Everything Can Be Tokenized: An Overview of the Development and Regulatory Landscape of the STO Market

This article was published on Public Chinese, author: Rimo.

The progress of the cryptocurrency industry has never stopped. The maturation of the world of innovation requires a continuous influx of fresh blood, rational capital, and investment methods that are more compatible with blockchain. STO plays an indispensable intermediary role in this process.

An Analysis of STO

Since its inception, STO seems to have not attracted enough attention from the market. The year 2020 was relatively quiet, but with the arrival of 2021 as the "institutional year" and the maturation of industry regulation, there still exists a vast imaginative space for multi-asset swaps and the expansion of ecological scenarios.

What is STO

The market definition of STO is currently very rich and has enormous combinability, much like building with Lego. First, looking at its full English name, Security Token Offering, the "S" stands for securities, aiming to regulate digital assets under the regulatory framework of securities law. The term "Token" is often referred to as "tokenization," "digital securities," or "security tokens," thus granting STO more conceptual and imaginative space, such as digital securities, security token issuance, asset tokenization, and digitization, among others.

Kendrick, CEO of Republic and a securities lawyer with years of experience, believes that "in some countries (like the United States), STO refers to the sale, issuance, and distribution of security tokens." Regarding how to define security tokens, Kendrick emphasizes:

"If a token is essentially similar to company shares or investment agreements, it is considered to have 'securities' nature. Specifically, if investors expect to gain returns in the future and the value of the token relies on the ongoing operations of its development team, then in many countries' legal systems, that token is likely classified as a type of security."

With the extension and development of the STO concept, its actual definition has greatly expanded. If we introduce more asset classes, it can even be understood as a series of on-chain or real assets that confirm rights and allow for "fragmented trading" on the blockchain.

Looking back at the progress of the cryptocurrency industry, the development of STO is somewhat similar to the booming DeFi. Many people initially defined it simply as "Open Finance," but after its explosive growth in 2020, people gradually became accustomed to calling it decentralized finance. Now, it can refer to various decentralized protocols and applications, and the definition of DeFi is no longer limited to the financial framework.

Therefore, whether it is DeFi or STO, simple concepts will burst forth with greater imaginative space as the market develops, evolving into more modular forms of expression. For example, some projects have proposed various new concepts and experimental directions such as STO + NFT, STO + DeFi, STO + DAO, and tokenization methods for both real and on-chain assets.

Compiled by Republic.co

Characteristics of STO

The background of STO's birth is under ICO, but unlike the relatively wild growth model of ICO, STO has been infused with regulatory genes from the very beginning. Therefore, legality and compliance are important prerequisites for STO and also its most important characteristic.

Secondly, leveraging the STO model, numerous issuers or individuals can achieve more flexible asset refinancing compared to traditional securities forms, making technological breakthroughs possible. By utilizing blockchain, it enables high liquidity across regions and exchanges, allowing companies to reach a broader range of investors and achieve fair competition in a more liquid and expansive market.

Additionally, the tokens of STO carry economic incentive mechanisms and functional roles. Compared to traditional securities, their economic and asset attributes are more flexible, allowing for a redefinition of property rights and production relationships, promoting collaborative operations among various ecological parties, and creating ecological incentives between companies and users. This allows users to gain a portion of decision-making power, achieving more practical application value and enjoying company benefits, thus extending similar equity and economic incentives into the ecosystem, leading to healthier development.

The Role of STO

As an innovative investment and financing model based on blockchain, STO breaks through traditional forms such as bank loans and private equity, providing a more powerful operational system for both issuers and investors. As an "upgraded version" of ICO, STO can effectively curb market chaos and fill regulatory gaps, filing for relevant exemptions or registrations under the supervision of various national securities regulatory agencies.

For issuers, many startups have long relied on bank loans and private placements for financing, while venture capital typically obtains funds by selling equity. Small and medium-sized enterprises often face difficulties in approval and high loan rates when raising funds through bank loans, while private equity methods are time-consuming and labor-intensive, requiring the search for investors and meticulous follow-up on various details.

With STO, issuers can broaden their financing channels, reaching more ordinary investors, and can utilize smart contracts for automated transactions, even facilitating cross-border settlements and payments.

Moreover, by eliminating numerous intermediaries such as securities firms, law firms, and investment banks, STO significantly reduces the economic and time costs for issuers. Traditional securities require intermediaries to complete a series of processes such as registration and clearing, while the application process and procedures for STO are more convenient. For example, with the Reg D exemption method for STO issuance, issuers do not need to disclose cumbersome financial information to complete complex processes, which can greatly shorten the time and economic costs required to complete project financing.

Compiled by Republic.co

For investors, especially individual investors, those who have completed KYC/AML and other related conditions on the platform can participate in STO through on-chain circulation, thus reaching a broader range of investors.

