Hype has been building for the past few months for what many believe could be crypto’s next ICO-style craze: STOs – Security Token Offerings. Replacing the unregulated frenzy of ICOs with a new wave of regulatory-compliant tokens blending elements from cryptocurrency and traditional stocks, many are predicting STOs will be big news in the very near future.
A Bitcoinist article from November 2018 described “the ICO party” as over and shared the South China Morning Post’s sentiments that STOs represent crypto’s “new sexy.” The article also quotes Polymath CEO Trevor Koverko’s claim that STOs are the “biggest and best-kept secret in crypto right now” and that 2019 was set to be the “year of security tokens.” Polymath is attempting to be one of the main players in the expected STO clamor, with the project’s official website talking of enabling “trillions of dollars to migrate to the blockchain.” As we discussed in recent articles on the various Ethereum-based stablecoins and the Winklevoss’ twins Gemini exchange, there is no shortage of entities looking to facilitate the expected massive flow of cash into STOs.
Many predicting the success of STOs see them as offering an exciting mix of cryptocurrency and traditional stocks. Much has been made of Millennials’ aversion to investing in the stock market, as evidenced in this widely-referenced Bank Rate survey which found that Millennials are the only generation of Americans who don’t see stocks as the best long-term investment vehicle. The same survey found Millennials were five times more likely than other generations to prefer Bitcoin or other cryptocurrencies as a medium-term investment – though, it’s worth noting, this still accounted for just 2% of total respondents. By offering an exciting new blend of crypto and stocks, STOs could offer companies a new way to connect with investors from this generation.
So what exactly are STOs? And how do they differ from ICOs?
The ICO Gold Rush
Initial coin offerings (ICOs) were pioneered by Mastercoin (later rebranded to Omni) in 2013. Mastercoin was envisaged as a protocol for layering more complex transactions on top of the Bitcoin blockchain. Mastercoin was distributed at a ratio of 100 MSC to 1 BTC sent to the project’s Bitcoin wallet. This seems to have captured the attention of a man who would have greater influence on popularizing the ICO than any other, as this 2013 Bitcoin Magazine article authored by Vitalik Buterin shows. Buterin would launch his own ICO for Ethereum a year later, selling 60 million ETH in exchange for around 31,529 BTC, with a then-value of around $18.4 million. Ethereum would itself go on to become the platform of choice for ICOs, with the 2017 explosion in ICOs almost entirely being driven by tokens issued via Ethereum.
As 2017’s crypto bull run gathered pace, ICOs were proving an incredible way for projects to raise a lot of money very quickly. In May 2017, the Brave browser ICO raised $35 million within 30 seconds. In November 2017, Filecoin raised $200 million in under an hour. EOS’s year-long ICO concluded in June 2018, raising a staggering $4 billion. And these ICOs were often proving similarly lucrative for participants. As this BitcoinTalk.org forum post from October 2017 shows, “ICO flipping” – buying ICO tokens and selling them at a higher price once they’re listed on an exchange – could often generate incredible returns.
But the ICO craze caused as much consternation as it did excitement. In stark contrast to the heavily-regulated world of initial public offerings (IPOs), ICOs had zero regulatory oversight and could be set-up by anyone with a website and relatively little technical know-how. In February 2018, US Securities and Exchange Commission Chairman Jay Clayton told a Senate committee that he believed every ICO he’d seen should have been classified as a security, yet none had sought regulatory approval. Governing bodies around the world were deeply uneasy about the billions being raised through ICOs and legislative measures were inevitably taken against them. China and South Korea both issued outright bans on ICOs in September 2017. While other countries were less decisive in taking action against ICOs, regulatory bodies in dozens of countries have mulled varying degrees of legislation and voiced concern that many ICOs could have been conducted in violation of existing laws.
The regulators had good reason to be concerned, with a much-repeated line from a June 2018 Statis Group study showing that 80% of ICOs conducted in 2017 were scams. However, while headlines focused on the ‘80% of ICOs were scams’ angle, the same report stated that 70% of the $11.9 billion invested in cryptocurrencies in 2017 went to what it calls “higher quality projects.” Of the $1.34 billion invested in what Statis Group identified as scams, close to 98% was shared between just three “projects”: Savedroid ($50m), Arisebank ($600m), and Pincoin ($660m).
While the market was saturated and ICO flipping became much less effective heading into 2018, the total raised through ICOs in 2018 dwarfed that of 2017. Statistics from Coinschedule.com show a total of more than $21.5 billion raised in 2018, compared with just above $6.5 billion in 2017. However, the same stats suggest that ICOs have since lost their luster. Multiple billions were raised by ICOs every month from December 2017 through June 2018, the latter of which saw funds raised soar above $5.8 billion, in large part due to the $4 billion+ raised by EOS. The last month to eclipse $1 billion in ICO funding was August 2018. January 2019’s figure of $294.5 million is the lowest since May 2017. A comprehensive market report issued by Fabric Ventures shows that 58% of ICOs issued in 2018 failed or refunded.
Where’s the Value?
While SEC Chairman Jay Clayton was forthright in decrying tokens launched through ICOs as securities, they differ from traditional stocks in one very important way. A stock literally represents a share in a company, with each stockholder essentially owning a small chunk of the company. Whether or not the stock class confers voting rights on the company’s direction to the stockholder, they can usually expect to benefit directly from the company’s success.
