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.
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
Security tokens also include assets outside the traditional world of finance – such as the DAO token which was attached to a purely cryptoeconomic investment and development fund operated solely by a blockchain. The DAO token entitled holders to dividends and voting rights, similar to shares in a traditional managed investment fund.
The DAO token was initially sold as a utility token through an ICO in 2016. However, it was retrospectively classified as a security by the SEC in the US in July 2017. The report that led to the ruling, called the DAO Report has also been used to retrospectively classify several tokens as securities since it was published. In conjunction with The Howey Test, the report is considered a useful tool in determining whether a token is likely to be classified a security token within the US.
Like all new asset classes, security tokens have had their fair share of teething problems. Several existing tokens have been reclassified as securities since the release the Dao Report, and more are likely to follow. Of those tokens considered securities, not all were sold via compliant methods or registered with the SEC. Furthermore, not all exchanges that trade security tokens are permitted to do so, which is why our exchanges guide below only lists exchanges that are legally registered to trade securities.
Security tokens are still in their early stages, but their future appears clear. They are increasingly being programmed to comply with local laws and regulations in line with the underlying security. Firms like Securitize and Neufund work with clients to launch tokens that are in strict compliance with local securities laws, wherever in the world that may be.
Programming a token with built-in compliance means that some tokens are only traded between individuals and institutions that are legally allowed to possess them. The ability to program tokens in this way is just one of several advantages security tokens possess over legacy systems.
Furthermore, the emergence of highly specialised security token exchanges will provide a lot of much-needed clarification to traders, who are likely scratching their heads about which security tokens they can and can’t trade. According to Securitize CEO Carlos Domingo “The exchange needs to onboard the investor” and then verify which markets the trader can participate in. This means that the onus will lie with the exchange, rather than the user, smoothing and familiar experience that cryptocurrency traders are familiar with.
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.
Blockchains are an immutable database of transactions, which helps protect against fraud, malpractice and corruption. And because most blockchains keep a public ledger that’s accessible by anyone, anyone can audit the ledger.
While some blockchains are notoriously slow, others are tailored to financial markets and can process transactions at dazzling speeds. With smart contracts, security tokens can automate the need for time-consuming tasks that normally require a middleman.
Smart contracts can help eliminate menial tasks that slow things down. Better yet, they can be programmed to deal with much of the legal requirements of securities – such as know-your-customer (KYC) and anti-money laundering (AML) laws, regulatory requirements and legal interpretation – meaning only those who are allowed to use the security will be able to trade it.
Part of the blockchain revolution has been opening up financial markets to those who otherwise would not be able to participate. As a result, capital flows in from places and people that it previously didn’t. Further, digital asset markets operate 24/7 and aren’t constrained by trading hours. The result is a more active and liquid market for securities and assets.
Security tokens enable fractional ownership of assets, increasing the liquidity of an asset – which is a valuable metric for traders. It’s like valuable art owned by multiple parties, real estate divided among thousands and even rare artifacts and precious rainforests safeguarded by the public.
It’s known that there is an $80–$100 billion dollar inefficiency in the way that securities are traded today – Securitize CEO Carlos Domingo on why security tokens are better than legacy systems
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.
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.
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.
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
In mid-2018 the SEC announced that Ether – the native token of the Ethereum blockchain – was not a security. It did note that tokens on top of Ethereum may be considered securities. Perhaps most importantly, the SEC added that it is possible for coins or tokens to change status depending on how they operate.
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.
James Edwards is a personal finance and cryptocurrency writer for Finder. He has qualifications in both psychology and UX design, which drives his interest in fintech and the exciting ways in which technology can help us take better control of our money. His expertise has seen him called on to report at events such as TechCrunch Disrupt, CoinDesk Consensus and IBM Think.
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