Beyond ‘Utility’ — Why Security Tokens will ultimately dominate

During 2017 and what might be considered the ICO ‘heyday’ it is fair to say that the legal status of many of these capital raising initiatives wasn’t a priority for founders — if it was considered at all.

As the year wore on, however, the size of the raises began attracting attention beyond the crypto-world — ultimately capturing the interest of financial authorities like the SEC and its jurisdictional counterparts worldwide — many of which began issuing stern warnings about regulatory compliance and investor protection legislation.

Alerted to the fact that their raises might be in breach of local securities laws, ICO startups began claiming they were actually issuing ‘utility’ tokens — often concocting elaborate token ‘use’ cases in the hope that this would distance them from regulator scrutiny. A statement by SEC Chairman Jay Clayton in early December put paid to that plan, though, with Clayton making it clear the SEC wasn’t buying it — saying:

“[C]ertain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.”

For ICOs choosing to persevere with the ‘utility’ strategy today, the consequences of having a token retrospectively classified as a security by the SEC are potentially significant — including hefty fines, orders to return all capital raised, and criminal prosecution.

Not surprisingly, there is now a groundswell of startups investigating the hows and whys of moving away from utility tokens — and a growing realization that the only ‘safe’ way to issue a token is to do it through a fully compliant Security Token platform.

Benefits of Security Tokens extend far beyond simple legality

In the short term, whilst the industry evolves, it’s likely that security token issuance will be restricted to wholesale and accredited investors. The compliance costs involved in extending such an offer to retail investors are prohibitive, whereas offers of securities to accredited investors are much less expensive — in addition to being exempted from many of the registration requirements of the U.S Securities Act. Similar regulatory exemptions for accredited or wholesale investors exist in most common law jurisdictions internationally.

Legality aside, the potential benefits to issuers of releasing Security Tokens are extensive.

From a capital raising perspective, Security Token offerings would incorporate elements of traditional IPOs — potentially giving investors a right to a share of profits, a right to vote, and a right to liquidation proceeds in the case of a winding up — rights that have typically not existed in earlier ICOs. Correspondingly, the issuer would be freed from the restrictions of traditional financing processes and be able to draw on a global pool of capital no matter their geographic location.

Other benefits of Security Tokens relevant to issuers include:

• A 24/7 365 marketplace — online exchanges providing around-the-clock liquidity
• Fractional ownership — attracting a deeper pool of investors in secondary markets
• Faster transactions — settlements in seconds instead of days
• Lower cost of liquidity — fewer middlemen equating to lower fees and operating costs
• Dynamic updates — Security Tokens are updateable and smart

The potential to tokenize multiple organizational assets — offer a range of tokens to better align with investor strategies. For example, growth, stable return, conservative or aggressive

Tokenization not just for ‘start-ups’

While the concept of a Security Token has entered the financial lexicon via initial coin offerings and is therefore associated with high tech startups in the blockchain sector, this is a shortsighted view. In fact, the tokenization of securities could easily be applied to existing businesses. Small to medium enterprises, for example, that previously would have never considered an IPO on the NYSE or the FTSE will be able to reach a worldwide investing audience at a minimal cost. Other advantages would include:

• Borderless transferability of tokens – potentially creating a value uplift in the tokens (versus ordinary equity sold within a jurisdiction) due to the international reach and investor competition that tokens allow

• An ability to market products and services to a true worldwide audience versus the more parochial approach of listing on a local exchange and soliciting only to local residents. This would be particularly attractive to companies in the IT space which is borderless and whose natural investors aren’t concerned with national borders

While it is unlikely that Security Tokens would replace the listed equities markets anytime soon they should quickly become an alternative option for issuers who seek international exposure to an ever-growing network of wholesale and accredited investors.