“ICOs are dead. Long live STOs”?

In 2016, Initial Coins Offerings (ICOs) emerged as an innovative funding source for blockchain-related start-ups. In a nutshell, an ICO is generally conducted as follows:

the blockchain start-up (e.g. protocol, decentralized application) puts together a team and writes down all the features, the scope and the purpose of the project in a Whitepaper

the start-up determines the mechanisms and economics of the issuance of a “utility token” supporting the project, with a parity vs. a reference currency (usually Bitcoin or Ethereum); this token does not give access to share capital but allows in one way or another to interact with the future service/product

the community of the project and investors (e.g. venture funds) purchase the tokens (with Bitcoin, Ethereum, EUR, USD…) with the view to using the service later and/or achieving gains once the project is on track and the value of the utility token increases on secondary markets

ICOs were embraced by the larger blockchain community, mostly driven by the lack of regulatory framework, the development of the ERC-20 protocol (Ethereum) and the surge in cryptocurrency prices (mostly driven by Bitcoin) which enabled newly created crypto funds to lock outstanding returns.

The following market bubble was inevitable and paved the way for the development of promising and less promising blockchain projects. One stunning example of this “ICO craze” is the BAT project that rose c.USD35m in less than 30 seconds in May 2017.

Eventually the ICO market, which peaked in 2018 with 650 offerings (according to Coindesk), plummeted in mid-2018 to become moribund in late 2018. From the January 2018 peak to March 2019, global crypto market capitalization decreased by over 80%, with a large majority of projects showing a market capitalization way below the ICO price (when still “alive”).

Concurrently, Security Token Offerings (STOs) seemed to become the next “big thing” everyone was talking about, and were supposed to follow up with the “hype” from ICOs: “2019: The Year Digital Securities Offerings Become the New ICOs”. Confronted with the disinterest from investors for the basic models of utility tokens, some ICO projects tried to shift their fundraising strategy towards the STO model claiming that it would be better adapted to their use cases. They soon realized that a STO could not just be an ICO “in a regulated form”.

STOs are not competing with ICOs but are really addressing a totally different issue, which is traditional finance. The ICO model, mix between crowdfunding and community development, is here to stay but requires a proper regulation and best practices to remain (see for example the regulatory framework currently being discussed in France).

Security tokens are transforming traditional finance

As stated by Anthony Pompliano early 2018 in its “official guide to tokenized securities”, security tokens’ primary focus is not to support blockchain projects but to transform the way traditional finance works.

Security tokens are digital assets that represent a fraction of an underlying financial instrument (equity, debt, real estate, raw material, patent, IP…) on a blockchain. Here the blockchain is no longer at the heart of the project but is rather a powerful tool to support financial assets.

The proper use of blockchain technology could optimize the financial transactions / settlements and bring substantial value for both the issuers and the investors, notably:

Efficiency: digitalization of assets, programmable equity, less middlemen involved, speed of execution (quasi instant settlements), reduction of issuance & administrative costs, storage of the tokens on a ledger

Transparency: clear view of the precise allocation of the tokens amongst holders, whitelisting of categories of investors, use of smart contracts setting rules in advance (e.g. distribution of dividends, stock-options plans)

Liquidity: ability to theoretically tokenize any “real-world” asset across borders with the aim of trading the tokens on secondary markets

Diversification: new source of funding for the issuers, access to new type of financial products for the investors (today, investing in a private equity fund is the reserve of tycoons and institutional players)

Immutability: the ledger is registered on a blockchain and cannot be dissolved, which ensures continuity

Break away from the “hype” and assess the real potential of security tokens

The promise of transforming traditional finance is real, but some issues need to be addressed in order to understand the real potential of STOs.

1. Relevant infrastructures need to be built to enable the existence of an efficient STO market:

Issuance platforms. A handful of platforms have been launched and are operating: Neufund, Polymath (which has specified the ERC-1400 standard for security tokens and developed a version of this standard), Securitize, Swarm… Other issuance platform projects are on their way, and key players in the sector are entering this market (see the acquisition of UK-based equity crowdfunding platform Seedinvest by Circle to “explore asset tokenization”)

Trading platforms. There is no point of tokenizing illiquid assets if they cannot be traded on secondary markets afterwards. On this front, very few trading platforms are active (tZero, Open Finance, Templum) and volumes are close to 0. Though it is still early and very few security tokens have been issued yet

Regulation. In European Union, even though security tokens are said to be covered by the existing regulation, a clarification is expected from the ESMA (European Securities and Markets Authority). For instance, the notion of “accredited investors” — who are enabled to invest in STOs — and the rules applicable to issuers need to be further defined

Credible advisory (legal, compliance, strategy, finance & valuation…). “Less middlemen involved” (e.g. banks and underwriters) does not mean that we are removing the advisors from the equation. We are dealing with securities so projects need to be extremely careful with the audience they can target (“accredited investors”), fill the relevant documentation, apply the appropriate compliance policy, etc.

