Security Tokens Are the New Crypto – But You Probably Can’t Afford Them

(Bloomberg) -- It was only last year that startups launching new digital currencies were raising ever larger sums through initial coin offerings, giving investors who hadn’t bought Bitcoin when it was cheap a chance to get in on the crypto craze. Then the main U.S. stock market regulator ruined the party, as it stepped up enforcement of its ruling that most ICOs were in fact securities that had to be registered with it. Now a bunch of startups are taking a different approach, asserting that they’re playing by the regulator’s rules by offering what they call security tokens. They’re marketing security token offerings, STOs, as the next hot crypto thing. They’re also pitching their wares only to the rich.

1. What happened to ICOs?

First, they raised a ton of money -- over $21 billion in 2018, according to CoinSchedule.com, a crypto market tracker. Then, a lot of the people who shelled out that money lost a lot of it. Monthly investments in ICOs peaked at $5.8 billion in June of 2018 before falling to one-tenth as much in December as prices of many tokens tanked by 90 percent. In part, that reflected the general bursting of what looks to have been a cryptocurrency bubble, as Bitcoin and other digital currencies re-enacted the fast up and faster down of the e-commerce market crash.

2. What else was going on?

Regulators were catching up. The U.S. Securities and Exchange Commission in particular went after a number of coin issuers, reaching settlements that generally required that they register as a securities offering and offer refunds to investors. Most ICO promoters said their coins were so-called utility tokens, which buyers could use in services provided by their business, and so weren’t securities. The SEC disagreed, finding that nearly all of the coins they examined weren’t necessary to running the issuer’s networks. Instead, investors bought them hoping to make a quick buck.

3. So what’s a security token?

It’s a virtual unit of currency, much like Bitcoin and its competitors. But where Bitcoin’s often-volatile value is entirely dependent on the price people are willing to pay for it at any given moment, security tokens are often promoted as being tied to actual assets, such as equity in companies, real estate or debt. Holders can even receive dividends. (They’re also sometimes called "digital securities,” in part to avoid the controversies that have grown up around ICOs and other crypto tokens.)

4. What difference does that make?

Crucially, issuers of security tokens acknowledge being subject to securities laws, and they design their offerings to fit within them. Specifically, they work within provisions of the Securities Act of 1933 that allows limited issuance to accredited investors, that is, those who are well to do. According to Autonomous Research, there were two STOs in 2017 and 25 last year; it projects 87 in 2019.

5. Why would a startup go this route?

Limiting their offerings only to so-called accredited investors, who are well to do, lets STOs avoid more rigorous SEC rules meant to protect average investors. STOs are also seen as a way to avoid not only the costly registration requirements that apply to the initial public offering of company stock but -- perhaps -- also the regulatory scrutiny and legal uncertainty currently enveloping ICOs. Sellers of security tokens hope their extra care at the start means the SEC won’t come looking for them later.

6. What are these businesses like?

Sports Ledger, a service that says it will facilitate interactions between fans and sports teams, announced in November that it would do an STO instead of an ICO "to pursue a fully regulatory compliant and future-proof method of raising funds." A small biotech company, Agenus Inc., is planning to issue up to $100 million in security tokens that will allow investors to bet on future sales of single products while having a limited impact on shareholders’ equity.

7. How does this work?

Take Spice VC, a venture-capital fund that raised $15.5 million by selling security tokens that entitle holders to a share of the company’s proceeds when it exits an investment. Spice followed the terms of Rule 506c of the SEC’S Regulation D, which spells out conditions under which offers of securities are exempt from normal registration rules, and Section 3(c)(1) of the Investment Company Act of 1940, which allows private funds to avoid SEC rules. That meant, in Spice VC’s case, offering sales documents to a maximum of 99 prospective investors, who had to register on its website, certify that they are accredited (read: wealthy), provide proof of identification and respect applicable lock-up periods before selling their tokens. Issuers using the exemptions must check that buyers aren’t laundering funds and disclose operational information to the public on a regular basis after the sale.

8. Should investors be wary of STOs?

Probably. Putting money into any new venture is risky, let alone a field in such flux. Proponents say buying digital coins may have some advantages for investors. In the case of Spice, it says its tokens will be easier for an investor to resell than a traditional claim on future earnings while waiting for a VC investment to pay off. In other contexts, reselling a coin that represents a share of a condo complex might be easier than selling a traditional part-ownership. But many analysts worry STOs could end up being yet another field filled with schemes to leave investors holding the bag. Some of these security offerings could just end up being "left-over junk that nobody else would buy," packaged as a trendy coin, according to Autonomous Research.

9. Where can investors buy these offerings?

Not many places, yet. Worried about regulatory scrutiny, most established cryptocurrency exchanges don’t yet offer security tokens. That’s given rise to a new wave of exchanges, with names like Templum, Polymath and tZero. Some have launched, and others are in the works. Spice VC’s own venture is a platform called Securitize, which has helped a handful of startups including Lottery.com raise a total of $130 million to date. tZero launched its platform for secondary trading of its own security tokens in late January 2019.

The Reference Shelf

• A QuickTake explainer of Bitcoin and blockchain.
• Are Bitcoin’s wildest days over?
• All about initial coin offerings.
• A guide to tokenized securities from Medium.com.
• A guest post on Nasdaq’s website explores how tokenization puts real assets on blockchains.

--With assistance from Ben Bain.

To contact the reporter on this story: Olga Kharif in Portland at okharif@bloomberg.net

To contact the editors responsible for this story: Crayton Harrison at tharrison5@bloomberg.net, John O'Neil, Dave Liedtka

©2019 Bloomberg L.P.