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4 Facts to Know About Security Token Offerings

Security Token Offerings combine the technology of blockchain with the requirements of regulated securities markets to support liquidity of assets and wider availability of finance. STOs are typically the issuance of digital tokens in a blockchain environment in the form of regulated securities.

A security token offering is, as its name indicates, a public or private sale of a “security,” evidenced by a digital token transferable on a blockchain to investors to raise capital.

Giving an asset another name does not transform it into something other than a security or exempt an issuer from compliance with securities laws.

1. STOs are subject to the same securities framework

As the seminal case “SEC v. Howey Co.” explains, even an orange tree can be sold in a way that constitutes the sale of a security. The sale of a digital asset by any name will generally be deemed a security when it is touted as an investment opportunity or otherwise has features akin to stocks, such as the payment of dividends or voting rights.

At its core, an STO is simply new wine in an old bottle and must, therefore, comply with existing securities laws.

2. A security token sold in an STO will not have liquidity

Most security tokens acquired in an STO cannot be transferred immediately because they are “restricted securities” sold in an unregistered, private sale, often under Regulation D, under the Securities Act of 1933. In fact, most security tokens will need to be held for a year before being sold in the public market. While the lock-up period may be reduced to six months if the issuer of the security token is a reporting company under the Securities Exchange Act of 1934, issuers usually seek to avoid reporting company status.

Blockchain technology provides a more elegant solution to this problem than the legends customarily placed on paper certificates, as the token can be “locked” in the purchaser’s wallet until the expiration of the applicable holding period.

3. A security token cannot be sold anonymously

Anonymity, or at least pseudonymise, may be a hallmark feature of distributed ledger technology, but it is inappropriate in an STO. An issuer must know to whom it is selling security tokens to comply with anti-money laundering laws, Office of Foreign Assets Control sanctions programs and its obligation to “know its customers.” Penalties for noncompliance can be severe and are unlikely to be worth any advantages associated with conducting anonymous transactions.

Additionally, issuers who want to promote their STOs will need to ascertain the “accredited” status of their investors prior to consummating any sale of a security token.

4. You should not go it alone

The complexity of existing securities laws makes advice of counsel a crucial component of a successful STO. Implemented correctly, however, an STO can be an excellent source of capital for a new or expanding company in the tokenisation, blockchain or broader distributed ledger space.

Late last year, Hester Peirce highlighted the “growing eagerness” of United States regulatory agencies to better understand tokenised assets and enable legitimate projects to flourish.

The Evolving World of Distributed Ledger Technology Regulations

A ledger is a book or collection of accounts in which account transactions are recorded. Each account has an opening or carry-forward balance, and would record each transaction as either a debit or credit in separate columns, and the ending or closing balance.

There are two primary reasons behind the governments around the world being rather coy about establishing legally binding regulations for distributed ledger technology and the resulting debate as to the legitimacy of such regulations: a lack of knowledge concerning the function, application, and potential of the new industry; the perception that regulations negate the goals of the blockchain.

Many governing bodies have taken the ‘wait and see’ approach to distributed ledger technology, allowing more data to be revealed before they fully analyse what needs to be regulated and how they will go about applying regulation. However, this has left the affected businesses in a state of limbo, not knowing if they are acting illegally, or if their activities will soon be deemed illegal, in certain countries where the topic is debated but not regulated.

The problem for many blockchain purists with the regulation of distributed ledger technology is that it contradicts the original purpose of the technology. The Bitcoin blockchain was designed and implemented to be self-governing and eradicate the need for government control and regulations, leaving hesitance within the community to submit themselves to laws and regulations enacted.

Creating the legal framework and regulations for distributed ledger technology presents many unique challenges, including establishing accountability; the application of contract law to smart contracts; the area of regulation; and the security of personal data in the case that blockchains can be decrypted in the future. Due to the rapid growth and application of the still budding technology, there has not been enough time to see all of the main issues emerge.

On the 11th of May 2017, members of the European Parliament met to discuss the future of blockchain regulation and if governments should begin to intervene. Due to the lack of clarity as to the consequences of the new technology, possible issues that may arise, and a need for it to have the freedom to develop, governments quelled their desire to apply regulation.

