Regulatory challenges of Security Tokens

Written by Leo Varnavas - Reviewed by Coin Review Team

Published: May 8, 2019 | Last Updated: May 8, 2019

The introduction of Security Tokens as the standard practice for investing in Blockchain-based assets is welcomed with a positive eye. This article explores some of the most common challenges STOs face today.

2024-12-09T03:48:18+00:00

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We like to talk about digital coins and the tokenization of products services and processes at scale, as if they are a mature and organized ecosystem.

In reality though -and despite the billions earned and lost from ICOs and speculation-, these assets are still in their infancy. The more we adopt and develop new solutions based on them, the more we come to realize that.

The exponential growth of Initial Coin Offerings seems to be cooling down fast at least that’s how it looks at the moment^[1]. In its past glorious days fortunes were made and lost, and a lot of shady people found a new way to separate people from their money.

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Now, it’s the era of the Security Token. Anything that even remotely implies a transaction with a profit potential, must be registered and operated as a Security Token. At least that’s the plan.

A process started by the SEC in the United States, it is becoming common practice in all advanced economies with various measures (although at a different pace on each occasion). The bottom line is simple. You want to raise money and offer revenue to your backers? Good.

Whatever your project is, you need to follow the rules any other investment vehicle does. No more “we’re new and we don’t know how to classify ourselves” excuses that allowed all sorts of scammers and/or unfit founders to gamble and lose (or steal) billions of dollars from investors.

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As we said though, new instruments come with new challenges. In the case of Security Tokens, we have a licensed, regulated, and more secure (by multiple smart contracts that oversee operations) vehicle. So far, so good. But when we take a look at the day-to-day function of Security tokens, we start noticing some interesting challenges. Let’s take a closer look, shall we?

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Power of Creation Is a Challenge to Security Token Investment

Token issuers have overwhelming power over their creation. They control the creation, the distribution, and the rules. As long as we are talking about utility tokens for extra lattes at your local coffee shop, we’re golden. But when we are talking about instruments licenced by government, federal, and state regulatory authorities, things get complicated.

Imagine a listed company issuing new stock and distributing shares to individuals without checking their credentials or eligibility. Adding or removing administrators at will. Imposing or lifting restrictions as it seems fit.

There are at the moment, tokens that include inside their code such allowances. Issuers and investors have to perform their own due diligence to avoid unpleasant surprises. Until regulations and security standards catch up, there’s no other way.

Reliability an Issue to Security Token

When you lose your private key and access to your tokens, a process begins to replace them. Some tokens will burn the old ones and mint new; other will just transfer an equal to your loss amount of tokens, to your new address.

But this process is also not without challenges when we talk about security tokens. If for example the token is registered and traded in an Exchange, loss and re-issuance means extra work and extra costs for both issuers and the Exchange.

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Additionally, if the loss is actually theft then the token as well as the investors face additional problems depending on the rights they enjoy. Security token ownership might include voting rights, power to transfer capital, power to sign and change contracts and agreements, and all sorts of other powers.

In the wrong hands, these powers can prove to be a legal and business nightmare for the unlucky token owners. Token platforms and standards have still a long road ahead of them to address decisively these security issues.

Delayed Transactions

Most of the tokens are built with the Ethereum protocol. But Ethereum is slow as a platform in times of high volumes and demand. It is all right to wait a few minutes or seconds for an everyday purchase, but, in a highly speculative intraday market environment, these delays are catastrophic for large volume traders.

There are also complaints about the cost of transactions. In times of high demand, those costs can become substantial especially if we are talking about the development of a big exchange with hundreds of thousands -or millions- of daily transactions.

Projects are starting to explore different platforms and standards. The need for a faster decentralized solution dedicated to high-frequency transactions is becoming more evident as the days pass and new products enter the space.

Jurisdictions and KYC Compliance in Security Token

As the number of security tokens is rising, platforms and authorities will have to overcome jurisdictions and KYC compliance issues. Different clients come from different jurisdictions. Each one having different laws and regulations regarding tokens and income.

There could be also overlapping transfer restrictions and requirements. This complex process has to be addressed centrally at the platform/exchange/authority level; otherwise it will be a nightmare for all new issuers and investors if done individually. The same applies to the Know-Your-Customer verification process which is a required for all investment products.

Investors have to pass the same process every time they want to participate in a Security Token Offering. At the moment it’s not such a problem because of the small amount of Tokens licensed to operate. But as the number grows, these restrictions will bring additional problems and unwanted burdens to new projects.

Some platforms have started addressing the problem by developing on-chain investors’ registries. It’s the first effort to minimize the problem of going through multiple KYC and other checks before every STO. A unified identification could also give more options to investors to choose how and with which wallets/addresses they would prefer to participate on each new offering.

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The establishment of Security Tokens as the new standard of investing using blockchain technologies, is introducing new challenges every day. We mentioned just a few here, but we have only touched the surface.

Issues like dividend distribution, voting rights, off-chain investor data keeping, code issues and their derivatives present new problems that the authorities and the investors demand to be solved.

If we want this second wave of token use to succeed for a longer period of time, we need to invest more time and capital into building long term standards, and be less focused on the short term fixes. Experience has taught us that a lot of times faster, proves to be more expensive in the end. And nobody wants that.

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References

[1] https://www.inwara.com/ico-research-more-icos-raised-funds

Disclaimer

The writer’s views are expressed as a personal opinion and are for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.