Are security token offerings the same as ICOs?

4 May, 2019

It is fascinating to consider whether or not Satoshi understood what would become of his Bitcoin idea when he released his first white paper more than 10 years ago. Did he have any inkling that a project he intended merely as a payment system would become a powerhouse investment vehicle? Who knows? Did he ever think Bitcoin would lead to initial coin offerings (ICOs) and their cousin, security token offerings (STOs)?

There is no way to know what Satoshi envisioned for Bitcoin because no one really knows who this person is. Unfortunately, we cannot just ask. But we do know that the ICOs and STOs are not the same thing. Furthermore, STOs and cryptocurrency are not necessarily synonymous. The former can exist completely outside of the latter.

A general misunderstanding of how cryptocurrency works in the larger realm of securities leads to much of the confusion surrounding STOs. Hopefully this post will clear up any such confusion you might have. The place to begin is differentiating between the STO and ICO.

Offering crypto to investors

As things now stand, there are thousands of different cryptocurrencies floating around in cyberspace. Some of them are actively traded on exchanges like Coinbase. Others have tokens associated with some but are not being traded at this time. Still others exist as mere ideas without any tokens or trading behind them.

Getting a new cryptocurrency out into the market requires creating some sort of value behind it. So in the absence of utility - that is, people using your token to buy and sell - value has to be created in some other way. The way most crypto developers choose to do this is through the initial coin offering, or ICO.

An ICO is the cryptocurrency equivalent of the stock exchange's initial public offering (IPO). Crypto developers sell 'shares' of their companies represented as coins generated by their blockchains. This process can raise a considerable amount of fiat which automatically puts a price tag on the coins.

Where an ICO is all about offering crypto directly to investors, a security token offering doesn't necessarily have to include a marketable coin. The key operating word here is 'token' as opposed to coin. In a blockchain universe, a token can represent anything of value. It is not exclusive to digital coins.

Offering shares to investors

A new company offering an STO is offering investors a digital token that represents the equivalent of an investment contract. The best way to understand this is to compare the STO with an IPO.

If you were to purchase stock during a company's initial public offering, you would receive a certificate representing your share of ownership in that company. The underlying asset that backs up your investment is the company itself. You own a share of the company along with all of its tangible assets, its sales, etc.

An STO works in a similar manner. Purchasing digital tokens automatically gives you an underlying interest in whatever assets those tokens represent. The asset could be a digital coin that derives its value from utility. However, the asset could also be something completely different. You could be purchasing an interest in a piece of technology, a commodity, etc.

You could make a very strong case that all ICOs are also STOs. The same is not true in the other direction. An STO does not have to involve cryptocurrency at all. This is where much of the confusion comes in.

Regulating ICOs and STOs

If you find yourself confused by the subtle differences between ICOs and STOs, you are in good company. One of the biggest challenges of regulating both kinds of investments is that government regulators do not really understand them either. Making matters worse is the lack of uniform regulations within the global investment environment.

Regulation depends on jurisdiction. For purposes of illustration, let us start with the US. Regulators there view nearly every kind of digital investment as an investment contract. Furthermore, all investment contracts in the U.S. are considered securities.

The U.S. Securities and Exchange Commission's defines an investment contract as one that meets all four of the following criteria:

  • It requires an "investment of money"
  • It is an investment in a common enterprise
  • It is offered with a reasonable expectation of profits
  • Profit is derived from the entrepreneurial or managerial efforts of others.

It is easy to see how ICOs would be covered here. People invest fiat in ICOs which are, essentially, common enterprises among those offering the coins and those purchasing them. The goal of investors is to make a profit on their money. They expect that profit to be the direct result of proper management by the offering organization.

It is interesting to note that U.S. law doesn't require that the "investment of money" in the SEC definition be by cash. It can be any sort of asset with genuine cash value. That pretty much lumps all ICOs and STOs into the category of securities in the U.S.

Different kinds of tokens

If we look at the regulatory picture in the UK, we see just as much confusion but for very different reasons. The UK's issue is not one of what constitutes a contract investment or whether or not investments must be made in cash. Rather, UK regulators have come up with three different kinds of tokens with different rules applying to each one.

Exchange tokens are those designed exclusively to be used in the exchange of goods and services. They are not created or backed by any central authority. Thus, exchange tokens can be created and distributed outside the purview of any regulatory control.

Utility tokens are tokens representing a product or service for the purposes of exchange. Holders are not granted rights to the given product or service as they would be if they were purchasing stock in a company. These kinds of tokens are regulated.

Security tokens are the last category. They are tokens that meet the government standard of specified investments similar to stocks, shares, and other debt instruments. They are fully regulated just like stocks and shares are.

Switzerland's environment is similar to the UK in that regulators also consider three different kinds of tokens. On the other side of the argument are those countries that have outright banned both ICOs and STOs. Some have even gone so far as to ban crypto trading in every possible form. Countries like China, India, Morocco, and Pakistan immediately come to mind.

Deciding whether to invest or not

We have now reached the inevitable point in the discussion at which we need to talk about whether not you should invest in an STO. Only you can ultimately make that decision. However, there are some points to talk about here. First and foremost, are you are already involved in cryptocurrency in some way?

Maybe you jumped on the Bitcoin bandwagon after reading something on the Mega website. You have purchased your own bitcoins and used them to open an account at a Bitcoin casino. If so, you should already be familiar with the basics of how cryptocurrency works.

For you, the important thing to know is that investing in an STO might not result in you owning additional crypto. You could wind up investing in a token that represents an entirely different kind of asset. That is not a problem as long as you fully understand what it is you are investing in. Make sure you know what the asset is. Make sure that asset has some future value that would make your investment worthwhile.

If you know nothing about cryptocurrency, blockchain, and investing in digital technologies, your best bet is to stay away from STOs for now. It is better to educate yourself on how all this works before putting any money at risk. Ignorantly putting money into an STO is like going to the roulette table without understanding how to place your bets.

Two different worlds

If you learn anything from this post, let it be that cryptocurrency investing is a completely different world compared to using bitcoins and litecoins to pay for goods and services. It is similar to the separate worlds of investing in securities and using fiat to pay your utility bill.

Cryptocurrency investing is a way of making a profit by putting money into ICOs, STOs, and other opportunities. Each investment represents an opportunity to both make and lose money. Therein is the critical component here.

If you are purchasing bitcoins just so that you can play Mega Moolah online, your use of cryptocurrency is limited to your own entertainment. That's fine. If you buy bitcoins because you hope to make a profit as coin price rises, you have now entered the arena of investments.

We urge you to be careful going down this road. Just like you do with Mega Moolah and your other favorite casino games, never invest more in cryptocurrency then you are willing to lose. Purchasing cryptocurrency as an investment could mean you hit the equivalent of the Mega jackpot. But it could also mean you lose everything you put into it. That is the nature of investing in ICOs and STOs.