Malta becomes first Blockchain Island

Malta made history by enacting regulatory bills concerning distributed ledger technology, blockchain-based businesses, cryptocurrencies and initial coin offerings, and blockchain-based service providers. The Maltese Parliament brought three laws into power in order to establish a governing body, create a system of registration and certification of distributed ledger technologies, and to regulate initial coin offerings.

The Malta Digital Innovation Authority Act established the Malta Digital Innovation Authority as the governing body to support the development and implementation of the guiding principles described in the Act and to promote consistent principles for the development of visions, skills, and other qualities relating to technology innovation, including distributed or decentralised technology, and to exercise regulatory functions regarding innovative technology, arrangements and related services and to make provision with respect to matters ancillary thereto. The primary aim of the MDIA is to promote the new technology and its innovations by developing and implementing key guiding principles. Regarding the regulation of such technologies, the Innovative Technology Arrangements and Services Act provides the MDIA with its regulatory functions, which includes providing technological arrangements for distributed ledger technology companies, as well as, the methods of certification and registration of such companies. The Virtual Financial Assets Act governs cryptocurrency wallets, cryptocurrency exchanges, and lays out clear criteria regarding the requirements for an initial coin offering.

The three acts established by Malta created the benchmark for governing bodies all over the world to follow, allowing for the expression of innovation while presenting clear regulations for the use of the developing technology. Many companies utilising distributed ledger technology were seeking legal clarification, which made Malta’s newly established regulations very desirable. Soon after the bills were enacted, a slew of high-profile companies announced their move to Malta. Binance is one such example, which opted to escape Asia’s purge on virtual currencies and move to the more open-minded regulations of the European island nation. Other cryptocurrency exchanges including OKEx and ZBX have followed suit.

Malta’s desire to adopt and grow the distributed ledger technology industry was demonstrated by their willingness to establish themselves as the ‘Blockchain Island’ in July 2018. However, the nation has surpassed this creation of the legal framework, with its other authorities integrating blockchain-friendly regulations into their respective industries. In March 2018, it was reported that the Malta Gaming Authority aimed to create a licensing system for game developers seeking to accept cryptocurrency as a form of payment, establish a method of calculating exchange rates, and the use of digital currency wallets with games. To do this, the Authority was to engineer a sandbox testing environment to allow game developers to see if their games were in line with their new regulations of the use of cryptocurrencies.

Other distributed ledger technology authorities emerging

Malta made headlines by becoming the first official regulator of distributed ledger technology to forge the ‘Blockchain Island’. In December 2017, Gibraltar, announced its intention to launch the world’s first licensing procedure and regulations structure for firms using the new technology. On the 1st of January 2018, the Gibraltar Financial Services Commission was established to be the nation’s authority on distributed ledger technology, applying to all businesses using the technology in or from Gibraltar. On the 17th of October 2018, leading Bitcoin exchange Coinfloor became fully compliant with the regulations of the Gibraltar Financial Services Commission, meeting the standards required by their nine regulatory principles.

The European Parliament has recently begun to move towards establishing regulations for distributed ledger technologies by publishing a non-binding resolution. The resolution details an innovation-friendly approach to the new technology, and that instead of regulating the technology, the European Union should remove barriers currently restricting the implementation of distributed ledgers. A focus of any regulation to come from European Parliament will be towards standing European Union legislation, specifically the General Data Protection Regulation, with the composition and process of current distributed ledger technology and blockchains seemingly making it difficult for someone to have their personal data and records removed.

They stand by their previous comments concerning a lack of understanding as to the potential problems that can be associated with the technology, and so they will require more time to establish measures to counter the major issues that may arise. It is apparent that general understanding of the technology needs to be improved through the education of relevant parties and that doing so could help the European Union to become a world leader in the field of distributed ledger technology: a route that European Parliament intends to pursue. Resolutions set out by the European Parliament are often used as a tool to express intent to create regulations, but resolutions are not legally binding.