A. From ICOs to STOs
The term ICO has been at the epicentre of discussions in the FinTech industry, being the main method of fundraising used by startup companies to develop innovative ideas on the Blockchain technology or other applications using Distributed Ledger Technology ("DLT").
Although bringing a revolutionary change in traditional means of financing, ICOs have been criticised for their legal uncertainty and struggled to become widely acceptable by governments due to the increased risk for fraud.
The term ICO does not distinguish what type of token is being offered, while most ICOs argue that their token is not a security but rather serves a function – a utility – on the issuers' platform.
As ICOs have faced multiple challenges, startups and companies wishing to make a transition to the digital world have been striving to find more satisfactory means of funding where there is more security to potential investors, less uncertainty and less fraud.
Security Tokens are regarded to be the game changers which will provide a more secure path to companies seeking to raise funds.
B. STOs – Security Token Offerings
Unlike ICOs, STOs are as their name suggests, securities and are treated as securities from day one. They are digital assets that are subject to security regulations and need to be compliant with any registration and/or authorisation requirements before being issued.
STOs are game changers for financial and ownership models, allowing any company to offer revenue such as annual income form the operations of the issuing company or other periodical income, percentage on profits, equity, debt or dividends and sometimes voting rights.
It is argued that Security Tokens are an improved model of traditional financial instruments because they are liquid, secure, virtually incorruptible and accessible to trade by anyone with an internet connection from all around the world. These give investors the opportunity to acquire Security Tokens with minimum investment – a digital analogue to the traditional term of securities such as shares or debts.
Private and/or public offerings of security tokens enable access to a pool of investors without sacrificing regulatory oversight. Therefore, STOs embody all the advantages of ICOs and traditional financial instruments giving stability and trustworthiness to the investors.
C. Security Tokens - Definition
Although there is not a widely approved definition or legislation interpreting what deems a token to be a "Security Token', transferable securities as per Directive 2014/65/EU on markets in Financial Instruments, "MiFID II", means those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
- shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares;
- bonds or other forms of securitised debt, including depositary receipts in respect of such securities;
- any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.
Therefore, one can argue that Security Tokens conferring similar rights to shares fall within the "other securities" notion under sub-paragraph (a) above, interpreting Transferable Securities as per Directive 2014/65/EU on markets in Financial Instruments, "MiFID II".
D. The Obligation
As per the EU Prospectus Regulation (the "Regulation"), any public offering of securities is prohibited without the prior publication of a prospectus, which has to be approved by the appropriate authority under a certain procedure, unless such public offering falls under the exemptions of the Regulation. However, such exempted offers of securities to the public should not benefit from the passporting regime. This means that the issuer of the STO has to ensure that it complies with every Member State's national requirements on the 'offering of securities' before the issuance of the STO. Below that threshold, Member States are able to require other disclosure requirements at national level.
E. Which are the exemptions to the obligation to draw up a prospectus provided under the Regulation?
The obligation to publish a prospectus under the Regulation shall not apply to any of the following types of offering of securities to the public:
- A public offering of securities where the total consideration is less than EUR 1.000.000 in the European Union or EEA* (expressed as the total consideration of the offer in the European Union or EEA over a period of 12 months).
- An offer of securities addressed solely to qualified investors as defined by the law.
- An offer of securities addressed personally to fewer than 150 natural or legal persons per EU or EEA member state, which are not qualified investors.
- An offer of securities whose denomination per unit amounts to at least EUR 100.000. Minimum sale price to be EUR 100.000 per unit.
- An offer of securities in the EU or EEA addressed to investors who acquire securities for a total consideration of at least EUR 100.000 per investor, for each separate offer.
*It is worth noting that different thresholds apply in each Member State as the Regulation provides that Member States are free to set out in their national law a threshold between EUR 1.000.000 and EUR 8.000.000. In Cyprus the threshold is currently set at EUR 1.000.000 but there is procedure in place to increase it to EUR. 5.000.000.
Member States are electing to set up the threshold between 1 and 8 million EUR according to the size of their financial markets. Some examples: Germany, the United Kingdom and Italy have elected to set up the threshold at 8 million EUR - Malta, Ireland and Lithuania have set the threshold at 5 million EUR.
Note: Irrespective of the above exceptions, when Securities are offered to the public or admitted to trading on a regulated market, a prospectus should be drawn up, approved and published.
F. Listing of Security Tokens on Secondary markets
Certain countries have started collaborating with token exchanges in an effort to build the infrastructure allowing Security Tokens to be legally traded on a "centralised" regulated security token exchange.
In order for Security Tokens to be admitted for trading on the secondary markets, an infrastructure must be built in order to allow for trading of Security Tokens whilst complying with KYC and AML requirements.
Certain solutions are being explored such as the possibility of centralizing compliance on the token issuance level by embedding a code on tokens ensuring they can only be traded by parties who are compliant.
Listing of Security Tokens will have to be overseen by the regulator who will grant the license to the exchange and permit it to operate. In effect, this will further provide investors a more trusted way of buying and selling Security Tokens as these exchanges will have to comply with KYC and proper systems safeguarding from cyberattacks and fraud.
G. Final Remarks - Comments
Yet, despite the extraordinary success of ICOs, there is already a new model taking prominence, this being the STO. The latter seems to be the future of the industry, possibly because it represents a sale of securities, rather than mere coins or utilities. Needless to say, this attracts the more serious investors who want the comfort and guarantees of investing in a security (be it a share, debt or other financial instrument) via a token. As mentioned above, in order to offer securities to the public, one must follow the rigid requirements of the Prospectus Directive.
However, the numerous exemptions available at law give the proposed issuer sufficient flexibility to be able to structure the intended STO without incurring an unnecessary burden, whilst still selling a product under the title of security. Through STOs, Security Tokens provide the potential of unlocking trillions in otherwise illiquid assets. The concept of STOs, although at its early adoption, has proved to have the potential to be applied on any real-world asset - from an art painting, music rights and real estate, to ships and renewable energy.
One still needs to understand how the market will adapt in order to fully accommodate Security Tokens to create a safe, legal and fully compliant infrastructure in order to unlock the full potential of Security Tokens and tokenization of assets on the blockchain.
Nevertheless, Security Tokens have the potential to bring a number of improvements to the traditional financial products, by removing middlemen, providing more liquidity to the market and in the same time also offering safety to investors.
Security Token offerings are the future.
They are a combination of the 21-century decentralised technology along with security laws which existed for many years and are capable of bringing the financial world as we know it to a whole new dimension.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.