In contrast, holding a cryptocurrency doesn’t necessarily mean you have any stake in the company or entity behind that currency. Ripple provides a good example of what this might mean for token holders. As we discussed in-depth in a recent article, Ripple offers several services to banks and financial institutions, with xCurrent and xRapid being two of the most important. Banks such as Santander are using xCurrent to facilitate payments, but this has limited relevance to the XRP cryptocurrency. The xRapid service uses XRP as a payment mechanism, meaning that XRP token holders may see direct benefits from use of xRapid, but only limited indirect benefits from the use of xCurrent. Many projects have deliberately distanced holding tokens from having some kind of ownership stake in the company specifically to avoid securities regulation. Instead, they have come up with a variety of creative ways to give their tokens some kind of value to holders.
Many projects have opted for some type of reward mechanism for token holders. VeChain and NEO both reward holders of their tokens with the distribution of a secondary token – Thor and GAS, respectively – which are then used to pay for network activity. Similarly, ICON rewards current holders with a share of new tokens that are released on the network. Others are simply supposed to increase in value as demand for the tokens rises in line with increased network usage. This is the model pioneered by Bitcoin and which currently best defines Ethereum, though Ethereum is expected to move towards a Proof of Stake (PoS) model which would see new tokens distributed to current token holders as staking rewards. EOS’s delegated proof of stake (DPoS) model gives token holders voting rights on the network’s block producers and also allocates network computing resources based on the amount held. Tron’s new BitTorrent token is used to reward content distributors and pay for improved download speeds. Airdrops of new tokens have also been used to incentivize holding tokens on many of these aforementioned networks.
While the long-term value of any of these tokens is a subject of frequent debate, the vast majority of cryptocurrencies have increased in price based on speculation alone. It’s worth noting that many projects tout the disconnect between their for-profit guiding enterprises and their decentralized crypto networks as a positive – both Ripple and IOTA, for example, have referred to the fact that the cryptocurrency and blockchain network will still exist even if the companies that created them disappear. But by directly mirroring the ownership stake benefits of traditional corporate stocks, it’s easy to see why STOs are being seen as adding a dynamic new value proposition to the crypto space.
The increased regultory oversight of issuing tokens which are explicitly securities should also act to reassure investors. A Money Morning article from early last year outlines why this would be true:
“STOs will… help weed out bad actors. The filing requirements with the SEC, as well as the cost – in the hundreds of thousands of dollars, depending on the size of the offering – will deter the fly-by-night operators that have plagued the ICO space.”
STOs vs IPOs
Just as STOs are expected to excite buyers by combining the benefits of stocks and cryptocurrencies, they also offer a range of benefits for the companies issuing them. A Yahoo! Finance article from October 2018 outlined five key benefits:
- Access to global capital – just like cryptocurrencies, STOs will be able to be bought and sold by a global investor base.
- New forms of marketing – this could include bounty programs to reward promotion of the STO through social media, as well as creating communities around the STO on social media platforms.
- Preferential terms compared to traditional Venture Capital (VC) funding – companies won’t have to give up a seat on the board to investing VCs, for example.
- Lower cost than a traditional IPO – the Yahoo! article particularly focuses on not having to hire lawyers for each country the STO is available in, as regulatory compliance in one jurisdiction should be enough.
- Additional use cases – for example, giving holders of a hotel chain’s token access to discount rates and other additional benefits.
These benefits can be summarized as allowing companies to raise funding from a global customer base that is then motivated to both use and promote their goods or services. Yahoo! states that this will be of most interest to high-growth international companies with a minimum of $10 million in annual revenue. The article also warns of a few new dangers that STOs present for companies. Because of their newness, there is a lack of legal precedent and long-term performance data to analyze. There is also a lack of clarity about regulation practices for STOs at the moment. Finally, STOs will require a high degree of cybersecurity.
Many companies are likely to decide that the risks associated with an STO are outweighed by the potential benefits. As discussed briefly at the start of this article, they are also creating a large potential market for platforms offering access to Security Token Offerings. Stablecoins such as Coinbase and Circle’s US Dollar Coin and the Gemini Exchange’s Gemini Dollars will allow investors to move funds into STOs without dealing with the volatility associated with cryptocurrency prices. Polymath is also aiming to be a major player in the emerging STO space, offering full KYC and AML compliance services through its Ethereum-based ST-20 token standard for STOs.
The Next Big Thing?
STOs are clearly getting a lot of people within the crypto space very excited. But they have yet to move beyond the hype stage and begin to live up to the enormous expectations many have for them. And there have also been warnings that not every regulatory body will be embracing the new token format, particularly from within China. A CoinDesk article from December 2018 includes warnings from several Chinese officials that STOs will be treated in the same way as outlawed ICOs. The Bureau of Financial Work’s Huo Xuewen was particularly forthright in stating the official Chinese anti-STO stance:
“I want to warn those who are promoting STO fundraising in Beijing. Don’t do it in Beijing. You will be kicked out if you do it.”
Even if STOs do initially live up to the massive hype, it would be worth remembering the rollercoaster rise and fall of ICOs. Regulatory oversight may keep outright scams from cornering the space, but it will do little to stem the wild speculation that is likely to accompany a fintech innovation that has been this heavily hyped.
Whatever their long-term impact, Security Token Offerings certainly seem likely to grab a lot of people’s attention in the near future.