A Dive into Financial Market Regulations that will be Applied on Security Tokens
1. Will Everything Become Security Tokens?
In our previous article “Why Security Tokens?” I discussed the reason why the blockchain industry was high on security tokens. To briefly recap, security tokens, compared to ICOs that used traditional securities or utility tokens, have advantages in 1) high liquidity, 2) easy and safe fundraising, and 3) simple token economy designing.
Then, are security tokens the perfect alternative that will salvage the blockchain industry from this bear market? Unfortunately, we cannot be so sure yet.
Realistically speaking, security tokens, which is still at its infancy, have a lot of hurdles to go through. First, because security tokens are the link between the cryptocurrency market and the traditional financial market, it has to comply with the rules of the existing financial market. Also, for security tokens to actually function as a ‘programmed security’, an appropriate technological standard has to be set.
This article will address the rules of the conventional financial market, i.e. the laws and regulations, that security tokens will encounter.
What regulations must security tokens abide and what characteristics do these regulations have?
2. Whose Regulation Should it Obey?
A security token is literally a ‘security’. It is no different from stocks and bonds, which is why security tokens must also comply with laws regulating the issuance and transaction of securities. This naturally makes us wonder:
“There are various types of securities and associated laws. Which laws should security tokens follow?”
It Differs by Country
To answer the above question, we must first know in which countries tokens are issued and traded. Every country has it own set of laws governing security issuing and transaction. We must also be aware that each country has a different standard and attitude towards categorizing cryptocurrency as a security.
Countries like Switzerland and Hong Kong that have regulated cryptocurrency early on saw financial authorities quickly come up with regulation guidelines applicable to tokens based on their characteristics.
In Korea, while issuing and trading securities are regulated by the Capital Market Act, the country is lukewarm towards establishing guidelines for cryptocurrency trading.
Because every country has its own circumstances, the right set of laws must be applied considering where a security token issuing company is based and from which people with what nationalities fundraising with conducted.
The Standard is Still the SEC
Yet, amidst such complicated situation, the standard for security token regulation is shaping up to be the regulation set forth by the SEC (U.S Securities and Exchange Commission).
The SEC is swiftly taking measures by setting cryptocurrency regulation guidelines.
The reason why the SEC regulation is becoming the standard for security token regulation is simple. The U.S. is the global center of the financial industry.
The SEC oversees are issuance, purchase, and trade of securities by legal entities in the U.S. and imposes strong penalties on non-compliance with SEC regulation. In other words, any company that issues securities outside of the supervision of the SEC will be unable to have American or American company participation in the entire process from issuance to trading. The effect of security tokens, which holds linking cryptocurrency and traditional finance as one of its key objectives, will be limited if it moves forward without the U.S., the hub of the traditional financial industry.
Although there are STO projects in the world that does not consider SEC regulations, the majority of STO projects accepts SEC regulation as the standard because of the reason stated above. The SEC is well aware of this and is working hard to quickly set regulation guidelines for digital assets.
However, the SEC is not establishing regulations optimal for security tokens. In November 2018, SEC Chairman Jay Clayton stated during New York Times Talks that he is “not going to change rules just to fit a technology.”
Because the SEC perfected the optimal set of regulations for securities throughout the years, the SEC claims new technology must adjust to these regulations. This means that the wisest choice would be fore security tokens to follow exiting rules instead of waiting around for the SEC to come up with new ones.
In truth, the requirement for complying with SEC regulation is not limited to STOs that explicitly say that tokens are innately securities. Now even utility token ICOs cannot ignore SEC regulations. As mentioned in our previous article, the SEC classifies all assets that pass the Howey test a security. Also, the ‘substance over form principle’ is applied to treat anything that is actually used as a means of investment, despite its original intent of issuance, a security.
This means that no matter how much a company argues that their ICO uses utility tokens, the tokens can be classified and regulated like securities the moment users use the tokens as a means of investment in actuality. In fact, the SEC has recently started active investigations into the all ICOs and has imposed penalties on 10 cases by classifying ICOs as securities in 2018 alone.
3. What SEC Regulations are We Talking About
Enacting the Securities Exchange Act in 1932, the SEC has made regulations and enforced laws for investor protection and legal securities issuance and trade. The SEC largely deals with 1) regulations on securities trade and 2) regulations on securities issuance. Similarly, cryptocurrencies have regulations guidelines for these two aspects respectively.
In terms of trade, a security token exchange has to obtain ATS (Alternative Trading System) qualification from the SEC. This process involves a separate review and approval method by the SEC on companies equipped with certain conditions. We will focus on security token issuance in general.
Regulations on Security Token Issuance
The SEC IPO regulation stipulates a complicated and time consuming process of registering securities at the SEC. Acknowledging that this process is too much of a burden for small companies, the SEC has prepared exemptions for those who comply with certain regulations.
Especially after the enactment of the The Jumpstart Our Business Startups (JOBS) Act in 2012, the SEC has overhauled existing laws to enable easier fundraising by small companies. STOs were also recommended to follow four exemptionary provisions: Regulation D, Regulation S, Regulation A+, and Regulation CF (CrowdFunding). Let’s look into what characteristics of these regulations and in what situation they are suitable.
Regulation D Rule 506
Regulation D Rule 506 allows companies to procure unlimited funds but can only receive investment by accredited investors (an accredited investor must have a net income exceeding $1 million or an annual $200,000 net income for the past two years). Reg D also limits re-sale.
For companies that do not need to secure liquidity and seek to collect funds from a handful of investors, following this provision would be most advantageous. Most famously, Telegram gathered $1.7 billion through Reg D.
Regulation D Rule 504
Though it falls under Reg D, Rule 504 is completely different from Rule 506. Rule 504 eliminates the need to seek out accredited investors, but the maximum investment cannot exceed $5 million. Additionally, because re-sale is limited, it is difficult to secure liquidity.
Because this rule offers preemptive rights to investors within a certain state, it is suitable for local businesses who want to gain funding of a humble amount.
Reg S applies to cases in which a U.S. company seeks funding from foreigners. Although there is no funding limit nor rules against re-sale, all issuance and transaction has to be offered to foreigners. The security token trade platform tZERO applied for Reg D and Reg S at the same time and succeeded in attracting $115 million in funding.
Reg A+ is a flexible provision that does not limit the type of investors and re-sale. Though there is a limit on funding of $20 million or $50 million depending on the tier, re-sale allows the securing of liquidity. Blockchain startups like Gab and Ridecoin, and other startups have used this provision, and is the most widely used fundraising provision.
Lastly, Reg CF is a provision for crowdfunding. Though it is commonsensical, the $1,070,000 cap limits its usage by many as a fundraising means.
4. Wrapping Up
As mentioned before, security tokens have to follow the regulations of the traditional financial market. In that process, many factors have be considered. What country will the token be issued, to what country’s people will funds be raised, how much investment is the goal — these complicated conditions have to be reviewed in choosing the right provision for each company.
Many perceived advantages of security tokens may have to be forfeited. Liquidity may be an issue and entering a borderless investment market may be difficult.
Recently, more and more people talk about security tokens as if they are the perfect savior of the blockchain industry. As we discussed in our previous article, security tokens do have many pros.
However, if you take a closer look at the bits and pieces, security tokens have a long way to go to include dealing with complex regulations. We need to make a clear assessment on the limitations of security tokens now as STOs are settling in as the new trend in the blockchain industry.
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