What can we learn from ICOs and what will be the driver for successful STOs in the future?
With Security Token Offerings (STOs) becoming one of the most discussed topics of the year, TokenMarket looks at what lessons can be learned from the ICO market in order to ensure the STOs success.
Read more Secuity Token pieces here.
Security Token Offerings (or STOs) has become a popular term in the crypto space over the last year. With the ICO market facing a tough time, many projects are turning to the world of STOs in order to progress and keep up with the ever-changing landscape that is cryptocurrency. Whilst some are welcoming the innovation, others are more sceptical citing that the lack of decentralisation is exactly what crypto was designed to combat.
TokenMarket has been working tirelessly to set a precedent in shaping the nascent market into an industry that can fulfil its potential and the potential of blockchain as a whole. Whilst we know that this is not everything that this market needs in order to succeed, we feel that these are the core pillars that the STO market needs in order to be as successful as the traditional securities market.
If you are new to the world of STOs then please read our guide on What are Securities and Security Tokens? to get up to speed.
Regulation and Legislation
ICOs were often criticised for its lack of regulation by governments as well as traditional investment firms. For some, they felt the ICO market was a “wild west” type scenario where investors were simply funding scam projects, buying into promises that were never delivered.
Pump and dump schemes were a popular way for illegitimate actors to make some fast cash, getting the community excited over a concept with no real means of product development. These schemes allowed the owners of the project to make a considerable amount of profit in a short period of time without ever having to do much work. High bonus structures also led to some members of a projects ICO community entering a project, receiving their tokens and selling them as soon as the ICO went on sale; devaluing the project and its token as a whole.
In some aspects, they were right. A report carried out by Satis Group in July 2018, identified that 80% of the ICOs carried out in 2017 were in fact actual scams. Whilst this statistic is alarming for many participants, it is even more alarming for financial regulators around the globe. For many, including the US Government’s Securities and Exchange Commission (SEC), statistics like these only further their opinions on ICOs being unsafe for investors.
For the SEC, Hong Kong’s Securities and Futures Commission and the European Securities and Markets Authority (ESMA) ICOs are still a bit of a challenge as they want to protect investors but also do not want to stifle innovation. It is a difficult thing to do but for the US Government, protecting its citizens from scams, and bad investments, is important. The American Dream wasn’t built on losing money, after all. However, the lack of insight into the ICO market has ultimately led to most ICOs being called STOs according to the SEC, with the government's website declaring that:
“ICOs, based on specific facts, may be securities offerings, and fall under the SEC’s jurisdiction of enforcing federal securities laws.”
Though ICOs do have some flaws, they are a fantastic way for smaller businesses to gain funding while putting very little capital up. A new wave of funding a project, which ensured that the business was funded as well as giving the participants access to a platform they were interested in, meant that it changed the traditional rules of investment. There are also some fantastic ICOs in the space which is truly trying to change the world for the better. But, whilst this space is still young there will always be a “wild west” market so to speak. However, ICOs created a playing field in which all participants were on the same level.
ICOs, in essence, tore the rule book up. For most projects, almost all of them were funded purely by participants, way before venture capital (VC) firms even considered getting involved in the space. It meant that projects were funded by participants who wanted to see them succeed, creating a greater sense of community for those involved. Mass scale groups are created with the projects owners, developers and participants all placed in the same environment; taking questions about the project as well as gaining an insight into what the community wants.
What the ICO market could not do in terms of regulation, the STO will be able to help change the opinions of the regulators. Security token offerings are exactly what they say they are: securities. This means that securities laws, from whichever jurisdiction they are carried out in, apply. For the UK, the Financial Conduct Authority (FCA) will oversee the STO market meaning that strict regulation, laws and penalties apply to the market as well as the issuers carrying out such offerings.
Whilst the term security token offering is rather all-encompassing, having laws which will apply to each offering on an individual basis will mean that regulation must be adhered to. Dependent on what these security tokens are offering, whether it be; real estate, shares, equity or natural resources like gold, then these specific subsets of laws will apply to each case.
Placing these securities on a blockchain, an immutable, incorruptible and detailed ledger in which everyone has access, means that these tokenised securities will, in fact, create a more financially transparent place to operate within. There will be less room for any fraudulent activity to take place and, with the same legal penalties as securities fraud, one would imagine there would be far fewer scams around. Pump and dump schemes that were once rife in the ICO market will be become harder to enact with more severe penalties being handed out. The maximum sentence for securities fraud in the USA is life imprisonment whilst the average sentence in 2015 was around five years. In the UK, the maximum sentence is around ten years, with the average sentence being around six years depending on the scale of the crime. This should be enough to scare any fraudster off.
