Introduction

Back in 2014, initial coin offerings (“ICOs”) came to light as the first crowdfunding option in the blockchain ecosystem and they are essentially the cryptocurrency version of initial public offerings. However, with the ICO market slowly ebbing away, security token offerings (“STOs”) surfaced as a reaction to the lack of oversight of ICOs, bringing the issuance of digital tokens using blockchain or distributed ledger technology (“DLT”) within the regulatory ambit.

Security tokens are typically the digital representations of the ownership of securities, including equity and debt security. With blockchain technology in place, assets can be “tokenized” by being divided into smaller portions in the form of tokens which are capable of being transferred, purchased, sold and destroyed based on the computer code rules of their blockchain.

STOs are increasingly being seen as an alternative to traditional and mainstream debt and equity fundraisings via the issuance of bonds and shares. With STOs structured to sit within the securities law framework as they are regulated by the Securities and Futures Ordinance (Cap. 571) in Hong Kong, there is a wider availability of finance and greater certainty for both issuers/fundraisers and investors, which in turn supports an enhanced liquidity of assets.

Advantages of STOs

At present, investors are most often limited to investing in a company through the acquisition of its shares or bonds. With STOs, investors could then potentially diversify their portfolio by investing in assets which are not suitable to be traded in traditional capital markets. There are a number of assets categories in which ownership often cannot easily be transferred or divided or traded, such include private debt and equity, interests in real estate, and intellectual property rights. By digitalizing and tokenizing illiquid tangible and intangible assets, owners can segment, fractionalize and monetize assets in whole or in part through STOs, allowing assets to be split and divided into smaller tradable fractions and be sold in the form of tokens. Asset owners and token issuers can then utilize the divisibility of STOs to raise funds from various parties. The digitalization and fractionalization of assets also reduces the entrance capital in respect of the minimum investment threshold for investors, allowing smaller investors to invest in expensive investments which would otherwise be a threshold too high for participation. Via the purchase of tokens which represent a small portion of assets, the investment risks and costs borne by investors could also be reduced and thereby encouraging the participation of more retail investors.

Another advantage of STOs is that the ownership of assets will be recorded and maintained in the DLT registry automatically in a permanent, secure and transparent manner. All information regarding previous transaction records and the former and current ownership of assets are present which increases transparency and accountability. With its automation, fewer intermediaries are required to facilitate the transactions of tokens, bringing about lower transaction costs and minimizing errors.

STOs still face challenges ahead

Whilst there are a number of appealing features of STOs, there remain practical obstacles. First, the relatively extensive regulations restrict the technical flexibility of STOs. In May 2021, the Financial Service and the Treasury Bureau (“FSTB”) of Hong Kong proposed to confine the services of a virtual asset exchange to professional investors. This is in addition to the rigorous vetting process already in place for issuers to become licensed as a virtual asset services provider. Save that the extensive regulatory framework may enhance the confidence of investors and attract a wider range of investors given the unique technology infrastructure that blockchain provides, the same may nevertheless keep the public out of the game due to the stringency of the statutory regulation.

Another paradox is that while various types of assets can be tokenized, the value of such virtual assets may be difficult for investors to analyse. The blockchain technology is susceptible to regulatory environment and policy changes; thus the value of security tokens can fluctuate heavily, causing potential loss for investors. Therefore, even though illiquid assets can be tokenized, the uncertainty in their return may turn conservative investors off, making investors hesitant about purchasing tokenized assets.

Finally, the anonymous and speedy nature of trading tokens may generate high compliance costs. It takes time to build a comprehensive infrastructure to screen the transactions for suspicious acts or potential money laundering activities. This is because it is much more complex to fully analyse the digital trail of security tokens than to scrutinise cash-based transactions. As such, STOs inevitably open up higher risks of money laundering and thus require heavier investment in compliance.

Key takeaways and conclusion

In conclusion, before using STOs to attract investors, issuers should ensure that they comply with the relevant requirements and regulations. The rise of technology has led to more seamless transactions along with higher risks of non-compliance. Given the unique features of blockchain technology, the Securities and Futures Commission is tightening the rules on anti-money laundering and counter financing of terrorism, aiming to align withFSTB’s proposal to regulate the trading of virtual assets. Apparently, increasing regulations may slow down the application of STOs; however, it is expected that a more extensive regulatory framework will provide more certainty for stakeholders regarding the proper process of STOs. Therefore, there are ample opportunities to develop STOs, and there is a need to stay close to the latest changes in compliance requirements.