Outreach: dedicated press, STO databases, serious rating platforms (notably with regards to questionable practices by some renowned ICO rating platforms)…

As of March 2019, we are seeing the premises of an ecosystem, but investors still need to be convinced of the interest of security tokens. Only 25 STOs were recorded by Bloomberg for 2018, and interest from the traditional investors is still low.

2. STOs will not overcome Initial Public Offerings (IPOs) anytime soon

Recent articles regarded STOs as a “new buzzword” in crypto: main arguments are that STOs will speed up the settlements and enable a global and 24/7 trading. STOs are also said to be a cheaper fundraising model than IPOs, with lighter regulation and paperwork.

Actually, the promise of replacing equity markets by security token markets can end up very disappointing for investors, as they will quickly realize that the “revolution” some people are selling is overhyped:

Global equity markets do not need tokenization to drive significant liquidity and market depth, while STO secondary markets are currently very far from being an alternative

Even though some issuance costs can be squeezed thanks to the automation of processes, filling an STO still requires a lot of time and energy. It remains to be demonstrated that an STO would be way less costly and time consuming than an IPO

3. The STO potential should be assessed with the seemingly most relevant use cases

While the potential reach of real-world use cases for security tokens is still to be discovered, two sectors seem to tick almost all the boxes and could represent a solid opportunity for large scale experimentation: Real Estate and Investment funds.

Real estate and Investment funds (notably VC and Private Equity) are typical sector where middlemen absorb a sizable part of the value created, where tokenization in small fractions could help target a larger (and more international) base of investors and for which the investment cycle (several years) can be adjusted according to the investors’ strategies thanks to secondary markets. Additionally, using the STO model would compel the funds’ partners to be more transparent towards the community of investors and reduce the opacity regarding the investment strategy, the performance and the overall management of the fund.

Democratization of these kinds of investments, which has started on a relatively small scale with equity crowdfunding platforms should unlock strong value for both issuers and investors.

As an example, Tezos was used in February 2019 as the underlying blockchain for the tokenization of a USD1bn real estate fund by Elevated Returns and Securitize. This is the type of projects that could become a market reference in this nascent market.

Another area for which STO can add value is the tokenization of patents and IP, markets which are illiquid by nature, very opaque and misunderstood by the public.

Several assets of this kind are currently in the process of being tokenized, and as necessary infrastructure to support secondary markets are finally emerging, we should be able to witness in the coming months if the interest from the market is serious and if the value creation is real.

4. STOs and privacy

Finally, another issue that might hamper the emergence of security tokens is the way they can affect privacy and anonymity. As mentioned previously, whitelisting and identification of “accredited investors” is key but can also contradict with the philosophy of investors that are more and more concerned with their personal data.

Significant enhancement of today’s infrastructure needs to happen to enable tokens to primitively hold certain properties. The research in the field of “zero-knowledge proof” (ensuring the accuracy of an information without disclosing it, tokens restricting transactions to wallets with certain properties, enabling audit of a token to certain entities without revealing personal information…) should help resolve the privacy issue.

Several projects are working on the implementation of blockchain protocols or layer-2 with novel properties. We should be able to notice breakthrough in these fields in a relatively close future.

Conclusion

The initial discussions around STOs were a reflexive reaction to the ICO market getting properly deconstructed. As most of ICO projects proposed weak and unfounded utility tokenomics designs, many projects not being able to deliver, and an absurd growth in investment leading to the formation of a bubble, the market needed a more realistic promise to hang-on to.

Security tokens and their promises of bringing the next wave of investment through STOs carry with them very probable breakthrough and relevant use cases, and STOs are a new solution to raise funds, with a different value proposition compared to ICOs and IPOs. However, we are still at the early stage of the STO movement, given that some key elements of the market infrastructures (e.g. institutional-focused issuing and secondary markets) are not ready yet.

STOs are not just a hype, it is a nascent and high potential market, but will need to be supported by the most obvious use cases to begin with.