Security token offerings will replace initial coin offerings this year, but that's just a sliver of their potential.
One pioneer in this space estimates security token offerings (STOs) could grow to $10 trillion in just two years.
It's clear STOs will revolutionize investing as we know it and reinvigorate the cryptocurrency markets in the process.
That's because security token offerings will do more than simply provide a legal path for companies seeking to offer new cryptocurrencies. A security token can be linked to virtually any type of investment, such as stocks or commodities.
One of the primary STO platforms, Polymath, estimates that security tokens will soon outdistance the now-dominant "utility tokens" like Bitcoin. Polymath sees security tokens exploding to a value of $2 trillion in 2018 alone and $10 trillion by 2020.
This was all triggered by the initial coin offering (ICO) phenomenon of the past several years.
Last year, ICOs drew a lot of investor attention by raising millions of dollars in seconds. Just in 2017, ICOs raised more than $5.3 billion worth of capital. The largest, Filecoin and Tezos, raised more than $200 million each.
But there was a problem…
Where ICOs Hit a Snag
ICOs took regulators by surprise. As something new, ICOs didn't clearly fall under any existing rules. Even after coin offerings started raising millions of dollars, regulators were slow to react.
That opened the door to scammers, who quickly discovered you could conduct an ICO, pocket a few million dollars, and disappear.
The rise of bad actors drew the scrutiny of the U.S. Securities and Exchange Commission (SEC). The SEC issued a warning about ICOs last July after investigating Ethereum's DAO fiasco of 2016.
The SEC concluded the DAO was an illegal offering of a security. This was a hint of what was coming. The agency issued further warnings in August and November.
The November warning reminded investors of the DAO investigation, noting "the Commission warned that virtual tokens or coins sold in ICOs may be securities, and those who offer and sell securities in the United States must comply with the federal securities laws."
By December, the SEC was taking action. On Dec. 11, the SEC announced it had halted the Munchee Inc. ICO; in January, it seized the assets of AriseCoin, calling that ICO fraudulent.
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At a U.S. Senate hearing in February, SEC Chair Jay Clayton summed up how far the agency had come.
"I believe every ICO I've seen is a security," he told the Senate Banking Committee.
At the end of February, the SEC sent subpoenas to as many as 80 companies and individuals involved with ICOs, according to The New York Times. In March, the SEC warned cryptocurrency exchanges against trading "unregistered securities" – in other words, ICOs the SEC considers securities.
The SEC's hard line could have spelled the end of ICOs, at least in the United States.
But the SEC isn't trying to ban the use of cryptocurrencies to raise capital. In his December memo, Clayton acknowledges ICOs "can be effective ways for entrepreneurs and others to raise funding, including for innovative projects."
And the SEC has always offered another, legal option – which is where security token offerings come in…
How Security Token Offerings Solve the Problem with ICOs
ICOs didn't need to fly under the radar of the SEC. The 2012 JOBS Act created several methods for raising funds ICOs could have used that would have kept them compliant with SEC rules.
These include "Regulation D," Regulation A+," and crowdfunding.
The main reasons no one bothered was because using these alternatives:
- Required more effort
- Required more money
- Included various limits and a holding period before the security can be resold on secondary markets (typically 12 months)
But with the SEC cracking down, the JOBS Act options – particularly Regulation A+ – look much more appealing.
Security token offerings are likely to use Regulation A+ for several reasons:
- Two Tiers: STOs can choose Tier 1, with a $20 million limit, or Tier 2, with a $50 million limit. The higher limit comes with stricter filing requirements.
- Open to All: Any investor is eligible to participate in a Tier 1 security token offering. For Tier 2, a retail investor is limited to 10% of their annual income or net worth. Most other alternative forms of raising capital are restricted to well-heeled, accredited investors.
- No Holding Period: Unlike Regulation D and crowdfunding offerings, Regulation A+ has no restrictions on how long an investor must hold the new security. If a Regulation A+ security is trading on an exchange, you can sell it whenever you want.
STOs will also help weed out bad actors. The filing requirements with the SEC, as well as the cost – in the hundreds of thousands of dollars, depending on the size of the offering – will deter the fly-by-night operators that have plagued the ICO space.
But as I noted earlier, security token offerings are much more than a way for cryptocurrency tokens to become SEC-compliant.
They're going to open the door to a dramatic shift to the very nature of investing…