How to get an STO approved by German regulators – Thought Leaders
After over 130 security token prospectuses were submitted to BaFin, the German regulator, it was the Bitbond STO that was the first to be granted approval.
In 2016, Bitbond became the first blockchain business to be regulated as a financial institution in Germany. The next logical step was to crowdfund our growth – compliantly – with a bond issued on blockchain technology.
As the first, we had no guidelines to follow, but we learned a lot in the process that followed. Rather than keep these insights to ourselves, we want to share them, in the interests of growing the whole industry and encouraging adoption.
What makes an STO an attractive option?
The institutional mismanagement of money that triggered 2008’s global financial crisis has had profound effects on investor appetite for alternative products. Crowdfunding and micro-lending have been growing, which has enabled a new frontier: decentralized financial products.
Relying on no bank or centralised authority, decentralized finance encompasses cryptocurrencies and blockchain-powered financial products that are decentralized, relying on less middlemen or intermediaries.
Security Token Offerings (STOs) – where a company creates a digital asset that represents a tradable stake or asset, which it sells to investors in return for capital – have been a natural progression from the crowdfunding boom launched by Kickstarter in 2009 and crowdlending movement initiated by Topa and LendingClub.
The sale of a digitized version of a security, STOs have become an onboarding point for non-crypto investors to learn about digital assets. At the same time STOs are a cheaper, and more efficient tool for businesses to fundraise, with the added benefit of a compliant structure to adhere to.
So, what does it take to launch a regulated STO?
Step One: Get your business, and your story, in order
Obtaining regulatory approval for any financial product is not easy. It shouldn’t be. With emerging technology like an STO, the barriers become even steeper.
Before embarking on the road to regulation, you need to clarify your motivations within your business. What makes an STO the most efficient method of fundraising for your goals? How will a diverse pool of international investors offer more value to your business than a smaller pool of sophisticated investors or experienced VCs?
For Bitbond, it made sense to launch an STO to the public, as the core product is about creating access to finance for underserved demographics, in a compliant way.
Similarly, when Blockstack, a decentralized computing ecosystem, was looking to raise money in a decentralized and accessible way, it made sense for them to make use of the SEC’s crowdfunding regulation, Reg-A+.
When a business is built on the idea of decentralization, using a fundraising method that encourages wider participation and access is the logical route to take.
Step Two: Talk – and listen – to regulators
In Germany, regulators have defined cryptocurrencies and other blockchain-backed tokens as units of account, so they have to be treated as financial instruments. This means any kind of service for third parties in relation to cryptocurrencies or crypto tokens must be authorised by BaFin.
Whilst they judge on a case-by-case basis, any token or cryptocurrency project looking to facilitate the issuance, exchange or other services around tokens must make their case to BaFin.
When BaFin are presented with a prospectus, they must give feedback within 20 days, which is a short time, even when they are assessing a product they already know.
With emerging technologies, a different tactic is needed: the blockchain industry needs to talk to the regulators, not just on the products we’re building, but on the ecosystem at large.
In April 2018, Bitbond reached out to BaFin, to present a legal framework of the Bitbond STO. By opening the conversation with something tangible to build from, we could tailor our prospectus around their concerns.
Over the next months, we went back and forth with the regulators; much of conversation centred on how blockchain transactions work, what additional risks and opportunities stem from them, the unique features of the Bitbond offering and how the proof of ownership in the security works if there is no central clearing.
We took things back to basics, when talking to BaFin to provide a crash course in the fundamentals of blockchain. We answered numerous questions on how the blockchain works, what Ethereum and Stellar are and how transactions work on these protocols.
This gave them the language to interrogate our project – and helped us identify the main areas of concern and the risks BaFin wanted to see addressed in a prospectus.
By teaching them the context, including the fundamental pillars of blockchain technology, and the way tokens facilitate the use of that technology, we can help regulators make more informed decisions, and ask better questions.
Step 3: Prepare a prospectus that addresses concerns and regulations
They may bring administrative hassle, but regulators play an important role in the financial ecosystem. They hold businesses like us to account to maintain the stability of the financial system and protect consumers.
In Bitbond’s case, the idea for the STO came in February 2018, conversations began with the regulator in April, a prospectus was submitted at the end of October, with approval being granted in January 2019: nearly a year later.
This took longer than a standard securities application, but that was because the concept we were presenting was so new – there was nothing the regulators could compare it with.
Investing this time was worthwhile, as we now have the first mover advantage with the first regulated STO in Germany.
More than that, we have the privilege of paving the way for more German and European businesses to launch compliant STOs.
An STO remains a more efficient way of fundraising than going through a private VC fund or accredited investors: there is only one prospectus to prepare, rather than having to tailor many proposals to individual institutions or investment banks.
This prospectus must cover all conceivable risk factors that exist for investors. These range from unexpected rises in transaction fees reducing the profitability of the bond, through to the tax risks associated with holding an emerging asset class that is subject to legal changes.
Projections must be made, and justified. Assets and liabilities must be declared and broken down in a balance sheet. The target market must be identified, and characterised.
An extensive history of the issuer and its business activities must be laid out, in language that the investors will understand.
Once all the details have been laid out, there are far fewer intermediaries needed between the business and investors, which makes the raising process significantly leaner, more efficient, and easier to manage.
With these future savings, educating the regulators is a worthwhile investment.
Conclusion: Education and open-mindedness will improve access to alternative forms of finance
It is in the interests of all stakeholders in this space – from regulators to businesses to customers – for emerging technologies to operate within a compliant structure. We have already started working with other companies looking to gain the regulator’s approval and use our technology for the issuance process.
As well as a fundraising method, an STO has become a vehicle to teach investors about digital securities.
It is exciting that the process of getting approval for a prospectus can become an extension of this educational process, which can act as a catalyst for regulatory engagement.
BaFin’s willingness to interact, and learn from the industry is an exciting opportunity for Germany to step up as world leaders of innovative financial services and products.
If the industry continues to invest time and resources to educate and work together with regulators, we can create a framework for compliant STOs, which in turn provides a welcoming environment for the next generation of compliant digital securities.
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