The first Security Token Offering (STO) was launched in 2018 by the US-based Praetorian Group, which subsequently issued the PAX coin (not to be confused with the PAX stablecoin) [1]. European players followed swiftly, and by July 2019 Bitbond made headlines with the first approved German STO, which raised more than two million Euros [2]. STOs are not to be confused with ICOs, Initial Coin Offerings, which were one of the main factors fuelling the 2017-2018 crypto bull run. The main difference is that STOs are limited to on-chain representations of securities, i.e., tradable, and highly regulated, financial assets that frequently comprise equities and fixed-income instruments, whereas tokens issued during an ICO can be categorized as “utility tokens” in a very broad sense. Despite the many advantages that STOs offer compared to IPOs, such as but not limited to, decreased issuance costs, faster and cheaper transactions, better transparency, and greater control for both issuers and investors, STOs have not reached mass adoption yet. Even the crypto exchange Coinbase offered their shares in 2021 to the public via a traditional IPO and not via an STO, thus sidestepping from the technology which, arguably, allowed them to achieve their impressive growth rates in the first place. This raises the question, why have STOs not taken off?
There are several reasons why security tokens have not reached the stage of mass adaption yet. The common denominator is that the propagandized advantages cannot be fully relied on and only exist in theory.
| Promised advantage | Current barrier |
|---|---|
| Easy, cheap, and quick transfer of tokens | Lack of secondary markets While it is true that security tokens can easily be exchanged between two different parties almost instantaneously and for a fraction of the costs than in traditional equity markets, the truth is, that it currently barely happens. Unfortunately, in the realm of security tokens, no player was able to establish a liquid secondary marketplace. However, the upcoming EU DLT Pilot Regime, which will come into effect in March 2023, could further propel the creation of a secondary market. The planned regulatory requirements will become much more favorable, both for new players hoping to create an MTF on a DLT basis and for incumbents who want to run a POC with DLT-based market infrastructure. In particular, the requirement to always use a Central Securities Depository for custodying securities, which is enshrined in the EU’s 2014 CSDR, will be waived for the duration of the regime. |
| Subscribing to a security token & automated corporate events | Lack of settlement currency / digital stablecoin Another hindrance to mass adoption lies in the settlement currency. Given that there does not exist a widely accepted EUR stablecoin, subscribers to an STO must choose between different options, which all present their own challenges. They can subscribe, if offered, either with a USD stablecoin (forex risk), cryptocurrencies (volatility risk), or traditionally via a wire transfer, which creates an unpleasant user experience due to a hybrid subscription model where rights and duties of a security token are fulfilled both on- and off-chain. Time will tell if the newly launched EUROC by Circle can fill the gap. |
| Blockchain will make everything easier to use | Lack of knowledge This factor is one that has multiple subfactors contributing to it. On one hand, it can be very frustrating when investors associate cryptocurrencies with security tokens and are reluctant to understand the differences between the two. On the other hand, mass media jumps on every opportunity to paint blockchain technology in a negative light. Hence, it is no surprise that blockchain technology is often mistakenly associated with the more questionable aspects of cryptocurrencies (scams, shady projects, hacks, lack of stability) and suffers from a negative reputation. However, external parties are not entirely to blame. Within the blockchain scene, there seems to be a trend to overemphasize the advantages of the technology. When selling their products, founders and entrepreneurs should not forget though that the end user often simply wants to benefit from the advantages of the technology but mostly does not need to know the (sometimes) complicated details of industry-specific terms like wallet, tokenization, custody, etc. |
| Seamless integration | Bad user experience Investing into a security token still often needs an awkward mix of on-chain and off-chain activities, creating an unsatisfying user experience. The effect of having to use wire transfers to subscribe to STOs has been explained above already. The off-chain experience does not end there, another major hurdle when investing in financial products is the strict KYC & AML regulations. Current KYC services have largely not been neatly integrated with providers that offer custody/wallet solutions for retail clients – authentication does not occur on-chain, for example via signing messages with a “trusted” private key associated with the investor’s (known) wallet. Instead, traditional “centralized” methods of identification (via ID scan, selfie, or video) continue to be used. All the factors conspire to make the end user question whether using blockchain technology really enhances their investment experience. |
| Liquid secondary markets | As previously described, liquid secondary markets are a requirement to attract more volume during primary issuances, otherwise many of the promised advantages of tokenized securities cannot be fully delivered. |
| Multi-listing on secondary markets | In an ideal world, there will be several interoperable secondary marketplaces to trade security tokens, which each ensure and enforce KYC & AML regulations. Order matching would ideally happen through on-chain orderbooks ensuring that marketplaces have real-time data available that they can display to their users. This data could be provided by an oracle service or network (e.g. Chainlink). |
| Digital settlement currency | For the future success of STOs in Europe, it is crucial that there is a EUR-denominated digital settlement currency. Investors are reluctant to use cryptocurrencies for their investments as it increases their risk exposure, stablecoins issued by banks come with centralization risks, and unfortunately, it seems like a CBDC issued by the ECB is still in process for a few years. A stablecoin that could fill in the existing gap is the recently launched EUROC stablecoin by Circle. |
| Token standards | Tokenization providers should work together and agree on certain industry standards. Not only does this increase the reputation of security tokens in general, but it also makes inclusion of security tokens on secondary markets more feasible. Additionally, with agreed token standards it also becomes more realistic that custodian & crypto registries will accept all security tokens regardless of the primary issuer. Groups like the European Blockchain Association have taken it as their mission to create such kinds of standards in the digital assets sphere. |
Overall, harmonization of rules and standards will make adoption more likely. The introduction of the Markets in Crypto-Assets (MiCA) law will address several existing concerns and remove those impediments starting in 2025.
Security tokens and tokenization have not reached the volumes that were predicted, and well-touted advantages have not been fully seized. Does that mean that STOs have failed completely? No.
Being part of the blockchain technology bubble, one can quickly forget how nascent this industry still is. Tokenization providers, investors, regulators, and other stakeholders are constantly learning, adjusting their products to obtain better product-market fit, or creating more industry-friendly frameworks. With time and experience, these efforts will bear fruits and make STOs an established form of raising (financial) capital.
However, it should be very clear that for STOs to be successful, the investing process should be as easy or even easier than traditional investments in securities. Providers of traditional investment services have had 30 years to refine and hone their product and client experience, so to a certain extent, the expectation that STOs can effortlessly capture their market share just because of the availability of the underlying technology is not entirely fair.
As we have discovered, security tokens have not yet reached the stage of mass adoption especially because their full potential has not been realized. But not only have the advantages in previous projects not been seized yet, but only a small fraction of what is tokenizable has also been tokenized. We are at the very beginning of the journey. Future exciting use cases of tokenization could be:
While Coinbase decided not to raise money through an STO, other companies in the digital assets sphere decided to do so. The most notable mention should go out to the non-custodial wallet provider Exodus. Exodus’ STO (EXOD) was significant as it was approved by the US Securities and Exchange Commission under an exemption to standard IPO requirements often referred to as “Reg A+” and has raised more than 75 million USD. The security token was issued on the Algorand blockchain and represents a US class A common stock. Exodus seizes the advantages of security tokens, and investors of 40+ countries can trade the security token on two different secondary markets (tZero & Securitize). At NYALA we expect that existing and emerging secondary markets will soon also list other security tokens next to Exodus.
[1] https://cointelegraph.com/news/praetorian-group-files-to-be-first-ico-to-sell-registered-security-tokens-in-us%20 [2] https://ico.li/de/bitbond-sto-geschlossen-was-ist-das-fazit/
