What Is a Security Token Offering (STO) and How Does It Work?

Security Token Offerings (STOs) are a relatively new form of raising capital through blockchain and cryptocurrency. They represent an alternative to traditional equity investment and are one of the most promising new trends in the crypto world.

Security tokens represent “stakes” in companies, financial products, investments, securities, and commodities, offering ownership rights in the value of these assets.

The difficulties and limitations associated with securing funding through traditional funding sources made other ways of sourcing capital, like STOs, popular. STOs are legal and regulated, making them a safe way for companies to acquire funding.

What Is a Security Token Offering?

Security Token Offerings (STOs) are an innovative class of security tokens that represent traditional legal ownership of real-world assets. Security token offerings are a unique blend of digital tokens, security tokens, and conventional equity. They are a mechanism for start-ups, established companies, and legacy institutions to raise funds through the issuance of digital tokens.

Security tokens enable individuals or organizations to acquire ownership rights in secure digital assets and represent shares in valuable assets like real estate or company stock. In addition, the use of security tokens ensures that ownership stakes are securely and transparently preserved on the blockchain.

Security token offerings enable any investor to buy into any asset—from cryptocurrencies to corporate bonds or real estate. Security token offerings have been growing as more investors realize the benefits of blockchain technology.

How Does a Security Token Offering Work?

Security token offerings are issued on the blockchain with proper regulation by appropriate authorities. Investors in a security token offering receive shares in companies deployed on blockchain technology.

This differs from a traditional IPO (initial public offering), where companies are listed on the stock market. Instead, issuers can build a new business or deploy an already existing one with the help of smart contracts. These smart contracts are self-executing legal agreements between two parties, usually stored on public blockchains. This reduces the friction involved in transactions, such as price fluctuations, fraud, and regulatory compliance problems.

Security tokens are also used in crypto-fractionalization, where existing real-world assets are secured through tokenization. Real-world assets such as real estate, capital markets, commodities, and equity funds can all be tokenized.

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It’s important to note that security token offerings technically offer the same securities available on traditional investment platforms. Tokenization does not in any way change these underlying securities. Rather, STOs provide a new way of approaching investments.

A great example of combining the power of blockchain technology and smart contracts to issue security tokens is Polymath (POLY). It offers a platform that allows verified investors to participate in securities token offerings.

Security Token Offering (STO) vs. Initial Coin Offering (ICO)

The major difference between a security token offering (STO) and an initial coin offering (ICO) is regulation. ICOs were designed to raise capital in an unregulated space. This led to numerous fraudulent ICOs being deployed to fleece unknowing investors. A 2018 report by ICO advisory firm Satis Group said almost 80% of ICOs were “identified scams.” This raised the need for a token-offering solution to protect the blockchain investor, which ushered in the STO era.

STOs were introduced with proper regulatory governance. STOs are registered with the appropriate regulatory bodies, meet all legal approvals, and are 100% legal. They require the issuing company to do significant regulatory and compliance work before the token offering.

ICOs have no barrier to entry, while only fully compliant companies can issue security tokens. STOs are also less prone to speculation and market manipulation than ICOs.

Advantages of a Security Token Offering (STO)

Security token offerings are highly secure due to the proper due diligence and compliance enforced before they can be issued. In addition, most security tokens are pegged to real-world assets such as bonds, stocks, funds, or Real Estate Investment Trusts (REITs), which makes it easier for potential investors to assess the fair market price of the offering.

All operations of an STO (issuing, trading, purchasing, and selling) are done on the blockchain, which increases investor trust, as blockchains are immutable and transparent.

Security tokens are more cost-effective than initial public offerings. The use of smart contracts heavily reduces the need for expensive legal counsel while eliminating traditional paperwork and reducing processing time significantly.

Security tokens offer crypto-fractionalization, which serves as a good entry point for beginner investors who may not have the funds to buy an asset all at once. For example, an artwork worth $1,000,000 can be split into 1,000 parts and sold for $1,000 each, allowing everyone to get a piece. The fractionalization of assets increases accessibility by dividing them into smaller units which more investors can assess.

Furthermore, STOs provide investors with quick liquidity and ease of business, as trading can be done 24/7 with minimal paperwork.

Disadvantages of a Security Token Offering (STO)

A major advantage of STOs also doubles as one of its biggest challenges: regulation. STOs undergo strict compliance and regulation that slow down the security token process. Platforms issuing STOs must constantly keep up with new and existing Anti-Money Laundering (AML), Know Your Customer (KYC), listing approvals, and several other regulations.

Investor regulations in certain countries also limit who can participate in STOs. This reduces the investor pool for the STO and lowers opportunities that potential investors can assess. STOs can also be expensive due to the administrative checks needed before the security token can be issued.

STOs Can Have a Large Impact on Traditional Securities

Security token offerings (STOs) have the potential to shape the evolution of traditional securities for real-world assets. The ability of STOs to provide tokenization for almost anything brings a new outlook to trade and asset-backed securities management.

The possibilities for investors are endless with the rise of security token exchanges, platforms, and marketplaces. This provides investors with a vast variety of security tokens readily available globally.

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