More than 80% of all 2018 ICOs that raised more than $50 mio later turned out to be scams. Moreover, only 8% of issuers actually launched a listing of their tokens on crypto exchanges. Investors in ICOs around the world have suffered enormous losses, including reputational losses, because many of the failed projects were financed and promoted by public persons. Yet, this does not mean that the market has become disillusioned with new methods of investment fundraising and is ready to return to conventional solutions – the Security Token Offering option, or STO, is increasingly gaining popularity. This option offers more security to investors while giving the founders a quicker and easier way to raise capital by issuing and selling company security tokens, or digital assets. So far, the mechanism has limitations. The secondary market for STO tokens remains underdeveloped – there are few STO brokers and exchanges yet. The prospects and risks of this concept were discussed at a Moscow conference, Advantages of the STO Market over Classic Venture Investment. Below are the highlights of the new system.
An alternative to IPO
Faster and cheaper – these are perhaps the main advantages of the STO procedure over the classical money raising options such as IPO. It is partly a response to the current market situation: in the first eight months of 2019, 107 IPOs were launched, which is about 20% less compared to the year before. The high brokerage and investment banking fees issuers have to pay, as well as excessive amounts of upfront compliance work keep companies from floating new shares.
“The STO market is growing, improving, and is already offering a good alternative to conventional fundraising; it’s a simpler and cheaper way,” says Yevgeny Kabanov, head of the Russian representative office of the Swiss company Rainier AG.
An STO token issued through this procedure is a digital analogue of an asset, he said, and gives more security to its holder. The blockchain is simply a different platform, while the company still has to set up processes to comply with regulations: issue a prospectus, provide complete information about the assets and submit timely reports. Due diligence is also required – companies have to implement procedures that allow them to meet the KYC and AML requirements in any jurisdiction.
“An STO is a mini-IPO,” Yevgeny Kabanov says.
Another kind of token
At first glance it seems that the two procedures do not differ much in terms of instruments offered to the investor: in both cases, it is a crypto token. However, according to Kirill Varlamov, a blockchain architect and the founder of OnGrid, in the case with STO the token has certain important features that allow for protecting the investor. It is not about standardы (for STO it is an ERC-20/ERC-777 compatible token), but about the issuer. STO tokens are issued by a depository, it is also connected to the register of shareholders, and each batch of tokens is tied to record in the shareholder register. If the holder loses control over the address, it is possible to recreate the tokens.
The procedure is simple: the securities are transferred by the project founder to the depository, the depository issues tokens and registers an emission, then tokens are moved to the holder’s address (for instance, investor’s address or an STO platform). And vice versa: the user can receive back their securities in exchange for the tokens.
For startups with a product
ICOs have been widely used as a fundraising tool mostly by young companies and startups that sometimes did not even have a prototype product. The STO procedure suits seasoned companies that need product scaling and additional investment. It can be real economy sector representatives (from plants to real estate), as well as fast-growing high-tech projects. For the latter, STO is recommended for their seed phase. For all of them, the procedure will improve their marketing since all fundraising projects improve brand recognition.
For Russian companies this can also become an opportunity to attract foreign investors while the situation is complicated due to the sanctions (the procedure itself is in grey area in Russia with no relevant regulations). All that’s left is to choose jurisdiction for an STO – as Kabanov says, most of his clients choose the US or Switzerland (Rainier AG is a member of the Crypto Valley Association). Germany and Liechtenstein are also open to the idea of STOs.
“Estonia has also declared the possibility of an STO, but I’m not aware of any such cases,” – Kabanov says.
Investments will grow
A significant growth in investments was observed as early as in 2018, only a year after STOs were launched. According to Rainer AG Advisory Group, they totaled some $442 mio, with the STO of the Bolton Group high quality consumer product trade platform being the most successful, its investments reaching $68 mio. As of now, the largest Security Token Offering is the STO of tZERO, a project of the subsidiary of the e-commerce platform overstock.com, which managed to attract $134 mio in the third quarter of 2018. Within the next two years, the new market is expected to grow, although not so fast as it has been with ICO. The emergence of larger stock exchanges, which will allow for development of the security token secondary market, is named as a necessary condition for this market’s advancement.
Risks will persist
Yet, investors in STOs should not relax: as the number of projects that seek to attract finances increases, so do the risks. This is primarily about the notorious human factor; potential investors are advised to learn more about the team of the project they like and the companies it entered into partnership with.
“Human desires and fears, greed, laziness and discredit – such risks are poorly described and presented to projects. Yet, these are risks both for those investing in STO and for public platforms and stock exchanges that should think of their reputation as well as of preventing projects that fail to correspond with the risk profile from making investments,” Lybrion managing director Vasily Kudrin emphasizes.
Project founders will find it more difficult to initiate investing, with the market to face tougher regulations and demonstrative rebukes of pioneers in this sector; competition between judicial agencies for the procedure is going to become tougher as well. Most importantly, large players are about to enter the market, primarily big tech companies as well as financial institutes, which will inevitably limit opportunities for small projects’ investments.
“STO is a rather attractive tool for drawing investments, with a wide range of functions and no excessive formalities or access barriers typical of traditional options such as IPO. Yet this tool proves attractive only if used solely by qualified investors. Regulators, stock exchanges and the projects themselves must be as cautious as possible to fulfill this condition,” says Prof. Artyom Genkin, President of the autonomous non-commercial organization Center for Protection of Depositors and Investors.
By Olga Blinova