Security Token Basics: Part 1 How to Launch an STO
Get started on the road to launching STOs.
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We have classified the process to launch a security token offering into three parts:
- Basics of Security Token and what preparation is required to launch an STO successfully?
- What happens during Pre-STO, STO and Post-STO stages?
- How to perform STO properly and why should you engage an STO service provider?
In this article, we have explained the basics of security token offerings and what needs to be done before launching an STO.
Blockchain is one of the promising technologies that supports crypto-assets like Ether, Bitcoin, utility tokens, and security tokens. Crypto-assets present an enormous opportunity to bring transformation to the financial services marketplace. Though people are familiar with utility tokens, security tokens are a relatively new concept. Before we discuss the process to launch Security Token Offering (STO), we will first explain what STOs and security tokens are.
When a token is subjected to federal security regulations and can derive its value from an external, tradable asset, it is categorized as a security token.
You may also like: JWT Token: Lightweight, Token-Based Authentication.
While utility tokens can only be used to get access to specific services, security tokens represent assets with rights of ownership. Security holders are entitled to profit share, equity, dividends, voting, and buy-back rights.
Due to the increasing demand for regulatory frameworks associated with token issuance, startups launching ICOs should follow legal regulations, which can give more credibility and security to investors.
It is true that the process can seem complicated, but there are a lot of benefits that accompany a security token issuance. Tokenizing securities improve the liquidity of underlying assets, which can engage more investors.
Security tokens also come up with other benefits like increased market efficiency, lower issuance fees, and fractionalization of larger assets. If a startup meets required regulatory obligations, the security token offering can create a vast potential for a variety of applications.
We will cover the following topics in this article:
1. Types of security tokens.
2. Reasons why security tokens seem appealing to founders.
3. How to launch a Security Token Offering.
Types of Security Tokens
- Equity Tokens: a type of security tokens that states ownership of an asset like company stock or debt.
- Debt Tokens: equivalent to a short-term loan on an interest rate on the amount loaned to a company, Steem is one of the examples of debt tokens, which is required to purchase Steem Dollars.
- Utility Tokens: provide users with later access to a product/service. With utility tokens, companies can raise funds for the development of the blockchain projects.
- Asset-backed Tokens: a token built on the blockchain platform, which is associated with a tangible or intangible object of certain value.
Launching a Security Token Offering (STO) is somehow similar to that of an ICO. You need to make certain preparations, deploy smart contracts for different rounds of sale and build a product.
Let’s understand why security tokens are more attractive to founders as compared to the ICOs.
Appeal Behind Security Tokens
- Low barrier to entry: From debt to parking spaces, security token offerings as cryptographic tokens are designed to tokenize any asset. Such flexibility allows smaller companies to raise funds through private capital markets at lower up-front costs.
- Get more for less: As compared to a traditional VC deal, Security Token Offerings offer advantages to issuers. The most significant advantage is that the founders don’t need to surrender voting rights or board seats. It provides peace of mind to founding teams and enables them to focus more on the growing business profits.
Another advantage is to allow security token issuers to sell a share of profit tokens or a simple dividend.
So, founders can retain a good percentage of the company’s ownership while the token holders can receive dividend rights.
Launching a security token does not require surrendering voting rights to investors.
- Accessibility to Institutional Capital: Due to the regulated nature of STOs, security tokens act as a gateway for traditional capital into the blockchain domain. Funding via a Security Token Offering can be international in nature.
Though ICOs also attracted foreign investment, they were limited to established companies that could handle the overhead and costs of pursuing foreign capital.
Security tokens represent an opportunity to take a simple route to international financial markets by allowing medium-sized companies to attract investment from VCs and family offices across the globe. Being borderless, the blockchain space makes the post STO liquidity larger than the tokens limited to a single jurisdiction.
In this article, we will walk you through a step-by-step process of how to launch STO and how to create a token.
How to Launch a Security Token Offering
The Security Token Offering Launch Process can be categorized into the following stages
- STO for accredited investors.
Come up with an idea, consult a legal advisor, and decide how can a token gain value
Before you plan to launch a Security Token Offering, it is essential to come up with an idea that can engage more investors. Since a security token has to follow certain regulations, ensure to consult a team of legal advisors that can help you with the regulatory requirements in different countries.
The way a token can gain value also matters a lot. Understanding the tenets for a token’s value is more important before it is created.
Three principles on the basis of which a token’s value can be decided are
Each role defined for the token has a specific purpose for which features can be decided as per the business needs.
Right: Having possession of a particular token, the holder can get certain rights within the ecosystem. The rights could result in a governance action, product usage, access to the market or product or a specific contribution.
Function: The tokens can also be utilized to offer leverage to the holders to perform specific tasks within the product. For example, a Blockchain-based digital advertising platform, Brave enables its token holders to enhance the customer experience using a BAT (Basic Attention Token) to add advertisements on the web browser.
