STOs and NFTs
The Non-Fungible Token (NFT) and the Security Token Offering (STO) markets have grown rapidly over the last couple of years. The STO market has gained recognition as a more trustworthy and reliable way of financing compared to Initial Coin Offerings (ICO), mainly due to the fact that STOs have to comply with securities laws and regulatory requirements. This shift in attention took place around the start of 2018, after experiencing peaks and crashes of a series of ICOs.
Given the increasing interest in NFTs, we noticed that for some it is unclear how NFTs differ from STOs. The confusion between the two can lead to them being used under the wrong circumstances, and it is often the case that an STO would be better suited for a financing project than an NFT. It is therefore important to understand how they differ from one another in their characteristics and purpose, in order to avoid a similar situation to what happened with ICOs.
In this article, we aim to clarify the differences between STOs and NFTs, and further explain why, based on their characteristics, the use of one might be more suited for certain situations than the other.
An NFT is a non-interchangeable (non-fungible) unit of data that is stored on a distributed digital ledger, that can be sold and traded. Each NFT is unique and undivisible, implying that in principle the fractionalisation of an NFT is not possible as then the fractionalised tokens would become fungible.
NFTs offer a new way to evidence the ownership and/or the rights of use of any kind of digital content. They do so by embedding into the content a non duplicable identifier that is recorded on a blockchain (e.g. Ethereum or Flow). Therefore, a digital content creator can prove the existence and the ownership of a digital asset. The creator could also, among others, determine the scarcity, earn royalties every time the NFT is sold, and sell it on any NFT market or peer-to-peer. By using smart contracts in NFTs, all the rights and conditions embedded therein are indefinite and are carried out irrevocably following each trade. Nevertheless, a concern has been raised regarding ownership of NFTs, implying that anyone can ‘mint’ a digital file as an NFT, regardless of the fact that they might not own (or have rights to) the digital content in the first place.
Although it seems that the digital assets’ market is rapidly adopting NFTs and exploring their potential use as proof of ownership, this is far from true regarding physical assets. Despite the increasing interest in issuing NFTs that represent physical assets, in reality it is difficult to keep track of both a physical asset and the digital NFT linked to it. For instance, an individual could buy an NFT online, whilst the holder of the physical asset could in the meantime sell the asset directly to another individual. The question is whether the NFT would then be enforceable as proof of ownership of the physical asset, which in practice is rarely the case.
Depending on the type of asset, additional documentation or action may be needed to transfer a physical asset. For example, when we look at the process to transfer a house, some jurisdictions may require a notarial deed stating the transfer of ownership or updating the public records to reflect the identity of the new owner. Furthermore, it is unclear how different intellectual property laws may interpret NFT rights in each jurisdiction.
STOs, just as NFTs, make use of blockchain technology but, unlike NFTs, combine the advantages of the technology with the requirements of the regulated securities market. An offering of a security token is typically the issuance (or representation) of a financial instrument in the form of a digital token in a blockchain environment. It is essentially a digital representation of ownership of assets (e.g. a share in a real estate company) or economic rights (e.g. interest on a debt instrument). In order to be sold as securities to investors, security token issuers must meet the requirements set by the law applicable within the jurisdiction in which they would like to issue and offer the tokens.
STOs offer many benefits to both issuers and investors. For issuers (for example asset owners or entrepreneurs), the issuance of security tokens allows them to issue and trade their assets online, and to benefit from the use of blockchain technology to generate funds and liquidity, while benefiting from strategic cost reduction. STOs also offer issuers the opportunity to sell their product to a greater online audience, thereby creating a community, and split their assets into smaller tradable fractions in the form of tokens, opening the market to a new type of investors.
On the other hand, investors are given the opportunity to invest in certain assets, such as real estate, at a lower price than it would traditionally require. In addition, STOs broaden the spectrum of available assets to invest in, fostering financial inclusion. Investors also benefit from the transparency that blockchain technology offers, with all the information being disclosed and updated on a distributed ledger. Finally, and most importantly, STOs are regulated, which means that unlike ICOs and NFTs they pose a lesser threat to scams, and offer increased investor confidence.
Over the past few years, we have seen an increase in eagerness of different countries to introduce laws facilitating the use of distributed ledger technology in the securities sector, which is a logical development in view of the potential that security tokens have to offer.
4. STOs or NFTs?
It is important to look into the specific characteristics of a project to determine whether an NFT or an STO would be more suitable. One of the most relevant elements to consider is the risk of requalification. There have been several recent lawsuits filed against creators of NFTs, such as the NBA Top Shot’s NFTs which have been alleged to ‘derive their value from the success or failure of a given project, promoter, or start-up’ and according to the plaintiff are therefore considered as securities that should have been registered with the Securities and Exchange Commision in the United States. This lawsuit reveals that issuers of NFTs are faced with the risk of selling products that may classify as securities, and could therefore be exposed to the legal consequences of selling unregistered securities. This risk would not exist with STOs, as security tokens would already qualify as securities in the first place.
In addition, STOs may be a more suitable way for issuers to gain liquidity and funding, while still holding on to (a part of) the ownership themselves. By fractionalising an asset by way of security tokens, issuers are still able to hold on to an amount of the issued tokens. As mentioned above, NFTs cannot be fractionalised without losing the non-fungibility element. As such, STOs offer certainty regarding ownership and enforceability of the rights attached to the tokens, which is not currently the case for NFTs.
At 2140 Consulting, we provide consulting and advisory services to companies or individuals looking to issue, trade or invest in NFTs or STOs. 2140 Consulting has been at the forefront of tokenisation since 2018, and strongly believes in its great potential, even more now that regulations are being adapted to promote the use of distributed ledger technology.
Written by Nefeli Maroulakis, Legal Advisor at 2140 Consulting.