The rise of the security token offering has revealed the need for a security token standard. StartEngine’s EIP-1450 and Swarm’s SRC-20 are just two of the protocols being developed to establish a regulatory-compliant security standard. We dove deep into Swarm’s SRC-20, StartEngine’s EIP-1450, and the latest in security token regulation.

Howard Marks is the CEO of StartEngine, a Los Angeles-based accelerator and crowdfunding platform that connects investors with technology startups. StartEngine has invested in 59 startups. After noticing that many entrepreneurs from the accelerator had a difficult time raising capital, StartEngine has shifted its focus to capital formation, using security tokens for equity crowdfunding. Previously, Marks co-founded the rebirth of Activision in 1991. Activision today is a Fortune 500 company and one of the world’s largest gaming platforms.

Timo Lehes is a Co-Founder at Swarm, an open infrastructure platform for digital securities that is not to be confused with the Ethereum distributed storage solution which is also called Swarm. Lehes started his career as a software entrepreneur and then worked in venture capital at a Swedish fund. He spent seven years working in private equity, including BankerBay, a network for mid-market private equity.

Democratizing Financial Markets

Here’s how the regulatory landscape evolved in the United States.

Marks says early financial markets were biased systems that didn’t allow everyone to participate. The market crash of 1929 created the worldwide Great Depression. In this time period, people were able to sell stock in companies without any supervision by government bodies. Companies could create additional stock without informing investors. The U.S. government stepped in with the creation of the Securities and Exchange Commission in 1932, the Securities Act of 1933, and the Securities Exchange Act of 1934. These acts required companies that were selling stock to the general public to register with the SEC. Retail investors were no longer able to invest in private stocks. The notion of the accredited investor was created for the private sale of securities.

Intel raised $8 million with its IPO in 1971. Today, most IPOs have billion-dollar valuations and are already established businesses. The market has shifted; most of the value for the investor has already been created before the IPO. The Jumpstart Our Business Startups Act of 2012 promotes investment in early-stage companies. The JOBS Act’s Title III is commonly known as Regulation Crowdfunding, or Reg CF. Title IV is Reg A+. Marks says startups can raise up to $1 million by filing a notice to the SEC via Reg CF. Startups can raise $50 million from qualified investors in the general public with Reg A+, which involves private security sales to retail investors. Shares are not registered with the SEC and can be freely traded after they’re issued under Reg A+, and one year later under Reg CF.

Reg D 506c only allows the sale of securities to accredited investors. In the U.S., accredited investors are individuals who own more than $1 million in assets (not including their homes) and have a yearly salary over $200k. Investors must provide tax documents, bank statements, or have a lawyer, accountant, or banker certify accreditation. Marks says these documentary verifications, other than self-certify, aren’t required with Reg A.

ICO Crowdfunding

ICOs revolutionized crowdfunding, allowing retail investors to participate in the market. In 2017, companies raised more fund through ICOs than through traditional equity crowdfunding. Many ICOs sold security tokens disguised as utility tokens. According to Lehes, the SEC has indicated that if a fund has community-driven initiatives and profit participation from token buyers, the tokens are considered to be securities. There has been a drop in funding ICOs since this and other regulations were announced.

Securities laws apply based on the country of which the investor resides, not the issuer. One of the biggest challenges with security token compliance is that each country has different security requirements.

StartEngine and EIP-1450

StartEngine took on the challenge to build ERC-1450 on Ethereum, an extension to ERC-20 that allows for the creation of tokenized securities that comply with rules that the SEC has put in place, including the Securities Act of 1933, the Investment Company Act of 1940, the 2001 Patriot Act, the 1970 Bank Secrecy Act, and the JOBS Act. The asset of a security is not on the blockchain; rather, ownership is represented on the blockchain.

A benefit of ERC-1450 is that if security tokens are lost, they can be re-issued by a registered transfer agent. Marks believes that “if you lose your password, you lose your asset” is not a practical approach. StartEngine is currently in the process of becoming a registered broker-dealer. They are also in the process of launching a security trading marketplace, known as an alternative trading system.

StartEngine is an all-in-all issuance, tracking, broker-dealer, and trading platform. Marks says that StartEngine’s security token platform is not decentralized, adding, “If an asset exists outside of the blockchain, that’s already not decentralized.”

Swarm and SRC-20

Swarm started with a focus on providing access and liquidity to fund managers with private equity and hedge funds. This is an asset class with credibility. It is easy to verify underlying assets. The platform provides the technology required for cross-border compliant security-token issuance. Swarm is building a security-token protocol called SRC-20, a contract implementation in which a token contract connects to an oracle to determine if a token is allowed to perform certain actions. Anyone can create an Ethereum-based security token by staking SWM, Swarm’s native tokens

“A takeaway from 2018 was that 95 percent of security tokens were issued on Ethereum,” Lehes says. As of January 2019, Swarm has announced it will support both Ethereum-based security tokens and Stellar-based security tokens. Swarm’s focus today is to tokenize existing assets rather than capital formation. Lehes also says that significant blockchains from CoinMarketCap’s top 15 have come to Swarm to discuss how they can implement security-token functionality in their blockchains.

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OST blockchain infrastructure empowers new economies for mainstream businesses and emerging DApps. OST leads development of the OpenST Protocol, a framework for tokenizing businesses. In September 2018 OST introduced the OpenST Mosaic Protocol for running meta-blockchains to scale Ethereum applications to billions of users. OST KIT is a full-stack suite of developer tools, APIs, and SDKs for managing blockchain economies. OST partners reach more than 300 million users. OST has offices in Berlin, New York, Hong Kong, and Pune. OST is backed by leading institutional equity investors including Tencent, Greycroft, Vectr Ventures, and 500 Startups.