Security token offerings are gaining recognition in the cryptocurrency world as they are seen to provide greater protection for investors than initial coin offerings. But experts warn of the risks involved, saying STOs have yet to emerge as a viable channel for raising funds. Zeng Xinlan reports from Hong Kong.
This photo taken on Sept 24, 2020 shows a physical imitation of Bitcoin at a cryptocurrency shop near Grand Bazaar in Istanbul, Turkey. (OZAN KOSE / AFP)
After the splash created by initial coin offerings in early 2017 followed by their abrupt collapse a little over a year later, the virtual currency world is again on the move with security token offerings.
The painful lessons of ICOs -which saw a record US$11.6 billion raised globally in 2018 through cryptocurrency tokens sold to investors and speculators, according to ICObench, an ICO rating website - have remained. Unregulated trading, inadequate securities laws, scams, and fraudulent practices are blamed for most of the failures.
But security token offerings, or STOs - public offerings in which digital security tokens are sold to investors through cryptocurrency exchanges - are seen as more secure than ICOs and have already won the confidence of financial markets in Southeast Asia. The Singapore Exchange, which runs the Lion City's stocks and derivatives trading market, has started its own STO market.
Will STOs become the next big thing in the cryptocurrency world? Could they gain the confidence of investors and become a game changer? Industry pundits have their doubts, while acknowledging that STOs are seen to offer a greater sense of protection for investors.
"I wouldn't say it is a game changer," said Wilson Tong Hin-sang, a professor at the Hong Kong Polytechnic University and director of the AMTD FinTech Centre at the university's Faculty of Business.
"It's an interesting market when we talk about asset digitalization and financial technology development. Digitalization is a necessary component. You can see a lot of potential, but it still takes time," Tong told China Daily. More transparent regulations and universal standardization are needed for an orderly development of the crypto space, he added.
Security tokens, which look just like a line of digital code, are similar to the traditional shares of a company. STOs are governed by securities legislation, and security tokens must be linked to a registered company with real assets being traded
Akin to IPOs in the stock market, STOs offer companies a new channel to raise money in a blockchain environment by means of tokenized digital securities. A token is a unit that represents something tangible in an ecosystem. Security tokens are digital representations of illiquid or real-world assets, such as gold, real estate or economic rights, like a share of revenue or intellectual property utilizing blockchain technology, which is also used in Bitcoin trading.
Security tokens, which look just like a line of digital code, are similar to the traditional shares of a company. STOs are governed by securities legislation, and security tokens must be linked to a registered company with real assets being traded.
"The real value of the underlying technologies of Bitcoin and cryptocurrencies comes in the form of its role in security, in transparency, in permanence, each of which is essential to financial markets' efficiency, trust and confidence, as well as safety and soundness," global consulting group Deloitte said in a 2020 report on STOs.
"Conceptually, STOs could have a lot of advantages over traditional IPOs by increasing liquidity and reducing trading friction," Tong said, explaining that the seamless online trading of security tokens through digital currencies could create more liquidity and simplify the trading process, as opposed to the cumbersome procedure of a traditional IPO, which usually takes up to six months.
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Under the current regulations of Hong Kong Exchanges and Clearing - the city's bourse operator - a company's listing on the main board calls for a review of its financial track record for three years and fulfilling certain profit and market capitalization requirements, while a listing on the Growth Enterprise Market requires similar requirements over two years.
Tong said the liquidity could be further enhanced for an STO as the online trading pattern significantly lowers the barrier for investors. "As it (an STO) is traded on the platform, then theoretically, you will have more market participants, so that will increase the market base. In Hong Kong, there are restrictions, but you could attract retail investors."
STOs could also accelerate the fundraising process and make it cheaper without the need for intermediaries, backed by its decentralized finance nature. "The process will be automated, the smart contract is almost like an instant type of settlement transaction, so you can avoid using intermediary agents," Tong said.
Decentralized finance, or DeFi, is a form of blockchain-based finance in which financial products are available on a public decentralizing blockchain network, as opposed to a centralized finance environment that relies on intermediaries such as brokerages, exchanges or banks. In theory, DeFi allows financial services, such as savings, loans and securities trading, to be accessed by anyone worldwide using a smartphone and the internet without the need for third-party platforms.
Using blockchain, the funding process will be encrypted in a smart contract. So the due diligence procedure can be smoother and more transparent, thus lowering the credit risk premium and the transaction cost.
Wilson Tong Hin-sang, professor at the Hong Kong Polytechnic University and director of the AMTD FinTech Centre at the university's Faculty of Business
By excluding middlemen, the funding process could be made more transparent, said Wang Shibin, co-founder of Hong Kong Digital Asset Ex Limited, a digital asset exchange. "Using blockchain, the funding process will be encrypted in a smart contract. So the due diligence procedure can be smoother and more transparent, thus lowering the credit risk premium and the transaction cost," he told China Daily.
Tong said STOs could also mitigate financing risks such as scams. A smart contract is a piece of code written onto a blockchain that defines the terms of a transaction between the buyer and seller, without requiring an intermediary. It reduces the costs of deploying intermediaries, mitigates the risk of manipulation, and saves time.
