When a token complies with security regulations and derives its value from an external asset which is tradable, it can be categorised as a security token. Unlike a utility token, it conveys ownership rights which entitles the holder to things like a profit share, equity, dividends, voting and buy back rights.
Investors are demanding that developers comply with regulatory frameworks for their token sales. It is imperative that anyone looking to issue a security token should in the current climate follow these regulations to gain increased credibility with investors.
Compliance with these regulations varies from jurisdiction to jurisdiction and it can seem like a daunting task to comply with as many as possible. However, the process comes with many benefits such as the increased liquidity of the underlying assets and increased market efficiency. There are lower issuance fees than via a traditional IPO.
Not all security tokens are created equally. Here are some of the variants of the security token.
· Debt Tokens: Tokens that represent a debt or cash generating vehicle.
· Equity Tokens: Tokens that represent an equity position in an underlying asset.
· Hybrid/Convertible Tokens: Tokens that convert between debt and equity based on their behaviour.
· Derivative Tokens: Tokens that derive its value from underlying tokens.
The benefits to projects
to the incredibly low barrier to entry the security token allows for
the tokenisation of everything. This flexibility lets smaller
companies raise funds from private capital markets with relatively
Unlike using the traditional venture capital route, security tokens allow issuers to raise funds without surrendering board seats or voting rights. Issuers can choose between sharing profits, revenue or voting rights allowing them to highly customise their launch.
As security tokens are regulated by nature, issuing one allows and encourages traditional investors to get involved. It also lowers the barriers for international entry for international investors which brings with it additional liquidity benefits.
How do you launch a STO / IEO?
One should not attempt to put the cart before the horse when planning an ICO. Preparation is key to a successful launch. As such, it is incredibly important that you have a well thought out idea. You should bounce your idea off of a legal adviser to check its viability. Do some planning and work out how the token would gain value (a key desire for investors.) You should structure your plan so that it is more engaging for investors.
The process of seeking legal advice will quite often require more than one legal advisor. Your project will probably end up consulting an entire team if you wish to offer a globally available security token.
When attempting to define for investors how a token will appreciate in value you should be clear in defining what rights it conveys. I.e voting rights, equity and profit shares. You should also clearly convey what function the token performs. Many tokens convey rights to access markets or to use platforms possibly with discounts.
Tokens can also act as a store of value and a value exchange. As a rule, the more properties a token has the more value it will be perceived to have.
Some tokens can be dismissed as utility tokens and as such avoid many regulations in many jurisdictions. As a rule of thumb in the event, a token passes the Howie test it is considered a security. The Howie test was established by the US Supreme Court and is used to determine if arrangements include an investment contract. When considering if a crypto token is a security one should ask:
Have you invested money in the same enterprise with the belief you will profit from the benefit of others. Any crypto that meets these criteria is considered a security token by the US and is subject to federal securities regulation.
Regulation, Regulation, Regulation
If you plan to operate in the United States you will need to comply with at least one of the following: Regulation D, Regulation A+ or Regulation S.
Regulation D allows an STO to avoid registering with the SEC as long as the issuers have completed “Form D” after the tokens have been sold. The party offering tokens can then solicit offerings incompliance with Section 506C. Section 506C requires a verification implying that investors are provably accredited and that the information provided throughout solicitations is “free from misleading or false statements”.
Regulation A+ allows developers to offer an SEC-approved token to non accredited investors totalling up to $50 million. Regulation A+ is considered the most time consuming and costly route to regulation.
Regulation S applies when an STO is launched from a country outside the US and is not subjected to the registration requirements of Section 5 of the 1993 Act. The developers still have to comply with the regulation of the country of launch.
To launch an STO inside the European Union companies have to make a prospectus and meet local security law requirements unless they qualify for the regulations below:
The qualified investors’ exemption (private placement)- similar to Regulation D in the US, companies can request qualified investors for the offerings.
The limited network exemption- Companies can trade their security to approximately 150 people per member state without issue.
The limited amount exemption- similar to Regulation A+ mentioned above, organizations can sell securities up to 5 million euros without the need to create a prospectus.
The large investments exemption – Organizations can trade their securities without issue if every investor buys at least 100,000 euro of issued securities.
The nominal value exemption – Organizations can sell the securities without any restrictions if each security’s value is equal to at least 100,000 euro.
This is where things can get confusing. Not all EU nations are equally welcoming of crypto and have different national level frameworks. By registering within the EU you will be able to sell your tokens to all EU nationals. However, you will only be subject to the laws of your country of registration.
France, for example, does not have the most crypto friendly regulatory framework and conducting an STO is prohibited unless the issuer is specifically exempt or licenced. There is a proposed new legislative process however, you may wish to look elsewhere in the EU, maybe somewhere like Malta.
Malta is a small island nation in the Mediterranean Sea. It is considered the most token friendly of EU nations and has made strides to make itself a global crypto hub. The government of Malta has come up with three bills to create a clear regulatory framework for Maltese crypto startups. These bills are the Virtual Financial Asset Act, the Malta Digital Innovation Authority Act and finally the Innovative Technology Arrangement and Services Act. Like other developed nations Maltese authorities ensure startups comply with AML and KYC.
