The first Security Token Offering (STO) was launched in 2018 by the US-based Praetorian Group which subsequently issued the PAX coin (not to be confused with the PAX stablecoin).[1] European players followed swiftly, and by July 2019 Bitbond made headlines with the first approved German STO, which raised more than two million Euros.[2]
STOs are not to be confused with ICOs, Initial Coin Offerings, which were one of the main factors fuelling the 2017–2018 crypto bull run. The main difference is that STOs are limited to on-chain representations of securities, i.e. tradable (and highly regulated) financial assets that frequently comprise equities and fixed income instruments, whereas tokens issued during an ICO could be categorized as “utility tokens” in a very broad sense. The question of what exactly constitutes a security varies widely across jurisdictions. As a case in point, there has been an endless back-and-forth in the US on whether certain crypto assets, like XRP, are to be considered securities — even if simple heuristics like the Howey Test[3] are commonly used, the questions are frequently settled in court.
Despite the many advantages that STOs offer compared to IPOs, such as, but not limited to, decreased issuance costs, faster and cheaper transactions, better transparency, and greater control for both issuers and investors, STOs have not reached mass adoption yet. Even the crypto exchange Coinbase offered their shares in 2021 to the public via a traditional IPO and not via an STO, thus sidestepping from the technology which, arguably, allowed them to achieve their impressive growth rates in the first place.
This raises the question, why have STOs not taken off?
There are several reasons why STOs have not reached the stage of mass adaption yet. The common denominator is that the propagandized advantages cannot be fully grasped yet and only exist in theory.
Promised advantage:
Easy, cheap, and quick transfer of tokens.
Current Barriers:
Lack of secondary markets.
While it is true that security tokens can easily be exchanged between two different parties almost instantaneously and for a fraction of the costs than in traditional equity markets, the truth is, that it currently barely happens.
In the stock world, transfers of ownership between non-institutional investors often happen through exchanges. They provide a marketplace that offers liquidity, reference prices, order books, limits, etc.
Unfortunately, in the realm of security tokens, no player was able to establish a liquid and well used secondary marketplace. However, the upcoming EU pilot regime that will come into effect in March 2023, could propel the creation of secondary markets one stage further. The planned regulatory requirements will become much more favourable, both for new players hoping to create an MTF on a DLT basis and for incumbents who want to experiment with DLT-based market infrastructure. In particular, the requirement to always use a central securities depository for custodying securities, which is enshrined in the EU’s 2014 CSDR, will be waived for the duration of the regime.
Promised advantage:
Subscribing to a security token & automated corporate events.
Current barriers:
Lack of settlement currency & digital stablecoin.
Another hindrance for mass adoption lies in the settlement currency. Given that there does not exist a widely accepted EUR stablecoin, subscribers to an STO must choose between different options, which all present their own challenges. They can subscribe, if offered, either with a USD stablecoin (forex risk), cryptocurrencies (volatility risk) or traditionally via a wire transfer, which creates an unpleasant user experience due to a hybrid subscription model where rights and duties of a security are fulfilled both on- and off-chain.
Time will tell if the newly launched EUROC by Circle can fill the gap.
Promised advantage:
Blockchain will make everything easier to use.
Current barriers:
Lack of knowledge.
This factor is one that has multiple subfactors contributing to it. On one hand it can be very frustrating when investors associate cryptocurrencies to security tokens and are reluctant to understand the differences between the two. On the other hand, mass media jumps on to any opportunity to paint blockchain technology in a negative light. Hence, it is no surprise that blockchain technology is often mistakenly associated with the more questionable aspects of cryptocurrencies (scams, shady projects, hacks, lack of stability) and suffers from a negative reputation.
However, external parties are not entirely to blame. Within the blockchain bubble there seems to be a trend to overemphasize the advantages of its technology. When selling their products, founders and entrepreneurs should not forget though that the end user often simply wants to benefit from the advantages of the technology but mostly doesn’t need to know the (sometimes) complicated details of industry-specific terms like wallet, tokenization, custody, etc.
Promised advantage:
Seamless integration
Current barriers:
Bad user experience.
