What Is A Security Token Offering (STO)?

Cryptocurrencies and Decentralized Finance (DeFi) are filled with great innovation and can smash cracks throughout traditional financial systems (TradFi). Still, some traditional investors may be unwilling to play in this new asset class because of the perceived lack of regulation and readily available information. Here, Security Token Offerings (STOs) come in. 

STOs aim to bridge the gap between the innovative world of blockchain technology and traditional financial markets by providing controlled and transparent investment vehicles. 

In simpler terms, STOs can be viewed as a form of regulated initial coin offering (ICO). ICOs are a new way of raising money for startups by issuing new digital tokens or coins and were very popular between 2017 and 2019. Many ICOs were badly criticized due to the lack of proper rules and scams and schemes. 

STOs address these concerns by complying with existing securities laws.

How does an STO differ from an ICO (Initial Coin Offering)?

STOs are subject to securities laws, similar to how Initial Public Offerings (IPOs) are regulated. This provides greater investor protection.

Security tokens issued through an STO represent ownership or rights in an underlying asset, such as company equity, real estate, or even a piece of art.
In contrast, ICOs often issued tokens that didn't represent any ownership stake and functioned more like utility tokens for accessing a specific decentralized application (dApp).

By offering tokenized securities that comply with existing legal frameworks, STOs provide a more public and transparent investment opportunity than traditional private placements. This can open up new avenues for companies to raise capital and for investors to participate in innovative projects. It's important to note that STOs are still a relatively new concept, and inherent risks are involved. Investors should conduct thorough due diligence and ensure they understand the specific information provided about the offering before investing.

This article will delve deeper into the workings of STOs, explore their benefits and drawbacks for companies and investors, and discuss their potential role in the future of finance.

What are Security Token Offerings (STOs)?

In an STO, a company issues digital tokens representing tradable securities, similar to stocks or bonds. These tokens are built on a secure blockchain platform, providing increased transparency and immutability compared to traditional paper certificates. Imagine a company conducting a public IPO (Initial Public Offering), but instead of issuing physical stock certificates, it issues tokenized versions on a blockchain. Users then get exposure to the project’s potential financial upside and downside risk. These tokens represent ownership (equity) in the company, just like traditional stocks.

Key benefits of STOs:

• Compliance: STOs follow current securities laws, thus reducing certain risks involved with ICOs.
• Transparency: Blockchain provides an open and immutable record of ownership for STO tokens.
• Accessibility: An STO offers a democratized way for investors to participate in the offering process. It might reduce the barrier to entry compared to traditional investments.
• Fractional Ownership: STOs allow for the fractionalization of assets, meaning one can invest in previously illiquid assets, such as real estate. However, one must conduct extensive due diligence before investing in any STO. 

Investment companies can share with you valuable information on how you can understand the specific risks and potential rewards involved in any given STO.

How Security Token Offerings Work?

Security token offerings have completely changed how companies raise capital and investors invest their money. Unlike the much-debated Initial Coin Offerings, which became famous between 2017 and late 2018, STOs are founded on grounds of some form of regulation and compliance.Here's a breakdown of how STOs work:

1. Asset Tokenization: Think of a company that needs capital. Traditionally, it would take the form of an IPO (Initial Public Offering). On an STO, however, you tokenize an asset—say, a company looking to raise capital within its capital structure—very much like real estate assets. These tokens represent fractional ownership of the said underlying asset.

2. Offering Details & Transparency: STOs must have detailed information on the offering—much different from a public offering—with the company preparing a legal document stating precisely that. It must adhere fully to the guidelines of bodies such as the SEC concerning what constitutes issuer and investor eligibility, how tokens can be traded after the offering to provide liquidity, and explicitly detail the use of proceeds.

3. Compliance at Its Core: STOs have a foundation based on compliance, unlike ICOs, whose scenario was gray. KYC (Know Your Customer) and AML (Anti-Money Laundering) checks are often executed to test if the potential investors' accreditation status measures up to the stipulated standards and if they comply with the set regulations. This extra scrutiny helps mitigate risks for both the issuers and the investors.

4. Opportunity to Invest: Accredited investors who meet specific income or net worth thresholds are invited to participate in the STO by buying security tokens. Such security tokens will mimic how traditional shares of stock differ in their use, with possibilities including voting rights or dividends.