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STOs vs ICOs – A Comprehensive Introduction For 2019

ICOs (Initial Coin Offerings) and STOs (Security Token Offerings) are

3 Mar
2019
SelfKey
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ICOs (Initial Coin Offerings) and STOs (Security Token Offerings) are becoming increasingly popular, with many companies looking for a way to raise capital or participate in investment opportunities. Ethereum launched the first successful ICO in 2014, raising $2.3 million within the first 12 hours. Since then, the amount of crowdfunding in the cryptocurrency space has skyrocketed, even surpassing VC funding in 2017.

Today, cumulative ICO investments are well above $22 billion, and a rich ecosystem has developed allowing blockchain-powered projects to launch their own ICOs. As a result, over 650 ICOs have received funds in 2018 according to Coindesk’s excellent ICO tracker – almost double the entire tally for 2017. The number of STOs is still tiny by comparison.

Nevertheless STOs have also proven to be hugely successful in many cases. Overstock for example, ran a month long STO which raised $134 million, and electric scooter startup SPIN raised an equally impressive $125 million.

These are just two examples of extraordinarily successful Security Token Offerings, but what exactly characterizes an STO? And what are the differences to an ICO?

Let’s find out!

STO vs ICO – Whats the difference?

The old adage says that it takes money to make money. In the case of investment opportunities this is particularly true, because accredited investors are able to take more risk than non-accredited investors.

What does this have to do with STOs? Well…. everything.

In 2017, the Securities and Exchange Commission (SEC) began taking steps to regulate ICOs. One of the key takeaways was their definition of a “security” and how that applies to the world of cryptocurrency. More specifically, the SEC defines a security as:

any transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. 66 S.Ct. at 1103.

This definition significantly pre-dates ICOs and is typically applied in a liberal manner by the SEC.

With this definition in mind, it’s easy to see why many token offerings may be classified as securities. Investors buy the token with the sole aim of selling it for a profit in the future. Tokens which satisfy this criteria are therefore called securities by the SEC, and fall under the purview of Securities Law.

This brings us back to accredited investors. Securities typically harbor a significant level of risk. In order to protect ordinary people from losing their money, the SEC essentially forbids non-professional investors to participate in security offerings. Instead only accredited – also known as professional – investors are allowed to participate.

As a result, US residents who are not accredited investors are not permitted to invest in an STO.

ICOs on the other hand are open to everyone, if it can be proven that the purpose of the token is not to gain a profit but to access a service. As mentioned previously however, the SEC applies its definition quite liberally, so it is hard to predict what constitutes proof in this context. In its discussion of ICOs, the SEC states:

ICOs, or more specifically tokens, can be called a variety of names, but merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.

With this in mind, token offerings that wish to service US retail investors need to ensure a strong use case for the token, and categorically avoid any hint of token price speculation. In other words, it needs to be a utility token rather than a security token.

Importantly, the SEC is spending a lot of time investigating past and current ICOs, occasionally resulting in a re-classification and a significant fine. Two recent examples of this are Airfox and Paragon, both of which launched a utility token in 2017, only for the SEC to deem them securities in November 2018.

As the table shows, ICOs and STOs differ in many crucial ways, and failing to understand even the subtle differences can result in significant legal problems.

Here is a break down of the key differences between STOs and ICOs:

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The comparison highlights the importance of the SEC and the regulatory landscape under which a token offering operates. Most STOs in the US market are typically launched under the umbrella of Regulation D506(c), an exemption which allows accredited investors to participate in a token offering.

Let’s now look at how the SEC defines an accredited investor.

Who qualifies as an Accredited Investor?

As equivocal as the SEC’s ruling on securities can be, their stance on accredited investors is crystal clear. According to the Securities Act of 1933 an accredited investor is defined in three ways:

  1. An individual who made more than $200,000 in each of the two preceding years and can reasonably expect to generate the same level of income in the current year.
  2. A married couple that has had a joint income of more than $300,000 over the preceding two years and can reasonably expect to generate the same level of income in the current year.
  3. An individual or couple with a net worth of more than $1 million, excluding the value of the primary residence.

Importantly, there is no regulatory body or agency which checks or certifies investors as accredited. Platforms wishing to service accredited investors need to follow a series of steps. It is not enough to simply provide a check box, asking if an investor meets the requirements. Instead, detailed financial information needs to be collected through specialized providers like KYC-Chain.

Conclusion – Better Safe than Sorry

Token offerings operating inside the US or planning on servicing US investors need to be very careful. Regulation and litigation are still relatively new to the space, and platforms are not safe from retroactive measures from either the SEC or private citizens. In November 2018 for example, both Airfox and Paragon where deemed to have sold security rather than utility tokens in 2017, resulting in the forced return of all invested funds, the requirement to follow US securities law and a $250,000 penalty.

That being said it is important to keep Jake Chervinsky’s statement in mind: “The SEC does not make the law. Congress makes the law & courts interpret it. SEC lawyers only decide their own enforcement strategy. Nothing they say is binding: they can change their minds & they can lose in court.”

Nevertheless, the SEC has clearly started focusing on cryptocurrency crowdfunding operations, meaning that ICOs are being investigated one by one and punished if found in breach of securities law. Interestingly however, this recent statement by the SEC suggests that there is a way for token offerings to go down “the path to compliance“, meaning that even illegal token offerings may be offered a way to turn their ship around.

Launch a KYC-compliant STO or ICO with KYC-Chain

KYC-Chain is a GDPR compliant KYC management tool that allows exchanges, ICOs and STOs to easily onboard users. As a sister company of SelfKey, KYC-Chain not only offers a global accredited investor check, but it is also deeply customizable, meaning you can easily adapt your onboarding flow to the legal requirements of your jurisdiction.

To learn how KYC-Chain can help you easily onboard customers in a secure and compliant manner, please get in touch. We’d be delighted to talk to you.

Further reading:

http://clintonlawfirm.blogspot.com/2011/01/what-is-security-under-federal.html

https://www.coindesk.com/after-fridays-sec-actions-experts-say-ico-party-is-truly-over

https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading

https://www.sec.gov/news/press-release/2018-264