Additionally, the issuance of STO under a regulatory framework can effectively prevent fraud and market manipulation, fundamentally ensuring the interests of investors and the fairness of transactions.

Using STO as a fundraising method can eliminate information asymmetry between issuers and investors, allowing both parties to establish direct and effective connections.

Market Size & Development Status

Since STO can tokenize a series of assets including real estate, private equity, gaming, derivatives, cash, and artworks, and bring off-chain assets on-chain through securitization, its potential market prospects are enormous. However, given the many fields involved, the overall market development scale and status of STO may not be measured with exact figures. Therefore, we will use some segmented market tracks for simple measurement and comparison.

From the real estate segment of STO, according to a report released by Security Token Market in December 2020, the market value of tokenized real estate is estimated to reach $25.75178 million, an increase of 1.26% from the previous month, while the trading volume of secondary market STO tokens was $179,861, with a month-on-month decline of 4.47%.

Compiled by Republic.co

From the Chinese art market, according to a report by the China Business Industry Research Institute, the market size of Chinese art platforms by transaction volume increased from 3.658 billion yuan in 2015 to 13.437 billion yuan in 2019, with a compound annual growth rate of 38.4%. It is estimated that by 2024, the transaction volume of Chinese art trading platforms will reach 30.723 billion yuan, with a compound annual growth rate of 18.4%. Meanwhile, the transaction volume of art information platforms is expected to reach 393 million yuan by 2024, with a compound annual growth rate of 16.2%. If we conservatively estimate that 0.1% of the asset share is tokenized, then the asset scale of the Chinese art market may exceed 3 billion yuan by 2024.

From the traditional investment field, Crunchbase data shows that despite the global pandemic, the total venture capital in North America grew by about 7% in 2020 compared to 2019, exceeding $150 billion, setting a historical record. Similarly, if calculated at a rate of 0.1%, then there exists a potential market size of $15 billion for tokenized investments in North America.

A group of scholars, including Peter Roosenboom, a finance professor at Rotterdam School of Management (RSM), Thomas Lambert, an assistant professor of finance at RSM, and Daniel Liebau, a fintech lecturer at RSM and Singapore Management University, jointly published a research report on the new type of Security Token Offering (STO) market, which studied 185 "real" STO sample data.

The report pointed out that one-third of these cannot be considered strictly as STOs. Instead, they are either stablecoins or ICOs disguised as STOs. The report also recorded three basic facts. First, the STO market developed after the ICO market bubble burst, with STO-related activities increasing since the end of 2018. Second, most STOs have not successfully raised funds, indicating that the STO market is still in its infancy and remains very immature (many companies may not yet be ready to launch STOs). Third, STOs are dispersed globally, mainly concentrated in the United States and jurisdictions with applicable securities laws.

Distribution map of STO samples from Q2 2017 to Q1 2020, source: Rotterdam School of Management

The Regulatory Landscape of STO

As mentioned earlier, the prerequisite for STO is to further advance in the interactive regulatory layer. Although the current industry regulatory system is not yet perfect and there are differences between countries, phased policy guidance still has certain guiding significance for the market, and the gradual improvement of regulation also helps the STO industry move forward.

In mid-December 2020, the U.S. Securities and Exchange Commission (SEC) officially filed a lawsuit against Ripple and its two executives, accusing them of issuing over $1.3 billion in unregistered securities. This incident caused a huge stir in the cryptocurrency industry, with many platforms, including the largest U.S. exchange Coinbase, announcing the delisting of XRP trading, and well-known institutions such as Grayscale also stating they would no longer hold XRP assets.

Looking back at the industry's development history, the SEC has repeatedly imposed penalties on many projects, and regulation of STOs and the entire cryptocurrency industry has never relaxed. However, regulation also helps reduce risks and ensure the healthy progress of the industry.

From the current policies related to STO issued by various countries and regions, developed countries such as the United States, Europe, Canada, and Singapore have relatively complete regulations and a more open attitude. At the same time, due to the securities nature of STO itself, it is naturally more suitable to achieve breakthroughs first in places with complete financial and securities systems and clearer regulations, reflecting a certain correlation between STO and the financial development level of a country.

China's attitude towards STO is relatively strict, while countries like Thailand and Japan have expressed intentions to conduct systematic investigations and regulations on STO, maintaining a relatively neutral overall stance. For most developing countries, due to their relatively backward development and the impact of turbulent external international situations, regulation of emerging industries is in a relatively passive state.

Hong Kong has been quite active in the STO regulatory field in recent years. For example, the Hong Kong Securities and Futures Commission has been placing compliant virtual asset trading platforms into a regulatory "sandbox." In 2020, OSL obtained a license from the Hong Kong Securities and Futures Commission to trade BTC, ETH, and selected security tokens, becoming the first licensed virtual asset trading platform in Asia.

