A Comprehensive Understanding of Global Regulatory Trends, Opportunities, and Challenges of STO

This article was published on November 13, 2018, on the Chain Catcher WeChat public account, authored by Sun Zhangtao.

I. Regulatory Landscape of STO

"Man is born free, and everywhere he is in chains. Those who believe themselves to be the masters of everything else are, in fact, more enslaved than anything else." This is Rousseau's classic discourse on freedom. I believe this also accurately reflects the relationship between regulation and STO (Security Token Offering).

Many people only know the first part of Rousseau's famous saying, "Man is born free," just as many blockchain practitioners think that regulation restricts freedom. Little do they realize that effective regulation is not just a Damocles sword hanging over their heads, but also a booster and protector for vigorous development.

Let us recall the origin of STO. The purpose of STO is to conduct token issuance with securities characteristics under legal and compliant regulation. It was formed when the U.S. Securities and Exchange Commission (SEC) decided to include tokens, a new species generated by blockchain, under securities regulation.

This move initially dealt a severe blow to the digital currency and blockchain industry, leading many to believe it would face catastrophic consequences. However, subsequent developments saw more and more countries and regions begin to follow suit, rolling out their own regulatory policies—despite certain discrepancies in the definitions of STO itself—allowing the market to gradually realize that regulation is not a disaster, but a means to gain legal status and develop openly and robustly.

It can be said that incorporating Security Tokens into the financial regulatory system and clearly defining them as part of the securities system has become an inevitable trend. Let’s look at a few typical country cases:

United States—All financing-related financial activities fall under the jurisdiction of the SEC. If a project wants to raise funds, there are generally two options: one is to register with the SEC and then raise funds; the other is to not register but raise funds under regulation. Currently, the most feasible method for issuing securities-type tokens in the U.S. is the second option, utilizing exemptions listed in regulatory acts for legal compliance.

Therefore, the core of STO is to meet the SEC's regulatory requirements. Here are several core concepts:

1) Qualified investors;

2) KYC and AML (investor due diligence and anti-money laundering investigations);

3) Information disclosure;

4) Investor lock-up period. The main exemptions corresponding to these regulatory requirements are Regulation D, Regulation S, and Regulation A+.

Among them, Regulation D is the regulation for private placements, Regulation S is for U.S. companies targeting overseas investors, and if one can pass these two exemptions, fundraising does not require registration with the SEC; Regulation A+ is akin to a mini-IPO, requiring two years of audited operating performance and is relatively costly.

As the most powerful country with the most complete financial securities system today, even though these exemption clauses were not originally prepared for STO, the U.S. provides the most detailed explanation of STO, and its current regulatory policies basically meet the multi-layered needs of STO for a considerable period.

Europe—Europe's regulatory policies for STO are divided into two levels: one is the EU-level financial regulatory policies, and the other is the financial regulatory policies of sovereign countries themselves. At the EU level: the main regulatory bodies are ESMA (European Securities and Markets Authority) and ECB (European Central Bank), with the ECB overseeing the entire European monetary policy and commercial banking regulations.

Currently, the EU does not have a particularly negative attitude towards STO, only requiring compliance with relevant securities regulatory provisions. ESMA also proposed at the end of last year and the beginning of this year that issuing tokens in Europe (without specifying whether it is ICO or STO) must meet relevant legal provisions. Compared to the U.S., Europe's regulatory policies are not as detailed but are relatively more tolerant and open, especially small countries like Malta and Gibraltar, which are at the forefront of openness, becoming the preferred destinations for various projects to enter Europe.

Singapore, Hong Kong—Singapore has not issued specific regulatory policies targeting STO itself; the regulatory basis is the "Digital Token Issuance Guidelines" released by MAS (Monetary Authority of Singapore) in November 2017. According to MAS, if a token belongs to capital market products, the issuance of such tokens may be subject to MAS regulation.

The SFC (Securities and Futures Commission) of Hong Kong published a statement on November 1 regarding the regulatory framework for management companies, fund distributors, and trading platform operators targeting virtual asset portfolios. Overall, the Hong Kong SFC is placing compliant virtual asset trading platforms into a regulatory "sandbox" for at least a year of observation to explore whether it is appropriate to regulate virtual asset trading platforms.