Switzerland is also a major player in the crypto world and whilst sitting very much in the centre of Europe, it exists outside of the European Union itself. They are considered pro-crypto although their Financial Market Supervisort Authority (FINMA) have stated that startups need to comply with current Swiss law. Token sales are reviewed on a case-by-case basis and are monitored on an ongoing basis.
Singapore has come up with guidelines for token sales hosted there. Organisations must register and submit their prospectus to the Monetary Authority of Singapore (MAS) before launch unless they qualify for one of several exemptions detailed in “A guide to Digital Token Offerings” by MAS.
MAS can regulate digital token offers or issuance if the tokens are capital market products under SFA (Securities and Futures Act).
MAS would examine the characteristics and structure of a digital token (including the rights attached to it) to know if it is a capital market product under SFA.
A digital token may constitute a share, a debenture and a unit.
The small offer of an entity in a CIS (Collective Investment Scheme) should not exceed S$5million within any 1 year, subject to certain conditions.
A private placement offer should not be made to more than 50 individuals within a period of any 1 year, subject to specific conditions.
In Japan there is no regulation on Security Tokens as yet.
The FSA (Financial Services Agency) will have legislation on security tokens on the way by the summer of this year. From statements made, we can deduce that they will be treated in a similar way as a traditional financial security.
South Korea and China have not taken positive stances on ICOs both outlawing them in early 2017. They have yet to announce any form of regulatory frameworks to legitimise STO’s.
Hong Kong, however, has taken a different approach to that of mainland China. Hong Kong has declared that tokens may be launched as securities and are therefore a regulated activity. Engaged parties should be registered with, or licensed by the Securities and Futures Commission if they are going to perform any form of activity in Hong Tong regardless of whether the parties are based there or not. Those involved in secondary trading of said tokens are potentially also subject to the SFC’s requirements.
Israel is looking to bring in custom securities laws to govern security tokens. A committee was established in mid-2017 by the Israel Securities Authority (ISA) and plan to evaluate token sales on a case by case basis for now. ISA has previously stated a security token is a cryptocurrency, entitling the token holder to the future cash flow or ownership rights in a specific venture.
The United Arab Emirates Securities and Commodities Regulator plans to regulate Initial Coin Offerings in their country. They are looking to introduce regulations to recognize tokens as securities. Securities in the Dubai International Financial Centre are governed by the Dubai International Financial Services Authority(DFSA) while the Abu Dhabi Global Market’s Financial Services Regulatory Authority (FSRA) governs securities in Abu Dhabi.
Canada has very similar laws to the USA. A token sale which falls under Canadian law should be registered and complied with a securities regulatory authority and should have a prospectus.
Choosing an issuance platform
Security tokens differ from utility tokens and require different infrastructure. Issuance platforms make the process of token issuance seamless and quick. Below are details of some of the leading platforms:
Polymath provides solutions both legal and technical to allow the securitization of bonds, assets or stocks via the blockchain. By combining KYC providers, smart contract developers, legal experts and token investors Polymath can help with every stage of issuance. Their native token POLY works similar to Ethereum uses the ST-20 standard. Financial security requirements can be coded into the security tokens design.
Harbor is an alternative blockchain platform designed to comply with current security token regulatory framework. They also assist with porting traditional asset classes to the blockchain. The Harbor platform uses a regulated system token, know as an R-token, which is a permission token Ethereum. It enables the transfer of tokens after the approval of the On-Chain regulator service.
Securitize is an end-to-end blockchain platform that can manage the processing of solicited investors from sign-up to capital received and handle the issuance and management of security tokens throughout its lifetime.
Securrency allows you to complete an STO using a drag and drop process. Their RegTex engine enables you to carry out KYC in over 160 countries and AML on both fiat and crypto wallets. The platform is blockchain agnostic, meaning you can select your blockchain of preference.
Swarm is a blockchain platform for tokenising real-world assets. Using the SRC20 protocol, Swarm offers a digital standard to tokenise everything from estates, agriculture, tech companies and renewables. The SRC20 protocol provides rules that each security token should follow represent a real-world object. Transactions are facilitated via their native token SWM.
The platforms mentioned above are mostly very similar to blockchain platforms Ethereum, Neo and EOS with an added layer of AML and KYC. Straying from platforms specifically designed to accommodate regulation may cause issues further down the line with regulators.
The White Paper
I cannot express the importance of a quality white paper. It is highly probable that most investors will never meet you and this will be their primary source of information on the token. If you get this wrong your project can fail before it even gets to market.
An STO or IEO whitepaper should include the following:
- A legal disclaimer
- The product details
- An industry overview
- The technical architecture
- The business model
- All assets and another type of security associated with the token
- The tokenomics and token usage details
- A list of Team members and advisors
The STO or IEO whitepaper writer should display this information in a well-explained and organized way. The content should be broken down into small sections to increase the readability of the document and you should avoid more than two headings per page.
