Overcoming Information Asymmetry in Security Token Offerings

light house

The Decline of the ICO, the Birth of the STO

During the last year, cryptocurrency markets have been gripped by one of the most dramatic bear markets the blockchain sector has ever seen. To make matters worse, the start of this downward spiral coincided with a period when funding through initial coin offerings (ICOs) was at an all-time high, with over 2,000 ICOs concluded successfully throughout 2018.

This steep decline in price, led by the two most common digital currencies used for ICO funding, Bitcoin and Ethereum, caused many early stage start-ups to run into stumbling blocks before they’d even left the starting gate. Companies which found themselves with large quantities of digital currency raised throughout their ICO faced two equally difficult choices; sell their holdings for fiat cash and contribute further to the bear market, or wait it out and experience a significant loss of funds.

Adding to this disaster was a mix of fraudulent ICOs throughout 2018. These projects had little intention of delivering on their promised roadmaps and instead carried out exit scams with investor funds. As a result, it’s clear to see why sentiment surrounding the ICO funding method has reached an all-time low.

However, it’s not just investors who are moving in droves away from the ICO model. After several high profile cases involving the U.S. regulator, the Securities and Exchange Commission (SEC), weighing in to levy fines, cease and desist orders, and even criminal lawsuits on several ICOs deemed to be selling unlicensed securities, many founders started searching for new, compliant methods of raising funds for their start-ups; wary of crossing the thin line between utility tokens, and tokens representing a security.

The Emergence of Security Token Offerings (STOs)

Of course, the ICO fundraising model wasn’t entirely negative. In fact, its improvements to traditional venture capital funding were revolutionary for many small enterprises which needed to raise cash quickly in order to become established in a competitive market. Likewise, the decentralized nature of ICO tokens allowed participation in raises irrespective of geography, increasing liquidity and improving access to a far greater investor pool for founders.

Owing to this, certain industry experts realized it would be beneficial to integrate these features into a regulatory compliant, trustworthy, and robust token protocol which stymied investors’ concerns. Thus, the security token was born.

Security tokens, like their utility token counterparts which were often offered through ICOs, are decentralized, blockchain-based digital assets which may be distributed to investors worldwide. However, unlike utility tokens, tokens offered through an STO are deemed to have passed the ‘Howey Test’, therefore they are governed under the same laws as traditional securities by most regulatory bodies, the SEC included.

As a result, many founders are examining the STO model as a viable and compliant way of raising capital and by 2020, it’s estimated that the STO sector will grow into a $10 trillion industry. However, for STOs to enjoy widespread success, there are several pain points which require solving. Perhaps the largest of these is information asymmetry between issuers and investors.

Asymmetric Information: What It Is and Why It Matters

Information asymmetry occurs when one party in a transaction is privy to greater knowledge than the other party, a problem across many industries — digital or otherwise. Markets which are plagued with information asymmetry generally encourage bad actors who participate in insider trading or market manipulation at the expense of investors.

For STOs, instances of asymmetric information most often occur when token issuers are secretly aware of factors which will affect the price of the token they are offering to their investors.

Usually, information asymmetry would be reduced via disclosure and transparency of public material related to the security token issuer; however, within a digital economy, this is significantly harder to police. Likewise, susceptibility to information asymmetry is high within the STO sector, as many start-ups which have failed to raise via venture capital may instead turn to security tokens to raise funds.

When investors participate in traditional venture capital, private funding rounds, the purchase of traditional assets through secondary markets, or go through third-party exchanges, they most likely use the services of an oracle provider, who undertakes regular audit certification, asset insurance, and due diligence on the asset issuer.

To encourage confidence in the emergent STO markets, oracle providers will be required to implement reliable disclosure protocols, which allow off-chain access to verified due diligence reporting and trustworthy information, thereby tilting the balance of information asymmetry back into the investors' favour.