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What are security tokens?

Find out why they're called the next big thing - and where to buy and trade them.

Security tokens refer to financial securities, such as stocks, bonds and commodities whose ownership is attached to a crypto-token, hosted on a blockchain. Security tokens represent a more traditional type of asset than value-based cryptocurrencies or utility tokens and as such are sometimes referred to as digital assets, rather than cryptocurrencies.

Thanks to improved regulatory environments worldwide – and particularly in the US – security tokens finally have the green light to enter the marketplace like never before.

Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific provider, service or offering. It is not a recommendation to trade.

What are security tokens?

Security tokens are revolutionary because they allow for securities such as stocks, bonds or derivatives, as well as commodities and real estate to be hosted on the blockchain in a tokenised format.

In the US, securities are classified depending on whether or not they pass the Howey Test. The Howey Test relies on four basic criteria, which are used to assess whether or not a financial product is a security. If a product conforms to these criteria, then it’s likely to be defined as a security by the SEC:

  • People invest money into the product.
  • People are expecting profits from the investment.
  • The act of investing is a common enterprise – multiple people, or groups of people, can share in the investment.
  • Profits are dependent on the issuer of the investment, investment promoter or a third party, rather than the investors themselves.

Because security tokens are a new and somewhat borderless asset class, they actually refer to much more than just the Howey Test’s definition of a security.

Definitions of security tokens often include assets like commodities, real estate, physical property and art. But the exact definition varies depending on where you are, who you ask and which country you operate in.

As a general rule of thumb, security tokens are attached to either a real-world asset, like gold: rights to future profits, such as dividend payouts; or equity, including shares in a company. A utility token can also entitle the holder to specific rights on a network.

Blockchain lawyer Michael Bacina discusses security tokens

Advantages of security tokens

Why are people so excited about security tokens? Security tokens allow for all the advantages that come with trading on the blockchain.

Security token exchanges

With security tokens set to lead the next evolution of blockchain markets, exchanges are excited to join in on the action. As such, a number of existing cryptocurrency exchanges are exploring adding security tokens to their rosters. In some cases new exchanges are being built to more closely comply with the regulation required to trade securities as well as cryptocurrencies.

  • Poloniex (in accordance with US law)
  • Coinbase (in accordance with US law)
Note that some exchanges already trade security tokens. However, they may not be legally allowed to select jurisdictions or may not even know they’re hosting a security token. We list only exchanges with explicit legal permission to trade securities in their given jurisdiction.

Finally, decentralised exchanges are another place where you might be able to trade security tokens, although given their decentralised nature, it is up to the user to research whether trading securities on such an exchange is legal according to their country’s laws.

Difference between utility tokens and security tokens

The difference between utility and security tokens lies in what they entitle the holder to and how they’re issued and used.

In short, a utility token gives you rights to operate and participate on a network, whereas a security token gives you rights of ownership or entitlement to an asset.

Utility tokens

A utility token gives the holder specific rights on a network, such as the ability to transact on Ethereum by paying fees in ETH or participate in voting on EOS by staking your tokens. On the peer-to-peer electricity trading platform, Power Ledger, users must first acquire and stake POWR tokens in order to buy or sell electricity on the network.

Utility tokens are typically issued through initial coin offerings – or ICOs. With an ICO, buyers sign up and purchase utility tokens for an agreed-upon amount, often less than US$1 per token. ICOs are conducted in a number ways, but a more common method is to send ETH or another cryptocurrency to a smart-contract address. When the token sale period is over, that smart contract then sends back the newly minted utility tokens in return.

Another way of issuing utility tokens is to airdrop them to existing cryptocurrency holders at random. Tokens anticipate that users will take up the use of the associated network because they now own the token.

Securtity tokens

A security token is a tokenised version of a real-world asset or security that can exist outside of the blockchain. Assests can be a share in an investment portfolio, a single Amazon stock or a gram of gold.

But the world of security tokens is more tightly regulated that ICPOs and airdrops. Securities have strict laws that accompany their sale and trade, whereas assets are usually a bit more fluid.

Stephane De Baets of Elevated Returns discussing the Aspen Coin STO

For example, Aspen Coin gives holders shares in a real estate investment trust (REIT), which includes the St. Regis Aspen Resort. A share in a REIT is a type of security. In addition to ownership of shares, the coin also entitles holders to dividends paid out by the REIT.

The security token offering (STO) was conducted through Templum Markets, which is an SEC-registered trading platform. In the US, only accredited investors were allowed to participate, but outside the US anyone was allowed to join, provided they had the minimum amount of US$10,000 to participate.

STOs must abide by strict know-your-customer (KYC) and anti-money-laundering (AML) laws as well as a host of other legislation. While many ICOs now implement KYC and AML, it wasn’t always the case, and and airdrops circumvent this practice altogether.

