When ICOs first became popular, nearly every ICO said that its token was not a security. The pundits called 2017, the year of the utility token. But this year, security token offerings (STOs) became popular. Emerging regulatory frameworks have paved the way for the sale of security tokens.
Background – The DAO and the SEC’s response
ICOs were the breakout phenomenon of 2017. They raised millions of dollars, with nothing more than a white paper. But many tried to avoid describing their tokens as securities. Instead, they called them “utility tokens”. Tokens which would be used on a future platform, performing some functions.
In 2016, The DAO hacking incident happened. The DAO was going to be a decentralized autonomous organization. It would be powered by smart contracts. Everything would happen automatically in the organization. Token holders would use their tokens to vote on what the organization (i.e. the DAO) would do. And its profits would be shared with the token holders.
By July 2017, the SEC (Securities Exchange Commission of the US) responded. The SEC said, tokens in The DAO incident were a security. A security which would be under its jurisdiction. It implied that it could have been an offence to sell those DAO tokens without a licence from the SEC.
To the SEC, the DAO failed the Howey Test. Because DAO token holders would invest money, and receive profits from the efforts of others, it was a security.
It was the first time that the US federal regulator had weighed in on the conversation around token sales.
But the attraction of ICOs were undeniable. Startups thought that they had found a way to raise funds without giving up equity. Sell tokens, for use on a future platform, and use funds from the token sale to develop the platform. It was like a crypto version of Kickstarter.
But the SEC weighed heavy on everybody’s minds. So, it became a thing for ICO projects to declare that they were selling a utility token. Not a security token. “Move along now,” they said. “Nothing here but utility tokens.”
Now, all that looks set to change. STOs may become the preferred way to sell tokens in the future.
A shift in the regulatory framework for STOs
With ICOs, the terms of the sale said, “This token could be worthless. This token doesn’t represent anything.”
With STOs, the terms of the sale would say, “This token is not worthless. It’s backed by something. Gold. Or shares. Or land. Or other stuff like that.”
A security token could represent so many things. It could be a share. Or a piece of real estate. Or really expensive paintings.
With Bitcoin, people spoke about coloured coins. But coloured coins had one limitation: One coloured coin for one asset.
Security token offerings could mean turning a single asset into hundreds of tokens. And so an asset could be held by hundreds of people.
If the asset was liquidated, the token holders would be entitled to a share of the profits.
The more people discussed it, the more attractive it seemed.
And slowly but surely, the conversation happened. “Why can’t we have a security token offering?” asked some people.
“Because the SEC said so,” said some lawyers. They were still hung up on the SEC’s statement.
“Maybe you can, if it’s done correctly,” said some other lawyers. They thought to themselves that there must be a way. Some of them came up with pretty clever ideas.
“We can build the platform for you to run STOs,” shouted some tech developers. And they started building. (They made sure to first confer with their lawyers, of course.)
And then, the regulators became interested. This was an opportunity to regulate STOs. This could make their country (not the USA) a key destination for blockchain projects.
So, bit by bit, regulators began to implement rules. Rules that would define the boundaries between utility tokens and security tokens. The gears were shifting.
For example, Singapore’s Monetary Authority came out with its digital token offering guidelines. It identified a few scenarios on when a token may be a security. If it is, a license under the SFA (Securities and Futures Act) may be required for to sell the token (e.g. case study 2), or to manage the funds raised (e.g. case study 4).
If a person were interested in running an STO in Singapore (for example), he would need to comply with the licensing requirements of the regulator.
Where to do it?
In fact, the world is now open for business. Singapore may be one of the top destination for crypto projects, but it isn’t the only option for STOs.
In a recent interview with Laura Shin, Binance founder Changpeng Zhao (a.k.a. “CZ”) was asked a rather interesting question.
She asked what his approach was towards regulations. She was talking about Binance’s move to Malta. (It happens at about 16:28)
CZ’s view was that, people in the US were overly occupied with US regulators. Whereas, his approach was to operate outside the US, away from the US regulators.
“Regulations differ by countries,” said CZ. “Smaller countries are easier to work with in terms of regulations.” That was a very astute observation.
CZ also shared that, Binance is “taking the lead” in several countries: Malta, Guernsey, Bermuda, Uganda, and “several other African countries.”
The world is open for business. And an STO can be carried out anywhere where the legal framework supports it.
Meanwhile, Back in the US…
Back in the US, the SEC kept looking around for people that violated its securities laws.
EtherDelta is a crypto exchange that allows ERC20 token to be traded. It’s popular, because you don’t need to pay for your token to be listed.
In early November 2018, SEC charged EtherDelta with selling securities. “Many ERC20 tokens are securities,” said the SEC, “so you need a securities exchange licence. Either that, or an exemption.”
“Since when were ERC20 tokens securities?” asked the EtherDelta owners.
“Since we issued our report on The DAO,” said the SEC.
Somebody asked if all ERC20 tokens are securities.
The EtherDelta founder, Zachary Coburn, probably doesn’t know the answer. Still, he paid a fine of $388,000 to the SEC.
If you’re planning to run an STO, it makes sense to seek advice about compliance.
Whether you run your STO in Singapore, Malta, or elsewhere, it doesn’t matter. We are now in the age of globalization.
What matters is that you comply with the securities laws set by the regulators.
This article was prepared for informational purposes only. No part of it should be construed as legal advice. If you need advice about running a security token offering, please consult with your lawyer.