It can be said that the global regulatory tide for STO, although not yet completely clear and somewhat chaotic, is becoming increasingly evident and unstoppable. This is an inevitable intersection of technology driving traditional securities innovation, the search for new vehicles for global asset securitization, and the competition of interests among countries.

_ Comparison of costs between traditional fundraising methods and STO, editor's note _

II. Four Types of Global Regulatory Trends

For all participants, regulatory policies are the biggest uncertainty. Although current regulatory policies are not complete and there are many policy differences, periodic guidance still holds significant importance, indicating the future development direction or industry opportunities for STO to some extent.

From the perspective of countries and regions that have issued relevant policies, they are basically developed capitalist countries and regions, which means that the attitude and details of STO regulation are essentially aligned with the economic and financial status of the respective countries. Unlike blockchain, which flourishes globally regardless of the economic and financial foundation of the country, the securities nature of STO dictates that it needs to complete the formation of regulatory systems in places with more complete financial and securities systems first.

From the dimensions of the degree of regulatory looseness and the nature of the regulating country (or region), the global countries can roughly be divided into four categories:

The first category includes economic and financial powers such as the United States, the EU, and Canada, which have a relatively neutral or even friendly attitude towards STO. At the same time, their financial regulatory policies are relatively complete, not opposing but having relevant laws and regulations for systematic regulation, ensuring that STO is fully under regulatory control while promoting innovation and development of new technologies in a legal and compliant manner.

The second category includes countries and regions such as Singapore, Estonia, and Malta, which have a relatively tolerant attitude towards STO, with slightly relaxed regulatory policies, basically embracing it enthusiastically. These countries clearly hope to seize the opportunity in the future global financial system (securities system) reconstruction through this new phenomenon of STO.

The third category includes China, which has always maintained relatively strict control over its financial system, thus previously implementing a one-size-fits-all approach to ICOs and not encouraging the tokenization of blockchain. However, we should also see another side: while China has a very firm attitude towards digital currency, it is relatively tolerant towards blockchain.

The inherent demand for asset securitization, the rush of countries to enter, and the liquidity demand of large valuable assets will inevitably lead more countries to join the regulatory trend. As an economic and financial power, China's measures are expected to remain strict, but it should not be absent.

The fourth category includes relatively underdeveloped countries in South America and Africa, which have not yet issued regulatory policies, determined by their national status. Whether in terms of the influence of traditional finance or technological level, they may not be able to support projects and regulatory systems.

"Those who do not plan for the long term are not fit to plan for the short term; those who do not plan for the overall situation are not fit to plan for a specific area." This military perspective on the battlefield is also applicable in business. As practitioners of STO, one must not only understand their role and positioning in the industry but also comprehensively assess the regulatory policies of various countries and future trends to strategically choose the direction of projects and the countries and regions for implementation.

III. Core Participants in the Industry

In my view, the main participants in the STO ecosystem include four core roles: asset owners (owners of assets being tokenized), trading institutions (issuance and trading platforms after asset tokenization), builders (technical builders of asset tokenization), and investors (qualified investors or institutions).

Asset owners are the most important link in the STO ecosystem and the biggest beneficiaries of STO regulation. Without assets, there is no STO; whether it is asset securitization or securities tokenization, it fundamentally relies on assets. For asset owners of commodities, real estate, artworks, etc., it is evident that they would not dare to enter this field before STO has complete regulation.

We can see that the dozens of compliant STO projects currently available mostly come from the United States, precisely because the SEC's comprehensive rules on STO provide a safeguard for asset owners, allowing them to embrace this securities revolution. Asset securitization enables assets to circulate, while tokenization makes circulation faster and unobstructed.

Trading institutions are important platforms in the STO ecosystem and the primary targets of STO regulation. Their positive regulatory cycle will promote industry advancement, while a negative cycle will hinder industry development.

Comparing traditional securities trading institutions, such as the New York Stock Exchange, NASDAQ, and Hong Kong Stock Exchange, with digital currency trading institutions like Binance, OKEX, and Huobi, each has its pros and cons: traditional trading institutions possess credibility under strong regulation, while digital currency exchanges are often questioned due to regulatory gaps; however, strongly regulated exchanges may lack transparency due to centralization issues, which is precisely the attribute of blockchain.