Security token offerings

Along with a new type of token comes a new type of token offering. Security tokens are issued via security token offerings – or STOs – that involve more legal procedures than ICOs or airdrops. As a result, you’ll find several new platforms developed to help aid the legal aspects of issuing STOs.

For instance the Polymath network uses a new token standard called the ST-20 which features built-in compliance, allowing users to issue security tokens in the US. Securitize and Harbor are two platforms that use the Ethereum blockchain to issue ERC-20 tokens with built-in compliance measures.

Then there is Neufund, a token issuance platform based in the EU, which has developed a hybrid model called the Equity Token Offering, a hybrid model that combines features of ICOs, IPOs and venture capital funding.

STOs are still a very new concept, so it is likely that their operation, legal status and availability will be subject to change over the coming months and years. Because they focus on laws within a certain jurisdiction, it’s also likely that eligibility will vary.

STOs vs ICOs

In the context of startup fundraising, STOs are becoming regarded as a more equitable way to raise capital than the previous ICO model.

This is because they give buyers an actual asset, such as a share of the company’s equity, rather than a utility token which is technically decoupled from the success of the underlying company. If a company issues a utility token and then later made profits in ways that aren’t connected to the utility token, the utility token holders have no rights to share in those profits.

As a result, many companies in the future will be under pressure to issue tokens via an STO instead of an ICO, when they can.

On the other hand, if a company issues security tokens via an STO – where the security token represents something like an equity share in the company – then the holders of the token are expected to share in that success through ownership of the token. Security tokens may even entitle the holder to dividends.

But remember that a security token can be almost anything tangible, such as previous metals or property. Just because you’re participating in an STO doesn’t mean you’re getting shares in a company.

This isn’t to say that utility tokens are less valuable than security tokens. Rather, they are two different products with two different use cases. The issue is that utility tokens have been used to fill the role of security tokens, often leaving buyers with a product of questionable value and legality.

Now that regulatory bodies around the world are taking on cryptocurrencies, information on whether a token is legally a utility or security is clearer. The way is now paved for security tokens to enter the market according to local regulatory bodies, such as the Securities and Exchange Commission (SEC) in the US.

As a result, it’s unlikely that one type of token will dominate. Instead, companies looking to fundraise will now have the option of deciding which type of token best suits their product.

It’s up to savvy consumers to make sure they are getting the best deal, which involves critically thinking about whether a security or utility token is best suited to the product.

Are security tokens legal?

It depends on the jurisdiction in which the token was created and is traded in.

Each jurisdiction has its own laws about what constitutes a security, who can issue securities, who can sell securities and who can buy securities.

If the country is hostile towards Bitcoin and cryptocurrencies, then there is a chance security tokens will be swept up in those laws too.

In the US, security tokens and cryptocurrencies largely come under the remit of the SEC, which has been known to use the findings published in the DAO Report in assessing whether or not a token is a security.

Securitize CEO Carlos Domingo explains the legalities of security tokens

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In a nutshell

Pros

  • Efficient and oriented to the future. A more efficient way to trade securities, it blurs the lines between cryptocurrency markets and legacy markets.
  • Regulated and legitimate. It’s to local laws and regulations that offer levels of consumer protection, and exchanges further legitimise blockchain markets.
  • Compliant. Regulatory compliance can be programmed into the token.
  • Driver of liquidity. Blockchain leads to more democratic involvement in financial markets, which is anticipated to increase liquidity over the long term.
  • Innovative. Fractional ownership opens up new investment pathways.
  • Traceable. Increased traceability means stolen funds could potentially be returned to the user.
  • Encouraging new tokens. Security tokens offer a more traditional form of investment than utility tokens.

Cons

  • Developing. It’s an emerging market with limited availability of tradable securities and assets.
  • Complex. It’s restricted by laws and regulations, which makes trading more complex than utility tokens or cryptocurrency.
  • Not always legal. It may not comply with the laws where you live.
  • Relies on personal responsibility. It requires more accountability on the user to know the products and markets they can legally interact with, especially on a decentralised exchange.
  • Potentially not secure. Blockchain security is still a developing field and is vulnerable to hacking and phishing.

FAQs

Disclaimer: Cryptocurrencies are speculative, complex and involve significant risks – they are highly volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of future performance. Consider your own circumstances, and obtain your own advice, before relying on this information. You should also verify the nature of any product or service (including its legal status and relevant regulatory requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may have holdings in the cryptocurrencies discussed.

Picture: Shutterstock

Disclosure: At the time of writing, the author holds BTC, XRP, BNB, ETH, XLM, PWR, VET, ICX, WAN, ETC, LRC, QASH, XMR, NEO, NXS, THETA and BAT.

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