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Since the introduction of cryptocurrencies and the subsequent emergence of initial coin offerings (ICOs) as a means of funding for startups, regulatory oversight of the digital currency space has sparked many debates. While many countries have instituted some form of regulation over cryptocurrencies, others are still a little skeptical.
From a tech angle, the regulation of the cryptocurrency and ICO space creates two different groups. Some blockchain and crypto experts and enthusiasts see regulatory oversight as a bad thing, asserting that it would lead to stifling innovation and give control back to the wealthy. Others see it as a good thing, arguing that regulation will sanitize the cryptosphere, spearhead mainstream adoption, and protect users and investors from fraud and other scam activities.
Initial coin offerings have become the IPO in raising startup capital for many cryptocurrency and blockchain-based projects. In 2017, startups raised $5.6 billion through ICOs. A report by Coindesk showed that in the first quarter of 2018, ICOs raised around $6.3 billion, surpassing the amount raised during all of 2017. But the ICO market is waning. As regulation has become a confusing topic in the ICO space, with many scams and fraudulent activities stripping investors of their hard earned money with no legal recourse, the industry has stepped up to find a solution. Among these solutions is the idea of Security Token Offerings (STO).
Though ICOs have already proven to be a viable fundraising option for crypto and blockchain based startups, STOs can be seen as the new regulated kid on the block. Each comes with a legal implication that should concern any individual or business that wants to raise funds. Here, we look at the legal differences that exist between an Initial Coin Offering and a Security Token Offering.
Initial Coin Offering (ICO)
An initial coin offering or ICO is a crowdfunding apparatus used to raise capital for new projects or startups. In an ICO, a startup or project creates a fixed quantity of cryptocurrency tokens and sells them to the public in exchange for other cryptocurrencies, bitcoin or ether. An ICO is like an initial public offering or IPO, in which investors buy shares but unlike an IPO, an ICO does not give an investor a stake in the company or project he or she was investing in.
The workings of an ICO have improved because of standards like the ERC20 Token. The ERC20 is a standard that spells out the details and protocols needed to produce a new digital asset. To receive other cryptocurrencies and give investors newly issued digital assets, projects use smart contracts (digital, self-executory contracts) that set the relationship between the investor and the project. Investors then send crypto to a project, and the new tokens are distributed to them at a later date.
An initial coin offering can get the public to buy the newly issued tokens on two main grounds: 1) that the token will increase in value, get listed on an exchange, and thus increase its market price – giving profit to early investors; 2) that the token has an intrinsic value that gives holders access to a certain project, product, or service.
Since ICOs are relatively new, clear-cut legal framework governing them is still a work in progress. There are minimal restrictions as to who can participate and issue coins via ICO. Anyone with the technical setup, who could create a present or future value through a product or service, would be able to convince the public to invest.
According to the Securities and Exchange Commission (SEC) in June this year, though there has not been laid out regulation on ICOs, they are most certainly regarded as securities. A New York court recently made it clear that financial crimes and scams committed through ICOs would be fought through the financial securities law.
These decisions have sparked a lot of debates, prompting the Venture Capital Working Group, a group of traders, lawyers, and crypto enthusiasts, to meet with the SEC and assist the regulatory body to accept tokens issued through an ICO as utility tokens instead of securities. Thus, currently, initial coin offerings are mostly utility tokens, representing access to a project or future product. They are not created as investments and are surely not in the grips of any securities law.
As a result of the less regulated ICO environment, it is pretty easy to set up one. Those who have a good idea will create a whitepaper, and if convincing enough, the public could buy in. Investors are cautioned to be vigilant, analyze, and cross-check the authenticity of a project before investing. The inherent high risk, lack of regulation, and failed projects associated with ICOs have spurred a new kind of token offering known as the STO.
A Security Token Offering (STO)
A security token offering or STO bears similarities with an initial coin offering. Unlike an ICO, where digital assets are issued as utility tokens, issued tokens get their value from a tradable, external asset. Thus, tokens offered in an STO are security tokens, actual financial securities backed by tangible assets like profits, future revenue of a project or company, and physical assets.
Once a project decides to launch a security token offering, the project in question will inherit securities regulations of the country from which the project is being instituted, as well as specific international securities rules. Failure to go by these laws could spell severe penalties. The financial securities laws in many countries across the globe are fully developed, signifying a well-regulated environment for security token offerings.
A security token offering is therefore touted as an ideal token mechanism that would not just make sure that scams and fraudulent token offerings are weeded out of the industry, but would also protect investors’ rights and income. On a downside, STOs are limited in terms of liquidity and secondary trading, as well as country-wide and global trade restrictions – making them difficult to trade when compared to utility tokens issued through an ICO. However, millions of dollars are being poured into the STO market to fix these problems.
For some industry experts, an ICO is ideal for raising funds with minimal restrictions. These experts believe that the cryptocurrency and blockchain industry doesn’t need much regulatory oversight from mainstream institutions, and doing so will reduce innovation. Additionally, the country-specific regulations that STOs have to adhere to make ICOs preferable. On the other hand, some experts believe that security tokens would sanitize the industry. The fact that it will be regulated by countries, and also make clear their anti-money laundering and know-your-customer policies, experts believe this will reduce the many scams and financial crimes that are committed in the name of ICOs.
But as the trends depict, the cryptocurrency industry is gradually moving into the STO space. Though this trend might be attributed to the bad name ICOs have gathered over the years, a lot of experts are optimistic that going with STOs would spur mainstream adoption, bringing both individual and institutional money into the cryptosphere.