Currency: The token is an efficient way, which can be considered a store of value to perform transactions both inside and outside the ecosystem.
Toll: A token can sometimes, be used as a toll gateway to enable its holders to use specific functionalities within the ecosystem. For example, you require GNT (Golem tokens) to get access to the advantages of the Golem supercomputer.
Value Exchange: Since every token has some value, it enables the buyers and sellers to trade or exchange value within the ecosystem.
A token should fulfill the above properties if it is to be launched successfully and add more value to a project.
The more properties a token can have, the higher its value in the market will be.
Security Token Regulations
Since most ICOs are investment opportunities within companies, many ICO startups classify the tokens as securities. To be a security token, it needs to pass the Howey test.
The US Supreme Court established the Howey test to determine whether an arrangement includes an investment contract (security) or not. In the context of crypto-tokens, the Howey test can be represented as three independent elements that must be met to create a security token:
- An investment of money.
- In the same enterprise.
- With the belief of profits from the efforts of others.
Otherwise, the token is considered a utility token. A crypto-asset which passes the Howey test is classified as a security token. It should be subjected to federal securities and regulations.
Let’s discuss the security token offering regulations required in different countries to launch a security token.
- Regulation D.
- Regulation A+.
- Regulation S.
Regulation D enables a specific offering to avoid being registered by the Security and Exchange Commission (SEC) if the creators fill the “Form D” after the securities are sold.
Issuers need to work with the three rules, Rule 506 (b), Rule 506 (c) and Rule 504. Rule 506(b) and Rule 506(c) do not put a limit on fundraising but allow accredited investors in the US. On the other side, Rule 504 does not have limitations on the status of investors.
Rule 506C also says that investors are accredited and verified and therefore, their information is free from misleading or false statements. Regulation D also allows General Solicitation, which enables companies to promise their projects and fundraising by advertising them.
It will allow the creator to provide SEC-approved security to non-accredited investors with a general solicitation for maximum $50 million in investment. Regulation A+ is appropriate for established startups as it puts restrictions on providing two years of financial statement. Unlike Regulation D, Reg A+ does not have any limitation on resale, thereby enabling more liquid markets.
The issuance of Regulation A+ can comparatively take more time than other options to register the security.
That is the reason why it is expensive than all other regulations.
Regulation S applies when a security offering has to take place in a country apart from the US. Therefore, it is not subjected to any registration requirement under section 5 of the 1993 Act. However, creators have to follow the security regulations of the country where they are executed.
Exchange Commission implemented Regulation S to shed light on the application of Securities Act registration requirements outside the US and its territories.
Reg S comprises of the following rules:
- Rule 901 implies the general statement that the registration requirements only implement to “sales and offers” of securities that occur within the US and its territories.
- Rule 902 sets definitions for Reg S.
- Rule 903 offers a safe harbor for transactions that involve the issuance of securities that comply with certain guidelines.
- Rule 904 provides a safe harbor for offshore resales complying with particular guidelines.
- Rule 905 says that equity securities of US domestic issuers traded in compliance with the Primary Offer Safe Habor requirements are deemed “restricted securities,” as stated in Rule 144 under the Securities Act and subject to holding periods before they can be sold again without limitation in the US.
Though all of the regulations discussed above are valid to launch a security token, it is crucial to consult a legal person before proceeding further.
1. European Union
To launch Security Token Offering, companies have to create a prospectus and meet local security law requirements, except if qualified for the regulations mentioned below:
- The qualified investors’ exemption (private placement): Just like Regulation D in the US, companies can request qualified investors for the offerings.
- The limited network exemption: Companies can trade their security to around 150 people per member state freely.
- The limited amount exemption: Just like Regulation A+ mentioned above, organizations can sell securities up to 5 million euros without creating a prospectus.
- The large investments exemption: Organizations can trade their securities freely if every investor buys at least 100,000 Euros of issued securities.
- The nominal value exemption: Organizations can sell the securities without any hassles if each security’s value is equal to at least 100,000 Euros.
Performing a legal activity in France is usually prohibited until the specific person is exempt or licensed. Activities that involve “financial instruments” are regulated activities. AMF (Financial Markets Authority) had earlier identified the absence of ICO regulations as a risk inherent to ICOs. As a result, the French Treasury has come up with a new legislative framework.
The New Legislative Framework
The proposed legislation would announce a new chapter to Book V, Title V of the French Monetary and Financial Code (CMF) that will be retitled as “Intermediaries in Miscellaneous Property and Token Issuers.”
Chapter 2 of Title V (Token Issuers) specifies the token’s definition that can be registered, issued, transferred, or conserved via a shared electronic registration mechanism. Any token issuer needs to comply with the requirements and conditions mentioned in article L. 550-8, which explains the function of AMF.