Investing into an STO still often needs an awkward mix of on-chain and off-chain activities, creating an unsatisfying user experience. The effect of having to use wire transfers to subscribe to STOs have been explained above already. The off-chain experience does not end there, another major hurdle when investing into financial products are the strict KYC & AML regulations. Current KYC services have largely not been neatly integrated with providers that offer custody / wallet solutions for retail clients — authentication does not occur on-chain, for example via signing messages with a “trusted” private key associated with the investor’s (known) wallet Instead, traditional “centralized” methods of identification (via ID scan, selfie or video) continue to be used.
All the factors together make the end user question whether using blockchain technology really makes their investment experience easier or not.
Which market conditions need to exist to propel the success of STOs?
Liquid secondary markets
As previously described, liquid secondary markets are a requirement to attract more volume during primary issuances, otherwise many of the promised advantages of tokenized securities cannot be fully delivered.
Multi-listing on secondary markets
It is very important that emerging secondary markets do not become siloed solutions but rather also enable tokens that have not been issued by the marketplace provider to be listed on their platform.
In an ideal world, there will be several secondary marketplaces to trade security tokens, which each ensure and enforce KYC & AML regulations. Order matching would ideally happen through on-chain orderbooks ensuring that marketplaces have real-time data available that they can display to their users. This data could be provided by an oracle service or network (e.g., Chainlink).
Digital settlement currency
For the future success of STOs in Europe, it is crucial that there is a EUR denominated digital settlement currency. Investors are reluctant to use cryptocurrencies for their investments as it increases their risk exposure, stablecoins issued by banks come with centralization risks, and unfortunately, it seems like a CBDC issued by the ECB is still a project that needs a few iterations before it will be released to the public. Additionally, there are questions about how much DLT these CBDCs really leverage.
Solutions like Monerium could be useful a method to bootstrap EUR denominated security token transfers fully on-chain until fully-fledged solutions become available. Another stablecoin that could fill in the existing gap is the recently launched EUROC stablecoin by Circle.
Token standards
Tokenization providers should work together and agree on certain industry standards that they want to have fulfilled. Not only does this increase the reputation of security tokens in general, but it also makes inclusion of security tokens on secondary markets more feasible. Additionally, with agreed token standards it also becomes more feasible that custodian & crypto registries will accept all security tokens regardless of the primary issuer.
Groups like the European Blockchain Association have taken it as their mission to create such kinds of standards in the digital assets sphere.
Overall, a harmonization of rules and standards will make adoption more likely. The introduction of the Markets in Crypto-Assets (MiCA) law will address several existing concerns and remove those impediments starting in 2025.
Other requirements that are needed besides regulation:
STOs and tokenization have not reached the volumes that were predicted, and well touted advantages have not been fully seized. Does that mean that STOs have failed completely? No.
Being part of the blockchain technology bubble, one can quickly forget how nascent this industry still is. Tokenization providers, investors, regulators, and other stakeholders are constantly learning, adjusting their products to obtain better product-market-fit, or creating more industry-friendly frameworks. With time and experience, these efforts will bear fruits and make STOs an established form of raising financial capital.
The biggest accelerator for STOs would be a so-called lighthouse project. Ideally, a well-known company, most likely in the FinTech sector, will raise financial capital through an STO. Such a move would give both CFOs of other companies and investors the confidence to follow through with their own STO, respectively investing into one.
However, it should be very clear that for STOs to be successful, the investing process should be as easy or even easier than traditional investments in securities. Providers of traditional investment services have had 30 years to refine and hone their product and client experience, so to a certain extent, the expectation that STOs can effortlessly capture their market share just because of the availability of the underlying technology is not entirely fair.
Has the full potential of tokenization been used yet?
As we have discovered, STOs have not yet reached the stage of mass adoption especially because the full potential has not been realized. But not only have the advantages in previous projects not been seized yet Only a small fraction of what is tokenizable has been tokenized yet. We are at the very beginning of the journey. Future exciting use cases of tokenization could be:
- Tokenization of fund shares
- Tokenization of equity
- Tokenization of structured financial products & certificates
[1] https://cointelegraph.com/news/praetorian-group-files-to-be-first-ico-to-sell-registered-security-tokens-in-us%20
[2] https://ico.li/de/bitbond-sto-geschlossen-was-ist-das-fazit/
[3] The test goes back to the US Supreme Court case SEC v. W.J. Howey Co. According to the US Supreme Court investment contract (and hence a security) is:
1. An investment of money/ 2. In a common enterprise / 3. With the expectation of profit/ 4. To be derived from the efforts of others