Therefore, how to effectively regulate STO trading institutions to ensure they possess credibility while also gaining the public, transparent, and traceable characteristics endowed by blockchain is the most critical factor in whether the financial practice of securities tokenization can succeed.

Builders are the technological drivers in the STO ecosystem and the core driving force behind asset securitization and tokenization. Their blockchain attributes make regulation challenging. The realization of securities tokenization relies on blockchain technology, involving the chains within blockchain and the tokens generated within those chains. The task of builders is to complete the tokenization of assets through chain reform and coin reform and connect them to trading institutions.

From a technical perspective, the tokenization of assets is not particularly difficult, but for regulation, it is the most challenging because the attributes of blockchain itself prevent regulation from being conducted as it is with traditional securities, which are strictly segmented by national barriers. Thus, to some extent, builders present a global challenge to regulators.

Investors are the driving force behind ecosystem development. Without investors, STO can only remain in the experimental stage, so the identification of qualified investors is crucial, as the recognition standards differ between individuals and institutions in different countries.

Of course, each role is not singular; for example, in the structure of Shenzhou Digital Group, MasterDax plays the role of a builder. In the past, it utilized underlying blockchain technology and cloud service platforms to open exchanges for multiple global clients and is currently building platforms for STO trading institutions.

Additionally, Shenzhou Digital Investment's Goopal Group, a decentralized blockchain group, has also incubated the Vdax trading platform, which has obtained a license for token trading and positions itself as a compliant STO trading platform.

IV. Penetrative Regulation

The future has arrived; the trend of STO is unstoppable. Projects must learn to embrace regulation, and investors must learn to be cautious and rational. For this new phenomenon of STO, current regulation still has significant room for development, with differentiated regulatory attitudes among countries. The penetrative regulatory challenges brought about by blockchain attributes are likely the most troublesome for governments.

Although China has not yet issued relevant policies targeting STO, as the two largest economies in the world, the attitudes and practices of the U.S. and China towards financial regulation are actually converging in certain aspects, namely penetrative regulation rather than sandbox regulation.

For practitioners who have already entered or are preparing to enter the STO field, it is essential to know how to make the most favorable choice between penetrative regulation and sandbox regulation, as this not only concerns future development but even life and death in the present.

In fact, the U.S. applies penetrative regulation to STO and the entire financial system: all projects intending to issue STO must comply with relevant regulations or exemption clauses from the SEC, which stipulates relevant provisions regarding investors and financing amounts. This is in stark contrast to the sandbox regulation seen in the UK, Singapore, Hong Kong, and other regions.

As of now, China has not introduced relevant policies and regulations for STO, but based on the national emphasis on finance and the increasingly stringent practices, it can be inferred that if STO is permitted in the future, it will certainly be under penetrative regulation rather than sandbox governance.

Thus, for STO practitioners, this means that if they want to operate STO between the two major countries, they must adapt to this strict penetrative regulation and comply with and serve the policies and the national will behind them. For instance, the current STO projects in the U.S. are largely based on exemption clauses, and once a securities exchange like NASDAQ truly joins, the rules of the game may change.

Another example is the establishment of the Sci-Tech Innovation Board in China's capital market on November 5. Many believe it will impact China's STO, with some even suggesting that under the effect of the Sci-Tech Innovation Board, China's STO will suffer a heavy blow. However, we need to first understand why China launched the Sci-Tech Innovation Board to better analyze and predict its impact on STO.

As a national strategy, the Sci-Tech Innovation Board has the important attribute of top-level design, which will inevitably gather more resources and obtain a green channel. This top-down support, along with the positive response from the internet and investment circles, is something that the relatively grassroots STO lacks.

It is foreseeable that under policy support, the two major attributes of the Sci-Tech Innovation Board—encouraging enterprise innovation on the content side and implementing a registration system on the form side—will make it easier for cutting-edge technology companies to obtain financing and enter the capital market. This will undoubtedly have a siphoning effect on STOs with similar attributes.