The Role of AMF Within the Framework
The AMF requires to offer additional advice related to the law’s provisions in General Regulation (RG AMF). Issuers have the right to submit a disclosure document to the AMF so that buyers can make the right decision while buying tokens.
The AMF then checks the disclosure document, and any advertising or promotional content circulated and published by the token issuer. Therefore, the content should be clear, accurate, devoid of false information, and should mention the risks that can be faced by investors when buying tokens.
They also verify if the token issuer is a legal individual or organization registered in France and under French law.
Though Switzerland is considered more token-friendly than all other countries, FINMA (Financial Market Supervisory Authority), which regulates the financial markets, has declared that tokens would have to comply with the current Swiss laws.
FINMA examines each token sale on a case-by-case basis and is currently surveying blockchain startups to violate Swiss law potentially.
Malta is an island country in the Southern European region that welcomes blockchain and digital currencies industry with open arms. Understanding the potential of the blockchain, the Prime Minister of Malta, Joseph Muscat said, “I understand that the regulators are wary of this technology, but the fact is that it’s coming. We must be on the front line in embracing this crucial innovation, and we cannot just wait for others to take action and copy them. We must be the ones that others copy.”
Malta is in contrast to other nations that have either banned cryptocurrencies or remained uncertain about it. With respect to the STO launch regulations in Malta, the government has come up with three bills, the Virtual Financial Asset Act, Malta Digital Innovation Authority Act and Innovative Technological Arrangement and Services Act, creating new structures for path-breaking technology called the blockchain.
Just like other countries, the authorities at Malta also ensure to comply with AML and KYC process.
However, unlike other countries, Malta believes in a technology-first approach. The authorities need to consider the technology behind the project and if it is feasible or not.
The Monetary Authority of Singapore (MAS) had come up with a guidance series for token sales. According to the Singapore Government, organizations must register and submit their prospectus to MAS before launching STOs, and unless qualified for one of the exemptions mentioned in “A Guide to Digital Token Offerings” by MAS.
- MAS can regulate digital token offers or issuance if the tokens are capital market products under SFA (Securities and Futures Act).
- MAS would examine the characteristics and structure of a digital token (including the rights attached to it) to know if it is a capital market product under SFA.
- A digital token may constitute a share, a debenture and a unit.
- The small offer of an entity in a CIS (Collective Investment Scheme) should not exceed five million within any one year, subject to certain conditions.
- A private placement offer should not be made to more than 50 individuals within a period of any one year, subject to specific conditions.
2. South Korea and China
In 2017 beginning, the People’s Bank of China together with other regulators of China announced token sales to be illegal. After one month, the Financial Services Commission in South Korea also declared the same for token sales in South Korea.
3. Hong Kong
Rather than what approached has been followed by its mainland China, Hong Kong declared that they may include the sale and offer of securities. Launching tokens under the category of “securities” and hence, defined as a regulated activity.
Therefore, parties engaged in a regulated activity need to be licensed or registered with the SFC (Securities and Futures Commission) no matter whether the parties are based in Hong Kong or not.
Parties that are involved in the secondary trading of such tokens may also subject to the SFC’s conduct and licensing requirements.
The Israel Securities Authority (ISA) established a committee in August 2017 to examine the applicability of existing Israeli securities laws to the sales of tokens. ISA has planned to evaluate the token sales on a case-by-case basis.
ISA stated a security token as a cryptocurrency, entitling the token holder to the future cash flow or ownership rights in a specific venture.
2. United Arab Emirates
The UAE Securities and Commodities Regulator has planned to regulate the Initial Coin Offerings in the country. The planning to introduce regulations was to recognize tokens as securities.
Securities in the Dubai International Financial Centre are governed by the Dubai International Financial Services Authority(DFSA) while the Abu Dhabi Global Market’s Financial Services Regulatory Authority (FSRA) governs securities in Abu Dhabi.
Securities laws in Canada are similar to those in the USA. The test to determine a security in Canada is identical to the Howey test followed under US law. The token sale, which is under Canadian law, then it should be registered and complied with a securities regulatory authority and should have a prospectus.
Though all of the regulations discussed above are valid to launch a security token, it is crucial to consult a legal person before proceeding further.
Choose the Right Security Token Platform
Because security tokens are not utility tokens, they require a unique infrastructure and a new approach. To make the cumbersome process of launching STO seamless and quick, you need to know about the top technical security issuance platforms.
Here are some of the top security token platforms to launch an STO.
- Polymath: Polymath provides the legal and technical solutions to securitize the bonds, assets, or stocks on the blockchain. It connects the KYC providers, smart contract developers, legal experts, and token investors to form the basis of a security token. It works similarly to Ethereum and has its ST-20 token standard, smart contract functionality, and native token, POLY.