Markets and Interest
Crowdfunding is still a fairly new concept and has been around for just over 10 years. As of 2018, Fundly, a crowdfunding platform, estimates that global crowdfunding platforms have received $34 billion. However, with traditional crowdfunding, projects give away a percentage of the company’s equity in exchange for funding. This is where ICOs changed the way that the projects could raise funds. In that respect, ICOs truly pioneered the way that projects were funded.
The market attracted some fantastic projects and also saw many people gain a new interest in the world of cryptocurrency and blockchain. The ICO market is still a huge market for many investors. At the time of writing this article, ICOs had raised over $7.5 billion in 2018 according to ICO Data.io. Whilst this is still only a fraction of the estimated $338.4 billion raised by Initial Public Offerings (IPOs) in 2017 according to EY’s Global IPO Trends, it is still a huge number considering that these companies were giving access to a platform that had not yet been built. EOS, the infrastructure for building decentralised applications, for example, raised over $4.1 billion in its ICO alone, showing how powerful the ICO space can truly be.
ICOs were of course not without their issues, with two of the biggest areas being the misplacement of funds as well as delivery on a final product. In a study carried out by the Boston College, Hugo Benedetti and Leonard Kostovetsky found that around 56% of ICOs disappear within four months of their public sale. Digital Tulips? Returns to Investors in Initial Coin Offerings found that traditional ICO investing can be a risky business, something that the financial regulators like the SEC have thought for a long time. So, what happens when traditional securities are suddenly tokenised?
Being backed by real assets as already previously mentioned means that these tokens are working within traditional securities markets. If we take the example of real estate, which is on track to becoming a $4,263.7 billion industry by 2025 according to Grand View Research, then tokenising a share in say a property development makes sense. According to Ryan Serhant in an article by Rachel Wolfson titled A First For Manhattan: $30M Real Estate Property Tokenized With Blockchain, he states:
“With blockchain tokenization, we can remove the unruly pressure of traditional bank financing, which is much healthier for the project and all of the stakeholders. Tokenization is paving the way for a new forefront in real estate development.”
For the use case of real estate, as well as many others, then it makes sense to fund a project through a tokenised system. Providing total clarity over who has invested, how much they have invested, as well as the issuers now having a total overview on how their project has been funded on the blockchain, makes sense. Eliminating traditional financial obstacles means that property developers and investors all have complete transparency over funding and the project as a whole. Tokenised securities, it seems, have a bright future.
Even though the ICO market as a whole has seen a steady decline since its peak in January, the secondary market in which these coins can be traded is still thriving. Many exchanges, including the likes of Binance, Coinbase and Bitfinex offer users the chance to buy and sell these tokens on a secondary market, almost the same as the traditional market trading that is carried out by the securities industry. However, there in itself lies some issues.
With little to no regulation on these exchanges, it opens the market up to illegitimate actors and those simply wishing to make some money fast. Though processes like Know Your Customer (KYC) and Anti-Money Laundering (AML) are in place and have shown a maturity within the crypto space, these are not in place across the entire market. Some view KYC/AML as a “pointless process” whilst others view it as a sign that if investors are serious about the crypto industry then they should have no fear of getting involved within these processes.
Whilst there are still many conversations about how these security tokens will be traded, what is known is that they will be monitored, stored and exchanged in a much more compliant and regulated system. With financial authorities like the SEC, FCA and ESMA all having a close watching eye on the market there is less room for scams, fraud and errors. As previously discussed, penalties in respective jurisdictions can start from five years and go up to life imprisonment, meaning that governments will take STO fraud as seriously as they do with traditional securities fraud.
The STO combats a lot of the issues and places them within a security trading environment, placing them in the $77.566 trillion a year securities market. Polymath, one of the first STOs in the space, estimates that STOs will become a $10 trillion a year industry by 2020, optimistic but not unrealistic if the current trends and interest in the space carry on. Should the same level of investment that happened with ICOs in 2018 then there is no reason why STOs should not succeed.
The ICO market saw a global boom at the end of 2017 and early 2018 creating thousands of new projects and a great community, however with that also saw a flood of illegitimate actors enter the space with bad intentions. With around $7.5 billion invested in these projects throughout 2018, it is clear that the ICO market is still not finished. Yet, the idea of an STO market excites a lot more of traditional investors due to it being more regulated, compliant and financially secure.
The wave of STOs incoming should be welcomed, highlighting the gap in the market for traditional tokenised securities. With the right interest and the same level of buzz that flowed through the ICO market, there should be no stopping the next wave of digital investment. We, for one, are extremely excited about the prospect.
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