ICO or STO: Similar in appearance, but different in ideology There is a battle of terminology that is currently being waged in the cryptocurrency world: ICO or STO? The explosive growth of ICOs in 2017 has already been doubled in the first half of 2018 with over $13.7 billion raised by ICOs this year, according to a . While traditional venture capital deals still dwarf these numbers, the rapidly expanding fundraising model has shocked the world of finance and widened the surprised eyes of even the most weathered investors. report from PwC and the Swiss Crypto Valley Association Yet despite the remarkable success of ICOs, there is already a new model on the rise, called a Security Token Offering, or an STO. After so much success and mind-bogglingly large numbers, you would expect ICOs to continue on their growth trajectory. Even if investors don’t understand the underlying technology, they can understand a trend, and with each new billion raised, you could expect more investors to explore ICO opportunities. It’s as much an exploration of behavioral science as it is economics. The issue? The regulators, the SEC being a vocal contingent, have said that ICOs are a problem. The problem is this. ICOs were purported to be this great tactic for companies to get their protocol tokens into the hands of users. It’s a structure in its early stages; the benefits of token economics are still being worked out by specialists, but the promise is there. Theoretically, token economics can improve network effects by rewarding user participation and also create better governance by giving the most active users a larger say in the protocol’s future decisions. Pretty cool. Of course, there are other benefits as well, but that is the subject of another post. In this use case scenario, the protocol is built, the network functioning. The tokens are being distributed to consumers for immediate use within the platform. We are talking about a digital sale of functional tokens, utility tokens with utility. However, the reality is that most ICOs are a pre-sale of those tokens. They are not yet functional. Indeed, the purpose of the majority of ICOs to date is to fundraise so that the company in question can build the protocol on which those tokens can be used. In this case, the utility tokens have no utility because the application on which they would be used doesn’t exist. There is no decentralization as the decentralized protocol doesn’t exist. The money is going to a business, to specific individuals. The use case of the tokens is hypothetical, and there are no guarantees that the utility will ever exist in the future apart from the promise of the individuals working on the project. And a promise is not a guarantee. Take a look at many of the recent Ethereum decentralized applications, and you will find virtual ghost towns. Even when the protocol is launched, and the tokens achieve a form of utility, the market may not take interest in the functional aspect of the token and so the decentralized application withers away as it fails to attract users. Why then do investors purchase tokens at all? The key to the question is liquidity and speculation. With ICOs, investors purchase tokens that can immediately be traded on crypto exchanges from anywhere around the world. As an investor, I could buy a token for $1 in the morning and sell it at $1.3 in the afternoon. There are day traders who have been making a living doing just this with stocks on the public market, and that investment behavior is one of the driving forces behind the current cryptocurrency market. This investment behavior is a type of game, a form of gambling, and most importantly . For the dedicated, enough to make a living, and for the idle, enough for spending cash. a way to make money In a topic that has been well-covered, the SEC views most of these ICOs as the sale of securities, not utilities, for the reasons listed above, which encompass the general parameters of the . These ordinary investors are participating in a frothy marketplace, one full of scam, fraud, and behind-the-scenes pre-sale deals, and they have no protections. The SEC cares about protecting investors, and that is the purpose of federal security laws. Howey Test a lot Given the uncertainty of the market, the lack of regulation, the apparent fraud and speculation, and the SEC’s warnings, there was a backlash to ICOs within the technology industry. First, Facebook in January. Then Google that ICO ads would be banned beginning in June, Twitter, and Mailchimp followed.. Clearly, the very term “ICO” generated problems. There had to be another way. banned ICO-related ads announced in March Enter the STO An article dating back to April 2017 that mentions an STO The first time the term security token offering, an STO, was mentioned that I could find was in a , dating back to April 14, 2017, but of course the idea of an STO had been gestating long before that specific terminology. Dating further back, you can find mentions of regulated ICOs, ICO 2.0’s, token offerings, and even “ICOs” that did not differentiate themselves by name but by structure alone. All of these refer to the same offering structure just with a different