What are security tokens?
Find out why security tokens are being called the next big thing, and where to buy and trade them.
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If ICOs and utility tokens were the big cryptocurrency trend of 2017, then the scene is certainly set for security tokens to take centre stage in 2019.
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 across the globe (particularly in the US) security tokens finally have the green light to enter the marketplace in a legal and compliant way like never before.
Below we explore security tokens in depth, we explain what makes them different to utility tokens, list which exchanges currently support them and take a look at how they work.
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.
Before we go on though, it's important to understand what a security is. Securities traditionally refer to a very broad range of financial assets which can be traded on a regulated market. Common types of securities include stocks (shares), bonds, options and derivatives.
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.
However, 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.
As such, definitions of security tokens often include assets like commodities, real estate, physical property and art. Thus, it is important to know that security tokens can in fact refer to much more than just "securities".
What this all means is that the definition of a security token can vary, depending on where you are, who you ask and which country you're operating in.
As a general rule of thumb, security tokens are attached to either a real-world asset (like gold), rights to future profits (dividend payouts) or equity (shares in a company). Alternatively, a utility token entitles the holder to certain rights on a network.
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 which led to the ruling, known as "The DAO Report" has also been used to retrospectively classify several tokens as securities since it was published. The DAO Report, in conjunction with The Howey Test, can be considered as two very useful tools 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. As mentioned above, several existing tokens have been reclassified as securities since the release of The Dao Report and more are likely to follow. And of those tokens which are regarded as 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 is looking 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 will only be able to trade hands between individuals and institutions that are legally allowed to possess them. Doing so helps avoid some of the situations outlined above. The ability to programme 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, which makes for the smooth and familiar experience that cryptocurrency traders are familiar with.
Advantages of security tokens
So why are people so excited about security tokens?
Security tokens are regarded as revolutionary because they allow for assets to be traded on a blockchain, with all the advantages that confers. Let's have a look at some of the advantages security tokens offer, over traditional financial markets.
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, while in some cases totally new exchanges are being built to more closely comply with the regulation required to trade securities as well as cryptocurrencies.
Below we've collected a list of exchanges that currently support security tokens.
- Binance (in accordance with Maltese law)
- Poloniex (in accordance with US law)
- Coinbase (in accordance with US law)
Lastly, 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 security tokens and utility tokens
Unlike most things in blockchain, the difference between security and utility tokens is actually quite clear.
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.
Let's expand on those a little bit.
As mentioned, a utility token gives the holder certain rights on a network, such as the ability to transact on Ethereum by paying gas 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 usually issued via initial coin offerings (ICOs) in which buyers sign up and purchase utility tokens for an agreed-upon amount, which is usually less than US$1 per token. ICOs can be conducted in a number of ways, but one of the more common methods is to send cryptocurrency (usually ETH) to a smart-contract address. Once 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, in the anticipation users will take up the use of the associated network because they now own the token.
Security tokens on the other hand exist in a much more tightly regulated world than ICOs and airdrops.
As outlined above, a security token is a tokenised version of a real-world asset or security that can exist outside of the blockchain. This could be a share in an investment portfolio, a single Amazon stock or a gram of gold. Securities have strict laws which 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.
As you can see, the difference between utility and security tokens is quite clear, both in terms of what it entitles the holder to, as well as how it is issued and used.
Security token offerings (STOs)
Along with a new type of token comes a new type of token offering. Security tokens are issued via STOs which involve more legal procedures than ICOs or airdrops. As such, several new platforms have been developed to help aid the legal issuance of 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 which 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 which looks to combine 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. Furthermore, because they focus on laws within a certain jurisdiction, eligibility to participate in STOs will vary on a case-by-case basis.
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.
As a result, it is likely that in the future many companies will be under pressure to issue tokens via an STO instead of an ICO, when applicable.
This is because an STO leaves buyers with a security token, rather than a utility token which is dependent on network usage to gain value. If a company issues a utility token and then later makes profits in ways that are not connected to the utility token, then unfortunately, utility token holders have no rights to share in those profits.
Furthermore, ICOs are more vulnerable to exit scams because the company issuing the utility token has no shareholders to which they are accountable.
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. Additionally, security tokens may even entitle the holder to payouts such as dividends.
However, it is important to remember that as outlined above, a security token can be almost anything tangible such as precious metals or property, so just because you are participating in an STO does not mean you are 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 frequently 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 have taken action on cryptocurrencies, information on whether a token is legally a utility or security is much clearer. As such, the way is now paved for security tokens to enter the market in accordance with local regulatory bodies, such as the Securities and Exchange Commission (SEC) in the US.
Therefore it is unlikely one type of token will dominate the other. Instead, companies looking to fundraise will now have the option of deciding which type of token best suits their product. Although it will still be up to savvy consumers to make sure they are getting the best deal, which will involve critical thinking about whether a security or utility token is best suited to the product.
Are security tokens legal?
The legal status of security tokens depends on the jurisdiction the token was created in and is being 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.
Furthermore, 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 a nutshell
- Efficiency: A more efficient way to trade securities than using legacy systems.
- Regulation: Subject to local laws and regulations which offer various levels of consumer protection.
- Compliant: Regulatory compliance can be pre-programmed into the token.
- Liquidity: Blockchain leads to more-democratic involvement in financial markets which is expected to increase liquidity in the long term.
- Innovative: Fractional ownership opens up totally new investment pathways.
- Traceable: Increased traceability means stolen funds could potentially be returned to the user.
- New tokens: Security tokens offer a more traditional form of investment than utility tokens.
- Legitimate: Security token exchanges offer further legitimacy to blockchain markets.
- Future-oriented: Further blurs the lines between cryptocurrency markets and legacy markets.
- Developing: Still an emerging market with very limited availability of tradable securities and assets at present.
- Complexity: Restricted by local laws and regulations which makes trading security tokens more complex than utility tokens or cryptocurrencies.
- Legality: May not be legally compliant in your area.
- Personal responsibility: More accountability on the user to know which products and markets they can legally interact with, especially when using a decentralised exchange.
- Security: Blockchain security is still a developing field and is vulnerable to hacking and phishing.
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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