In traditional finance, a security is defined as a stake of ownership in a publicly-traded corporation (like shares of stock), a creditor relationship with a public entity (such as a bond), or in the case of options contracts, a right to ownership.
Security tokens are tokenized securities. They are digital forms of traditional securities that live on a blockchain. These tokens could represent ownership of a fraction of any valuable asset, like a car, real estate, or corporate stock.
Why do these tokens exist, how do they work, and what are the benefits? We’ll answer those questions and more.
Crypto Refresher: Tokens vs Coins
First, a distinction needs to be made between tokens and coins. The term “cryptocurrency” is sometimes used to broadly refer to anything that moves along a blockchain.
But coins or currencies are those crypto assets that represent value on their own. Bitcoin (BTC), Litecoin (LTC), and Ether (the native currency of the Ethereum network) are all considered coins. Their main use case is to store value and act as a medium of exchange.
Crypto tokens, however, serve a specific function of some kind. There are different types of tokens, like utility tokens or security tokens. Utility tokens are backed by a project and company that has developed a use case for the token.
An example of a utility token is Brave’s Basic Attention Token (BAT). This token is given to users of the Brave browser in exchange for opting in to view advertisements. Brave users can then use the tokens to tip their favorite content creators. BAT exists as an ERC-20 token running atop the Ethereum network.
Recommended: Crypto 101: A Beginner’s Guide to Crypto
What is a Security Token?
Security tokens don’t need to have a utility. A security token represents some kind of ownership, most commonly a share of the company issuing the token. The concept is the same as buying shares of stock on a traditional stock exchange. For this reason, security tokens are sometimes referred to as equity tokens.
Security tokens are regarded as securities by financial regulatory authorities. This makes a security token subject to regulations, just like ordinary stocks and bonds.
Some investors in the crypto space — which has so far been largely unregulated or left to stand in legal gray areas — might see this as a negative. On the other hand, investors who come from the world of traditional finance might celebrate the fact that security tokens offer all the legal protections and regulatory clarity they are accustomed to.
Recommended: Cryptocurrency Rules & Regulations You Should Know
The Howey Test
In the United States, anything that meets the definition of a “security” falls under the regulatory purview of the Securities and Exchange Commission (SEC). This includes security tokens. While this seems straightforward, there are still quite a few tokens that have characteristics of securities while also being utility tokens, leaving their future uncertain.
The SEC uses something called “the Howey Test” to determine whether or not something qualifies as being a security. The test has a four-part parameter:
1. Investment of money… meaning that someone has invested in goods or services
2. In a “common enterprise”… meaning that investor’s funds are either interwoven (horizontal commonality) or there’s a direct correlation between the promotion of the investment and its success or failure (vertical commonality)
3. With an “expectation of profit”… an expectation of profits can be either from fixed returns or capital appreciation
4. “Solely on the efforts of others”… meaning that if any profit involved stems from the efforts of the people who promoted the investment, it fulfills the fourth part of the Howey Test
It boils down to this: when someone invests money into something in the hopes of profiting from the efforts of another person, that investment can be considered a security.
How Do Security Tokens Work?
Most companies create security tokens in the same way. A company will issue a security token that represents a claim of ownership in the business. Then they establish a whitelist of crypto wallet addresses of the investors who will be permitted to buy those tokens.
To be put on the whitelist, potential investors have to be able to prove that they are compliant with any restrictions and regulations put on that security. This involves, at a bare minimum, compliance with know your customer (KYC) and anti-money laundering (AML) laws. While it’s not possible for a security token to incorporate all the regulations of numerous jurisdictions around the globe into its protocol, companies can comply with most regulations by restricting who can buy and hold the token.
While trading through a counterparty that is whitelisted, most people can trade security tokens just about however they like. Open Finance, Blocktrade, and tZero are some of the first exchanges designed for this type of activity.
How Are Security Tokens Used?
Security tokens differ from other cryptocurrencies in that they can be digital, liquid contracts for ownership of a part of an asset.
There are many potential applications for a token of this type. Real estate investment trusts (REITs) could issue shares of stock on a blockchain, and those security tokens would amount to owning a piece of real estate.
Companies could go public on security token (STO) platforms, giving access to a wider range of investors than those who would traditionally be eligible to invest in a company before its initial public offering (IPO) on a major stock exchange.
Benefits of Security Tokens
Security tokens bring all the benefits of blockchain with none of the friction, delays, or fees associated with traditional capital markets. At the same time, a security token can fractionalize any asset that already exists in the traditional market, no matter how big that market might be.
As security tokens are issued on a blockchain, investors can have full confidence that their ownership stake will be preserved on a public ledger. There’s little to no opportunity for market manipulation, corporate deception, or misunderstandings about how many shares there are or who owns them.
Investors may also have the peace of mind that comes from knowing that the tokens are classified as securities by regulators, eliminating any uncertainty surrounding what laws apply to the purchase, sale, or ownership of security tokens.
How to Invest in Security Tokens
For individuals who want to invest in security tokens, one place to start is with an STO platform. These exchanges host these digital assets, allowing investors to buy and sell tokens as they would stocks or any other investment.
Projects like The Elephant, Funderbeam, and Causam Exchange are working to merge traditional and crypto markets, utilizing blockchain infrastructure to bring access to capital markets to a wider audience in a more accessible way than was once possible.
The Takeaway
Security tokens are like little pieces of an asset that live on a blockchain. They have properties of both traditional financial instruments and crypto assets. Some enthusiasts hope that security tokens can one day improve financial markets for the world by allowing a greater number of people access to investments.
Photo credit: iStock/LightFieldStudios
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