However, as a financial practice of asset securitization, the main function of STO is to broaden financing channels, reduce financing costs, and enhance liquidity, which aligns closely with the original intentions of the Sci-Tech Innovation Board. The relationship between the Sci-Tech Innovation Board and STO is not one of mortal enemies but rather one of potential integration and mutual benefit.

Both the Sci-Tech Innovation Board and STO are incremental reforms. The Sci-Tech Innovation Board aims to fill the gaps in China's capital market in serving technological innovation. STO can not only provide capital support for blockchain-related enterprises but also leverage the borderless nature of blockchain and its inherent token financial attributes to greatly enhance the global liquidity of traditional assets by bringing off-chain assets on-chain, thus bringing new opportunities to the capital market. The focus of both the Sci-Tech Innovation Board and STO is to provide better support for high-tech startup companies through the capital market, and they do not conflict with each other.

In the context of a cooling global capital market and the prolonged U.S.-China trade war, China's move to continue deepening reforms and expanding openness is significant. The impact of the Sci-Tech Innovation Board on China's capital market is profound, and as a financial practice, STO is naturally also deeply affected, with the possibility that the Sci-Tech Innovation Board may become a pilot for securities tokenization in the future.

Xiao Lei, who has extensive research in both traditional securities and blockchain fields, believes that STO will have more underlying assets, but it is currently difficult to break away from the centralized exchange system. The Sci-Tech Innovation Board may increase regulatory agencies' attention to various digital assets and may even adopt blockchain technology to assist in regulation.

I strongly agree with Xiao Lei's view. Whether it is STO or the Sci-Tech Innovation Board, both are experimental and play a positive role in providing support for high-tech startup companies in the capital market. They are not opposing ends of "you die, I live," but can coexist. The essential attributes of STO—asset securitization + securities tokenization—may be introduced into the new Sci-Tech Innovation Board, and the model of "Sci-Tech as the body, STO as the use" is not without possibility.

V. Opportunities Under the Sandbox Mechanism

At the same time, for blockchain enterprises looking to operate STO in both countries, it is essential to consider not only the issue of penetrative regulation but also to find their own role—likely becoming a part of the landscape dominated by internet giants or capital behemoths.

Over the past year, whether it is China's BAT internet giants or Wall Street commercial giants, they have all laid out their blockchain strategies. Compared to relatively grassroots startups that originated from blockchain, these giants have undeniable advantages in talent, users, capital, and scenarios, coupled with favorable policies, which will undoubtedly allow them to take the lead in the Sci-Tech Innovation Board or STO.

However, blockchain startups can also transform through STO as a financial practice. Because aside from penetrative regulation like that in the U.S. and China, there are also relatively relaxed and inclusive sandbox regulations.

The concept of "regulatory sandbox" was first proposed by the UK government in March 2015. According to the UK Financial Conduct Authority (FCA), a "regulatory sandbox" is a "safe space" where fintech companies can test their innovative financial products, services, business models, and marketing strategies without being immediately bound by regulatory rules when encountering issues in related activities.

It can be said that sandbox regulation encourages more innovative solutions to actively turn ideas into reality by proactively and reasonably relaxing regulatory requirements and reducing barriers to financial technology innovation. This approach has inspired many countries to follow suit, with Australia, Canada, Singapore, and recently Hong Kong adopting this method.

For blockchain innovation enterprises, once the close constraints are lifted, they will have tremendous explosive potential, because compared to internet giants and capital behemoths, they possess unique advantages: a group of blockchain technology talents who have been tempered, idealistic entrepreneurs, early-stage investment funds, and deeply ingrained blockchain thinking—attributes that non-blockchain practitioners lack and cannot easily make up for in the short term.

Therefore, startups with greater dreams and ambitions can choose to explore STO in countries and regions with sandbox regulation at this stage. Under relatively relaxed sandbox regulatory policies, what practitioners need to do is to thoroughly run through all aspects of STO, turning the concept of asset securitization + securities tokenization into practical implementation.

Importantly, against the backdrop of the retreat of virtual digital currency speculation over the past year, the secondary market has already borne a serious negative reputation, so STO must clear its name from the primary market. Only in this way can it gain recognition from the state and government, trust from investors, and willingness from the public to understand and gradually accept it.