Compiled by Republic.co

Various Participants in STO

The entire STO ecosystem is composed of multiple participants, mainly including issuers, investors, issuance platforms, trading parties (Security Token trading platforms, trading and liquidity protocols), as well as technology providers, legal consulting agencies, and other participants.

Issuers refer to the holders of tokens and providers of assets, while trading parties refer to the places where tokens are traded, including platforms like Polymath, tZero, and various protocols. Service providers include institutions like Centrifuge, Republic, and Securitize, acting as intermediaries connecting issuers and investors, and are an indispensable part of the STO ecosystem.

For example, Republic.co was established in 2016 and has become one of the world's largest investment platforms after six years of development. The platform's business covers various fields including startups, equity crowdfunding, real estate investment, esports and gaming investment, and mid-to-late stage underwriting.

Republic.co has established deep cooperative relationships with top venture capital funds and family offices worldwide, including a16z, Y Combinator, ZhenFund, NGC, and others. Republic was also the first project invested by AngelList and Binance, with investors including Blockchain Ventures, Algorand, NEO, ZhenFund, NGC, FBG, and other well-known investment institutions both domestically and internationally.

In 2020 alone, Republic.co completed $150 million in financing for 157 companies, including private equity, equity crowdfunding, real estate financing, gaming financing, and token financing, among which are many unicorn companies like Robinhood and SpaceX.

In 2021, Republic is set to issue digital securities called Republic Note under regulatory guidance. When a project successfully exits, Republic will monetize the carried interest of that project and use it for platform token dividends, with over 12,000 investors from 25 countries participating in the public offering of Republic Note.

Barriers in the Market

As an emerging market, the long-term project and market performance of STO still require further observation. First, the regulatory attitude towards STO development plays a crucial role. If scrutiny becomes stricter, it may complicate compliance progress or directly affect market sentiment.

Secondly, the high liquidity of assets may lead to sharp price fluctuations. Although STO has accelerated the pace of financing and listing for startups, temporarily increasing the number of ST holders, many startups face risks of closure due to poor management and other reasons, leading to low project completion rates. These potential adverse factors may trigger asset volatility.

On the other hand, different exchanges have adopted different ST asset standards, causing market liquidity to be fragmented and preventing ST trading across exchanges, which will restrict asset trading circulation.

STO requires a complete securities logic, involving collaboration among various parties, asset standards, and coordination of trading processes, thus placing high demands on technology. The entire system's underlying infrastructure also needs continuous iteration and improvement.

Future Combinable Directions

STO + NFT

As a non-fungible token, NFT has achieved significant growth in the cryptocurrency field and is seen by many as a promising area that could succeed DeFi as another rapidly developing track.

From its field of development, everything in the real world, including artworks and collectibles, can be brought on-chain through STO, which naturally aligns with the development direction of NFT. If NFTs undergo compliance procedures through STO before being introduced on-chain, then NFT assets will possess compliant rights tokens, effectively addressing legal rights issues related to NFTs and ensuring the authenticity of assets and their actual ownership. STO can allow more off-chain assets to be mapped onto the blockchain in the form of on-chain NFTs, achieving synergistic development of the two markets.

STO + DeFi

STO can bring real, valuable funds from the traditional financial world into DeFi. For the DeFi industry, the entry of institutional-level compliant funds can promote the market's healthier development. For instance, the initial purpose of some startup teams in financing is generally to develop projects, hoping to achieve more returns in the future. If STO's filtering is utilized, it can help projects shift from speculation to the value discovery process of investment, better serving project and industry development after financing, rather than "cashing out" tokens, but rather seeking to form a positive cycle for the entire industry.

STO + DAO

STO assets possess confirmation rights of shares, and if combined with the flexible attributes of tokens, granting them expanded economic incentives and governance functionalities, it may redefine production relationships, achieving ecological incentives between companies and users. This allows users to participate in the governance process of the company and gain a portion of decision-making power, further promoting fairness and transparency within the company.

Large Institutions + STO

Large, traditional institutions are also actively trying to enter this vast market through STO, helping the industry further "break out."

The digital securities trading platform Fusang Exchange previously expressed its hope to jointly launch a digital bond product called "Longbond SR Notes USD Feb 2021" based on the Ethereum blockchain with the China Construction Bank Limited Labuan Branch (CCBL). However, the issuance time is currently delayed.

Singapore's DBS Bank has also stated that it not only supports the trading of cryptocurrencies like Bitcoin but also hopes to utilize blockchain technology to provide an ecosystem for funds through STO and secondary markets.

Conclusion

The blockchain field is constantly breaking traditional paradigms to provide new insights and innovations. It is a place full of imagination. STO attempts to disrupt traditional financial regulatory thinking through blockchain, promoting new asset development under a compliant framework through tokenization, allowing more off-chain assets to enter the industry in a more compatible manner, and ensuring that truly valuable assets can better settle within the industry.