name. blog post by Manhattan Street Capital An STO is similar to an ICO in that an offering is made by a business to the crowd, in which consumers purchase crypto tokens built on a blockchain, but the two do not share many similarities beyond that. Whereas ICOs are the sale of coins, purported utilities or even currencies, STOs are the sale of securities. STO participants are investors, not users, who pay and receive a security (i.e. equity, debt, revenue share, etc) that is represented by a token. In order to sell securities to the crowd, a company has to register the offering with the SEC (difficult and expensive) or use an exemption from said registration. STOs are typically done using an exemption called Regulation D 506(c), which is a public offering of securities to accredited investors (anyone with a net worth of $1 million+ or an annual income of $200,000 or more for the past two years—$300,00 in combined annual income for spouses). This regulation means a company can solicit the general public, but potential investors must verify their accreditation status before they can participate in the STO. Another popular option for STOs is to use the exemption Regulation Crowdfunding, which is an offering for the general public, meaning both accredited and non-accredited investors can participate in the offering, with the caveat being that there is a limit to how much an STO can raise in a given year, the limit being $1,070,000. The last important exemption that an STO can use is Regulation A+, which like Regulation Crowdfunding allows everyone in the crowd to participate but the annual limit is increased to $50,000,000. Along with that higher raise cap limit, the offering must be qualified by the SEC, which does not need to happen with the other exemptions. To date, no STO has been qualified by the SEC, but I expect this to change soon. The reason is simple: this is the gold standard for raising capital from the general public, and there is no lock-up period when it comes to trading the security tokens issued in an STO, meaning that I could buy and sell my securities in the same day just like you currently can with cryptocurrencies (whereas Regulation D 506(c) and Regulation Crowdfunding have a one year lock before those tokens can be traded). As the marketplace gets more sophisticated (read: less scams and fraud), the investors will express a greater demand for security tokens because they offer them governance and protection. Who wouldn’t want this? Well, most investors in ICOs do not want this because they like instant liquidity with the websites who are calling themselves “exchanges” and are unregulated. The cost of these platforms is low, if there is a cost at all, because the company is not burdened with any kind of supervision or rules and because they will take anyone and trade anything to anyone. Concepts such as KYC and AML, common buzzwords in the space regarding identifying the investor, are foreign to them or viewed as irrelevant. There are other risks with these unregulated exchanges through which investors can be taken advantage of. Among those are: , in which a company or individual trades ahead of the investor (this is possible because they can see the investor’s decision to buy before it is added to the blockchain) and then dumps the shares when the price goes up to make a profit front running , in which a group of investors works in collusion to buy a lot of tokens to drive the price up. Once the price reaches an agreed-upon point, the pump and dump schemes dump their coins, driving the price back down, hurting the investors duped by the false momentum pump and dump , or washed trades, in which a group of investors trade back and forth amongst themselves to create the facade of liquidity. painting the tape Many investors are ok with all of that if you give them a place to trade. Amazing! The security tokens from STOs will be traded on Alternative Trading Systems or with broker-dealers, which are closely supervised by FINRA and registered with the SEC. These ATSs and broker dealers have high costs because of the required supervision with the appointment of a chief compliance officer, training of every key employee, taking all of the necessary FINRA exams, following thousands of rules, and finally paying people for the experience and skills they bring to the company necessary to fulfill those functions. Movies have taught us that the good guys ride off into the sunset. The current crypto “exchanges” do not have to do any of this. Instead they hire a few great programmers to build the platform and in the meantime keep the trading fees low for investors. This is clearly an unfair advantage for those who choose to ignore the law compared to those who comply. How is this going to get resolved? That part of the story remains to be told, but in the end we have to hope the good guys win. After all, Hollywood told us so. StartEngine is a leading equity crowdfunding platform that has helped 250+ companies raise over $80M. We are also currently raising capital. Join the nearly 3,500 StartEngine Owners who have already invested in us. Invest in StartEngine here . For more information, view our Offering Circular .