It is very important to make clear the token sale details so a token summary sheet should be included and also made available as a separate document.
You should focus on the solution your project offers, not too much on the blockchain itself. Whilst a part of the solution they are not the solution itself.
Make your project summary short. If it exceeds 400 words investors may be put off. Well designed charts and diagrams really add to a whitepaper. Tools such as Draw.io allow you to quickly and professionally produce flow charts and technical diagrams.
You will need to detail which regulations apply within which jurisdictions.
If writing is not your strong point you should consider hiring a writer to assist in the process of producing the documents.
Once armed with a whitepaper, you need to approach experts in the field of your area of interest and begin building a team. You will need a range of professionals from areas such as accounting, sales, marketing and consultation.
The quality and reputation of your team will go a long way towards adding credibility to your project. It would be advisable to avoid anyone without a background in any ICO or STO project.
Getting the right legal advisers is essential to ensure the token passes all required regulations. These experts can be hard to find as the STO is a new concept and there are multiple legal frameworks to comply with. It is essential that all legal advisers have an in-depth knowledge of the STO process.
Next, it’s time to make a marketing website. The site should be secure and able to handle multiple requests at any one time. Here are some tips on what will make your site stand out:
It may seem obvious but you need to provide details of your project. People are there to better understand the idea, learn how they will benefit and look for timescales, roadmaps and token distribution information. Don’t make the site too text heavy. It should have lots of visual graphics to give a clearer idea about the project. A token sale countdown is always a good idea. Some people will be visiting your site looking for support so it is important to include clear links to your support channels. If you are not experienced in web design you should probably seek the help of creative web designers.
You are now ready to launch your STO. It is time to introduce your concept to the market and create your security token.
Introducing yourself to the market.
Prior to your sale, you must introduce yourself and your product to the market to create as much awareness as possible. There are many websites that list upcoming ICO and STO’s. You should engage with all of these. Take special care to ensure all information is accurate and up to date.
Many token offerings also run marketing campaigns using press releases, email marketing and social media campaigns. Get in touch with crypto websites and explain your product to them. When doing so make sure you clearly explain the utility of the product and the architecture of your minimum viable product.
After introducing the security token the token needs to be created to start the sale.
You will need to choose a partner exchange, several of which I have mentioned earlier in more details such as Polymath, Swarm, Harbour, tZero, Securitize, Alpha Point and Seccurency. There are many crypto exchanges that maybe be willing to partner with you that do not practice sufficiently high levels of due diligence when attempting to determine if an individual can legally invest in a security token or not. An exchange should not allow a non-accredited US investor to obtain a security token that falls under Regular D exemption.
Some exchanges are specifically geared up to trade in security tokens. The SEC regulates the exchanges directly and they solve the current biggest problem that security tokens have. i.e, the lack of liquidity. Make sure to choose an exchange that allows investors to comply with AML and KYC regulations in their country.
Custodians to collateral assets for security tokens
Assets held by your project including but not limited to real estate, leases, fiat, digital assets and shares can be used as collateral for security tokens. At the point of tokenization the assets should be placed in the custody of a trusted third party using mechanisms like Special Purpose Vehicles or be placed in a Trust Company. Here are some of the companies that are qualified custodian organisations that can assist in securely storing your tokenised assets.
CoinBase is one of the most reputable names in crypto and Coinbase Custody has a partnership with ETC (an SEC-registered broker-dealer) and FINRA, offering services to couple Coinbase’s crypto asset security with broker-dealer financial reporting experts. They have raised around $216M from investors such as NYSE and Union Square Ventures and currently store more than $20B of crypto assets.
Prime Trust is a technology-driven trust company that offers various services such as AML/KYC, bad actor checks, funds processing, escrow and transaction technology. They serve as qualified custodians and offer custody for assets including digital assets, fiat and real estate documents.
A strong marketing campaign is vital to the success of a project. You need to ensure you have allocated an adequate budget for marketing activities. Getting your STO listed on leading sites may incur costs, running ads on social media will also eat up your marketing budget. Join relevant industry forums and post regularly to social media. Telegram, Slack and Twitter are particularly helpful in communicating with potential investors.
Whilst in the sale stage to the public it is essential that you continue to communicate and offer potential prompt assistance whenever needed. This relationship will need to continue with token holders post-sale as well.
It is vital to keep all investors updated as the project progresses and as you build your product. You should stick as closely to the roadmap as possible and be forthcoming about any changes or delays. It is important to have and project a strong culture of professional discipline. By executing the business plan as detailed in the roadmap you will manage your investors expectations.
Once up and running technical support services will be required to help customers on an ongoing basis.
As you can see the free and easy days of having an idea and simply issuing a coin are gone. The barriers to entry have increased significantly as has the quality of the competition. ICO’s are growing up. The market right now seems very similar to that after the dotcom bubble burst. Many projects have failed, prices are low and only the strong have and will survive. Whilst it may be more difficult than ever to have a successful coin launch. These are the times when the tech giants of tomorrow will be made.