of the amount raised via the token offering above $25 million will go into a cash fund that will act as insurance in the case of cybersecurity issues related to its unique business model.
Currently, the company has no revenue or functioning products or services, but it intends to develop an exchange for trading security tokens. Since its own tokens trade over-the-counter due to a lack of a national exchange for security tokens, the company is effectively working to solve its own problem and potentially open the door to a national market for security tokens.
What It Means for Securities Markets
The idea of a crypto token replacing a security entered the limelight in 2017. While initial coin offerings, or ICOs, became popular, the SEC aggressively cracked down on them for failing to register as a security. The agency sought to provide the same oversight and investor protections as stocks and other securities—especially given the propensity for fraudulent ICOs.
Security Token Regulations Worldwide – Source: Wikipedia
That said, there are compelling reasons for security token offerings, or STOs, to replace conventional IPOs. The average IPO costs of $4 million to conduct with 4% to 7% fees on top of that amount, according to PwC. By comparison, a STO could cost just around $100,000 and dramatically reduce regulatory costs (e.g. simplify the “know your customer” requirements).
tZERO became one of the first companies to support security tokens that are exempt from SEC registration requirements, but the new era of SEC registered STOs could open the door to a much larger market. After all, institutional investors and large cap companies account for the majority of trading in most industrialized multi-trillion-dollar securities markets.
Other Catalysts to Watch Ahead
INX and tZERO aren’t the only companies eyeing the potential for security tokens to disrupt the multi-trillion-dollar securities industry. There are many other companies that are seeking ways to enable companies to either undergo STOs or tokenize their existing securities to enjoy many of the benefits associated with blockchain technology.
Some of the most visible examples include:
- Watchdog Capital recently announced that its regulatory-compliant Gladius platform would be available for security tokens. While the platform can be used for SEC-exempt offerings, certain Reg A and other offerings need SEC approval.
- BSTX, a joint venture between BOX and tZERO, are seeking to list security tokens that are full-fledged public securities. The exchange would back up ownership records on a blockchain and update the logbook at the end of each trading day.
- Openfinance aims to provide a secondary market for digital securities, targeting the $9.5 trillion alternative asset market. Smart contracts help ensure compliance with U.S. securities law automatically and prevent unqualified trades.
There are also several other regulatory catalysts that could open the door to the market. While the SEC and FINRA have signaled support for security tokens, there are still a lot of nuances that are open for interpretation. Other agencies, such as the IRS, may also play a role in how the securities market ultimately takes shape given their tax influence.
The Bottom Line
The idea of tokenizing securities first arose in 2017 with initial coin offerings, and after a period of instability, the market is finally starting to mature with security token offerings. With the rise of new security tokens and exchanges, investors are finally close to having an option to trade crypto and blockchain-based securities while issuers could dramatically lower their costs.
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