The SEC has recently clarified its position on the ICO market. Despite the magical thinking of issuers and buyers alike, there is no fundamental difference between a utility token and a security token. While the former does serve an additional purpose – facilitating transactions on a platform or within a product’s ecosystem – such tokens were purchased with the expectation that their value would increase, putting them into the sphere of securities. Read any of the buzz on ICOs from 2017 or earlier and it’s impossible to deny that the excitement stemmed primarily from making money, not using a new service.
Further stultifying the ICO market is the SEC’s refusal to ‘grandfather in’ any tokens. If an ICO issued tokens that were clearly a security at any point, they should start getting their legal affairs in order now, rather than waiting for the SEC to levy punishment. The only exception so far is Ethereum, which, according to an SEC official, should not be treated as a financial instrument due to its decentralized nature.
Lest we work ourselves into high dudgeon with libertarian screeds against the US government, let’s not forget that SEC has good reason to be wary of the ICO boom. Not only have numerous startups folded after promising the moon (and earning enough to buy it), but there have been pump and dump schemes that, despite clear fraudulence, managed to fleece investors out of huge amounts. The new reality is that anyone looking to issue a token for crowdfunding purposes must prove they actually have something to offer beyond vaporous enthusiasm or claims of transcendental ‘disruption’.
Enter the STO.
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The term ‘Security Token Offering’ has been tossed about for some time now but has only recently gathered a head of steam. An STO works like an ICO in many ways – a company creates a new type of altcoin that will either serve as the token of exchange on their platform, raise money to pay for development, or both. The company then generates a certain amount of the token, often the total amount that will ever exist, and issues it over a limited period of time to interested investors.
Where an STO diverges is its adherence to the tangled web of financial law. An STO must be registered with the SEC as a security, meaning it has to satisfy the KYC (know your customer) and AML (anti-money laundering) regulations that exist to keep dirty money out of the US financial industry. There are also requirements about whether or not the token can be sold to retail (read ‘amateur’) investors, or only those accredited (read ‘professional’). The issue of the secondary market is important, too. Currently, thousands of ICO tokens are traded on exchanges by their original owners or individuals many, many sales removed from the initial offering. While the SEC has not explained how they would limit such dealing, it seems like an inevitability unless crypto-friendly regulation is passed at the federal level.
An important aspect of an STO is that its very existence limits the potential of investor fraud. In order to receive the SEC’s blessing, a company must prove it has something backing up its token. This can be a product (such as an app), an ecosystem (ala Ethereum), a platform, or value-markers like assets or cash flow. Something more tangible than hype and extravagant promises, in other words. This prevents the pump and dump schemes that have plagued ICOs since their inception. One example of a company following these guidelines is Spin, which is looking to break into the electric scooter market with a $126 million fundraising goal through an upcoming security token offering.
None of this means that the ‘STO’ designation is bulletproof. A company can still label itself as such without actually following through with the SEC, and regulation can always be evaded in the short term through trickery and obfuscation. Don’t assume that an investment is safe just because the right three letter acronym is affixed to it. As always, ultimate diligence lies in the hands of the customer.