The POLY token acts as an economic unit for all types of operations on the Polymath’s blockchain. The process to launch financial products on the blockchain can be streamlined with Polymath, as it can embed financial security requirements into the security token’s designs.
- Harbor: Harbor is another blockchain platform designed to launch Security Token Offerings and comply with the security tokens and current regulatory framework. It also enables traditional asset classes to move to the blockchain.
Harbor platform uses a regulated system token (R-token), which is a permission token on the Ethereum blockchain and enables the transfer of tokens after the approval of On-chain Regulator Services.
- Securitize: Securitize is an end-to-end blockchain platform that can manage the processing of solicited investors from sign-up to capital received and handle the issuance and management of security tokens throughout its lifetime.
- Securrency: Securrency is a complete securitization platform that allows launching Security Token Offering with a simple drag and drop process. You can use their RegTex™ engine, which enables you to perform KYC in over 160 countries and AML on both fiat and cryptocurrency wallets.
Since the platform is blockchain agonistic, you can get an abstraction layer and APIs called as InfinXChange™ to select a blockchain of your preference.
- Swarm: Powered by blockchain, Swarm is a real-world asset tokenizing platform. With SRC20 protocol, Swam offers a cryptographic standard for security tokens to tokenize assets like real estates, agriculture, tech companies, and renewables.
The SRC20 protocol states a set of rules that every security token should follow to represent a real-world object. Swarm also has its native token, SWM, like other platforms for facilitating economic activities.
The above platforms are like blockchain platforms required to launch an ICO, for example, Ethereum, Neo, EOS, or Hyperleder, but these blockchain platforms are not well-designed for the security tokens.
Therefore, you need to choose the ideal platform from the above list as per the requirements and regulations followed in a specific country.
Write a Whitepaper
An STO whitepaper is the most crucial marketing document of the product, and if written incorrectly, can kill the product even before it goes to the market.
Sections that should be covered when writing STO whitepaper:
- Legal Disclaimer.
- Product Details.
- Industry Overview.
- Technical Architecture.
- Business Model.
- Assets and another type of security associated with the token.
- Tokenomics and Token Usage Details.
- Team members and advisory.
Also, an STO whitepaper writer should consider the following global rules to write it in a well-explained and organized way:
- Ensure to break down the content into smaller sections to enhance the readability. There should be no more than two headings on one page.
- Always remember that the critical audience of the whitepaper is the crypto-investor. So, do not forget to add a token sales summary sheet with token sale related details.
- Also, try focusing more on the solution, not blockchain. DLTs are a part of the solution, but it’s not a solution.
- Try to keep the executive summary short. If you write it beyond 300-400 words, it can bring down the reputation of your project.
- Make sure to add flowcharts in the paper to make it look well-designed and organized. Draw.io, OmniGraffle, and Lucidchart are some of the best tools to create diagrams and technical architecture.
- Also, write about regulations under which a security token is categorized.
Once you are ready with a whitepaper, you should look out for the expertise in your area of interest and build a team.
Gather a Team of Experts
After you come up with an idea, select the security token platform to build Security Token Offering and draft a whitepaper, ensuring to look out for a team of experts who have experience in cryptocurrency development and consultation.
Gather a team of professionals from different areas like accounting, development, sales, marketing, and legal. A Security Token Offering backed by a professional and experienced team can bring profit to a business. While consulting anyone, make sure they have worked on any ICO or STO project before.
It is highly essential to confer with the right legal advisors to ensure that the security token passes all the regulatory frameworks or security tests. Finding legal experts can be a challenging process as STO is new to the market and not every lawyer understands the regulatory requirements.
Ensure to confirm if the legal advisor has in-depth knowledge of the Security Token Offering and what all is required to launch a token legally.
Create a Marketing Website
Creating a website is essential to introduce and sell the security tokens to crypto investors. You should have a website that can run securely and handle loads of numerous requests at the time.
The website designed for Security Token Offering should allow investors to register to participate in the security token sale. The web platform for an STO should be integrated with KYC/AML to validate users.
Here are some of the tips to make an STO website stand out:
- A website should talk about your project: Investors visiting your site will be interested to know the idea behind the project, how the product benefits them, and the development roadmap and token distribution information.
- Add visual graphics: Visitors on the website might not have enough time to go through the long paragraphs of text. Therefore, it is always good to include creative yet informative visuals to give a clear idea about the project.
- Live Token Sale Countdown: Always remember to embed the live token sale countdown on the website so that investors could quickly get to know about the sale.
- Add Customer Support Channel’s Link: Do not forget to add the customer support channel’s link to provide instant help to customers/investors in need.
It is good to get in touch with a team of experienced and creative website designers.
Once you are ready with the prerequisites to launch STO, you need to enter the Pre-STO stage where you have to introduce your idea to the market and create a security token.
Published at DZone with permission of Akash Takyar. See the original article here.
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