Tokenization

Security Token Offering: benefits to markets, issuers, and investors

Gene Deyev

Nov 15, 2021 • 5 min read

What are security token offerings?

Back in 2017, STOs descended from ICOs (Initial Coin Offering), taking the next step in decentralized finance development. After ICO failed to meet both regulators' and markets' expectations, Security Token Offering unintentionally became its next-generation alternative and remains a milestone of all the decentralized finance to this day. A process of issuing tokens backed by securities or other assets is called tokenization.

Security Token Offering is a combination of legal and technical processes that transfer a company's stocks to the blockchain and make them tradable. The main unit of such a process is a security token (also called ownership token) – a tokenized security itself. The fundamental characteristics of the security token include the following:

Regulated as security. A security token is a share/bond/investment fund/any other security type unit embodied in a blockchain token, but in its essence, it still remains a security. The general rule sounds like this: if a crypto token's value draws from a particular company or external asset, it is referred to as a security token. A determining metric in this issue is the Howey test – we wrote more about it in the article "Tokenization taxonomy. Utility Tokens vs. Security Tokens vs. NFT".

Issued by private companies rather than public ones. Unlike public companies that have gone through the Initial Public Offering, private companies are not traded on the stock exchange. Accordingly, investing in them is neither really possible nor cost-effective. While taking a company to the IPO is enormously expensive and often a destructive course, which usually starts from roughly $1 million, conducting a security token offering suggests a lot less risk and a lower price for the business.

Benefits of security tokens

We already said that tokenization is a disruptive technology that is changing the lives of every actor in the financial market. Let's take a closer look at how it profits markets, STO issuers, and, of course, investors.

Benefits for markets

Tokenization is a field primarily beneficial for private markets because of its crucial advantage: the traded shares. A possibility for the company to trade its stocks is essentially a dogma of economic success. In other words, this is the only condition that makes it profitable and attractive for investors. This is why companies go for the IPO, which, as mentioned above, takes an excessive amount of businesses' resources. The specific instrument tokenization offers, in this case, are DeFi protocols like, for instance, AMM (Automated Market-Making).

In its essence, AMM protocol substitutes a broker-dealer. Brokers act as a mediator between the two parties, purchasing stocks from people who want to sell them with the purpose of selling to those eager to buy. Automated market makers (AMMs) use liquidity pools instead of a conventional market of buyers and sellers to allow digital assets to be exchanged without authorization and automatically. As an example, think of a liquidity pool as a place where your stock and another tradeable currency, such as dollars or euros, coexist. Investors that wish to purchase or sell the issued tokens remove tokens from the pool and exchange them for dollars, or vice versa. At this time, assets in the AMM pool should be deposited by the issuer, but in the future, investors or other parties interested in receiving a part of the pool's commissions may be allowed to fill it. We described the way DeFi protocols work in detail in our article "How does DeFi unleash the potential of tokenized securities?"

The key takeaway is that while remaining private, the tokenized businesses acquire the advantages primarily only available for public companies. As a result, private markets become more liquid and attractive to investors, which is nothing but a benefit for the global economy.

Benefits for issuers

The first thing security token issuers acquire is, of course, enhanced investor access. Tokenized enterprises may now obtain funds from a far larger pool of investors, even if they remain private. The issuer retains a negotiation power and is the one who targets the specific sort of investor: this is why it's also fair to say that the issuer gets more favorable terms of raising capital. Moreover, tokenized assets have superior liquidity; therefore, they are more appealing to investors, and their risk is also decreased.

A second benefit is cheaper issuance. Access to a larger pool of investors and the automation of technical processes allow fewer or no middlemen in the STO issuance process.

Benefits for investors

Extended investment opportunities. Primarily, this feature is of value for unaccredited investors: now, there are significantly more companies and assets they have access to. According to the McKinsey report, private markets grow at least 50% faster than the public markets; taking these two criteria together, we get a highly beneficial opportunity.

Secondly, it's easier to make an exit thanks to enhanced liquidity.

The lower investment cost is the final tangible benefit. Thanks to the reduced number of intermediaries and the possibility of fractional ownership, there's no high investment threshold anymore. Fewer middlemen make the margin offering's cost reduced, while fractional ownership is an option allowing partial investment strategy, making it similar to crowdfunding in a way.

Challenges of securitized token offerings

Although the STO market is growing exponentially today, there is still a long way ahead prior to complete adoption.

One of the security token offering issues is an incomplete legislative structure. Although a number of countries have established a robust legal framework for security token offering providers and STO activities in general, there is still a noticeable gap when it comes to the regulation of certain sides of the industry. P2P transactions, decentralized exchange services, and generally the realm of crypto remain a foggy area in which investors might face significant risks and losses; just as easily, the issuers might fail the offering due to not getting SEC's approval.

Another more common problem the STO market is dealing with is the lack of awareness. The absence of clear and universal nomenclature is a critical difficulty in studying and creating clear rules for the growing crypto asset and blockchain industries. While this is presumably a struggle people working in decentralized finance might have noticed, it's also a statement Cambridge Centre of Alternative Finance issued in their research.

The decentralized finance industry is not yet introduced to the mass audience on a sufficient level, and it's easy to understand how any unknown or relatively fresh technology may not gain immediate trust among business owners. Ergo, the next step security token offering providers and issuers should focus on is raising financial literacy. This can be accomplished by engaging in or developing educational programs, holding conferences or networking events, or launching educational campaigns.