STOs also allow more flexibility in the assets class by making traditionally non-tradable assets tradable and allowing tradable assets to be divisible - splitting illiquid assets into smaller tradable fractions in the form of tokens. Therefore, sellers might be able to raise money without having to sell off all their assets.
"STOs can cover various types of assets, such as illiquid assets, collectibles and even intellectual properties," Tong said. "Through tokenization, it would be possible (to trade) without selling an investor's entire assets," he said, adding that the cheaper and more-flexible channel is appealing especially to new and smaller companies that may not satisfy the requirements of a traditional IPO.
Hong Kong businesses are already on the move with regard to STOs.
HashKey Group, a local fintech startup, told China Daily it is getting more inquiries about STOs. "We have a lot of inquiries from asset owners who are interested in understanding tokenization and how they can get started," said Walter Jennings, the company's head of corporate communications.
Launching an STO involves multiple processes and is subject to various regulations in different jurisdictions. It normally includes preparation in which issuers prepare investor information; design the offering where issuers decide the structure of the token, including the quantity, the value per unit and duration of the offering; select service providers such as blockchain platforms and brokerages; and create the security token as well as the crowd sale, in which companies sell the tokens to the public to raise funds.
This undated file photo shows the logo of the Securities and Futures Commission of Hong Kong. (PHOTO PROVIDED TO CHINA DAILY)
'Lots of restrictions'
Despite all its advantages, an STO doesn't provide a shortcut for companies, said Jennings, pointing to the process that companies still need to undergo before tokenization. "You still need due diligence and provision of information. But having said that, it is not as onerous as it seems."
"It's just the beginning. There are still lots of restrictions and control for good reasons," Tong said, referring to the efforts being made against money laundering and terrorism financing.
In Hong Kong, security tokens are classified as securities and are subject to securities laws, according to the Securities and Futures Commission, the city's financial watchdog. Virtual assets trading platforms require a Type 1 license for dealing in securities and a Type 7 license for providing automated trading services to trade in security tokens. Any person engaged in distribution or broker-dealing activities involving an STO needs to have a Type 1 permit regardless of whether that person is based in Hong Kong or not. Trading is also confined to "professional investors" - defined by the SFC as "high-net-worth" institutional, corporate and individual investors.
The SFC said investors should also be mindful of the risks in trading virtual assets on unregulated platforms. "If the platform ceases operation, collapses or is hacked, investors may face the possible risk of losing their entire investments held on the platform," warned Thomas Atkinson, the commission's executive director of enforcement.
Tong, however, believes the high entry barrier could hurt liquidity. "Only qualified investors can participate, and ordinary investors are shut out," he said, pointing out that liquidity is a major hurdle in the development of STOs. "The STO market actually doesn't seem to develop as fast as expected although people see a lot of good things about it.
Another worry for investors is the quality of the companies seeking an STO. They are usually small, not well established and are unable to meet the requirements for an IPO. This could increase the investment risk
"The main reason is that you don't have adequate liquidity," Tong pointed out, attributing it to the immature global regulatory environment that hinders the free flow of security tokens and the investment education that is yet to catch up. "A platform that is acceptable to one market doesn't mean it is acceptable to other markets," he said. The global standardization vacuum has imposed limitations on STOs as the nature of tokens is seen as "borderless virtual assets", he said.
Although the distribution and exchange activities of virtual assets are regulated in all analyzed markets, 45 percent of them do not regulate payment activities, while 23 percent do not regulate storage activities, according to research by the Cambridge Centre for Alternative Finance after analyzing 23 selected jurisdictions and international organizations, including Hong Kong, the Chinese mainland, the United States and the European Union.
The lack of investor education is restricting market liquidity, said Tong, blaming the tendency of both domestic and overseas investors to allocate the majority of their portfolios to domestic equities. "Typically, investors are attracted by stocks that are well-known to everybody. Investors in one market would normally focus on stocks in their own markets rather than those in other markets although you may want to diversify," he explained.
Benefiting from a mature stock market, Hong Kong investors have a long-held tradition of trading stocks, which may affect their decisions on whether to make an STO investment, Tong said. "The STO market may not be as attractive as other financial markets. It remains to be seen how Hong Kong investors would choose between shares in the stock market and tokens in the STO market."
Tong said he doesn't foresee STOs becoming a big thing in the near future. "I don't expect a significant STO market emerging in the short term. Liquidity is an issue and STOs are still new in Hong Kong."
Another worry for investors is the quality of the companies seeking an STO. They are usually small, not well established and are unable to meet the requirements for an IPO. This could increase the investment risk. "If you have these small and newly established enterprises in the market, their rate of survival could be quite low," said Tong, warning it could turn into a risky investment. The quality of these companies is questionable, and market capital would be wasted. "Many of their projects may not be able to survive."
"STOs are a nascent form of raising funds and the market is still evolving," the SFC said in March 2019. The commission has repeatedly warned investors of the risks of trading in virtual assets, such as insufficient liquidity, volatility, opaque pricing, hacking and fraud.
Independent fintech analyst Muneeb Jan said he doubts that STOs could become an alternative method of financing.
"It's just an update of the ledger and the account technology. There really isn't any venue for alternative financing," Jan said, citing the ICO bubble of 2018. "That model of financing is heavily operated," he added.
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