As the ICO Market Dwindles, the STO Model Starts Gaining Attention

The ICO fundraising model exploded in popularity during 2017 and remained a force to be reckoned with for a large part of 2018 as well. While many ICO tokens that were issued during the cryptocurrency market’s historic bull run increased in value dramatically, the same cannot be said now as the majority of new ICO tokens fall in value once they are listed on cryptocurrency exchanges.

The utility token model is also yet to gain significant traction, as price speculation still dominates over utility for most tokens. With most ICOs, backers have little to no protection, and issuers can have little incentive to fully commit to developing a project - during the ICO boom, it was common for projects to receive millions in funding despite having no working product at the time of the token sale. Of course, there have also been outright scams, with projects disappearing into thin air after raising funds.

All of these weaknesses in the ICO model have resulted in increased attention being given to another blockchain-enabled fundraising model – the security token offering, or STO. Here, we should be careful to consider that the STO is not necessarily an evolution of the ICO but is, in most cases, a completely different model when it comes to substance.

What Is a Security Token Offering?

To put it simply, a security token offering is when an investor receives a security token (also referred to as a tokenized security) in exchange for payment. The security token offering should be registered with the relevant authorities and the issuer of the security token should disclose all of the required information and assume all of the responsibility that comes with issuing a security.

A security is a financial instrument that can be traded (change ownership). Some of the most common categories of securities are bonds, stocks and derivative products (futures contracts, options, and so forth).

A security token is a traditional security in the form of a digital token, leveraging the properties of blockchain to provide increased transparency and liquidity.

Here, we can see the first major difference between an ICO-issued token and a STO-issued token. Securities grant their owner certain legal rights, for example equity, entitlement to interest payments or profit dividends.

On the other hand, most ICOs claim they are issuing utility tokens, which are designed to unlock access to services provided on a blockchain platform. In this example, let’s take a look at Ethereum’s model. New ETH enters into circulation as a reward to miners for their service of securing the decentralized Ethereum network. Miners then sell their ETH to cover operating costs (and, ideally, have some ETH left over).

Users acquire ETH since it is necessary to access certain services provided by applications running on the Ethereum network and pay transaction fees to miners. At this time, price speculation plays a substantial role in establishing ETH’s market value, but the token is also successful at providing the economic incentive model that is necessary to maintain a secure decentralized network.

Some ICOs issue tokens that do grant some of the previously mentioned rights to their holders, but don’t register their token as a security with the relevant authorities. This is one of the cases where the line between utility tokens and securities becomes blurred and can lead to legal ramifications for the token’s issuers.

In the United States, for example, the “Howey Test” is used to determine whether a transaction (such as a token sale) constitutes an investment contract that should be registered as a security:

It is an investment of money

There is an expectation of profits from the investment

The investment of money is in a common enterprise

Any profit comes from the efforts of a promoter or third party

The STO Is Not an Evolution of the ICO

While (legally compliant) security token offerings place more responsibility on the token issuers and offer investor protections that are absent from ICOs, they shouldn’t be viewed as “safe bets” and should be examined critically, just like any other investment. Even though ICOs and STOs share similarities in form (an investor receives a blockchain-based token in exchange for payment), the STO model shouldn’t be viewed as “ICO 2.0” as the two models have many differences in substance.