A Beginner’s Guide to Security Tokens

Introduction

A security is a financial instrument that holds value and can be traded. Under this definition, many of the instruments we see today – stocks, bonds, options – could be considered securities.

In a legal context, the definition is considerably more narrow, and varies from jurisdiction to jurisdiction. Should an instrument amount to a security according to a given country’s criteria, it is subject to heavy regulatory scrutiny.

In this article, we’ll discuss how blockchain technology is poised to streamline the long-standing financial markets with security tokens.

What is a security token?

A security token is a token, issued on a blockchain, that represents a stake in some external enterprise or asset. These can be issued by entities like businesses or governments and serve the same purpose as their incumbent counterparts (i.e., stocks, bonds, etc.).

Why use security tokens?

To draw on an example, let’s say that a company wishes to distribute shares to investors in a tokenized form. These tokens can be designed to come with all of the same benefits one would expect from shares – notably, voting rights and dividends.

The advantages of this approach are numerous. As with cryptocurrencies and other forms of tokens, security tokens benefit from the properties of the blockchain they’re issued on. These properties include transparency, rapid settlement, no downtime, and divisibility.

Transparency

On a public ledger, the identities of participants are abstracted, but everything else can be audited. Anyone is free to view the smart contracts that manage the tokens or to track issuance and holdings.

Rapid settlement

Clearing and settlement have long been regarded as a bottleneck when it comes to the transfer of assets. While trades can be carried out near-instantly, reassigning ownership often takes time. On a blockchain, the process is automated and can be completed within minutes.

Uptime

The existing financial markets are somewhat limited in their uptime. They’re open for fixed periods during the days of the week, and closed on weekends. Digital asset markets, on the other hand, are active around the clock, every day of the year.

Divisibility

Art, real estate, and other high-value assets, once tokenized, could be opened up to investors that may not otherwise be able to invest. For instance, we could have a painting worth $5M could be tokenized into 5,000 pieces, such that each is worth $1,000. This would dramatically increase accessibility, while also providing increased levels of granularity over investments.

It’s worth noting, though, that some security tokens may have a limit on divisibility. In some cases, if voting or dividend rights are conferred as equity share, there could be a limit on token divisibility for execution purposes.

Security tokens vs. utility tokens – what’s the difference?

Security tokens and utility tokens bear many similarities. Technically, the offerings in both groups are identical. They are managed by smart contracts, can be sent to blockchain addresses, and are traded on exchanges or through peer-to-peer transactions.

Where they differ is mainly in the economics and regulations that underpin them. They can be issued in Initial Coin Offerings (ICOs) or Initial Exchange Offerings (IEOs), so that startups or established projects can crowdfund the development of their ecosystems.

By contributing funds, users receive these digital tokens, which enable participation (either immediately or in the future) with the project’s network. They may confer voting rights to the holder, or serve as a protocol-specific currency to access products or services.

Utility tokens are not intrinsically valuable. If a project grows to be successful, investors are not entitled to a portion of the profits as would be the case for some traditional securities. We could analogize the tokens’ role to loyalty points. They can be used to purchase goods (or can be sold), but they offer no stake in the business distributing them.

As a result, their values are often driven by speculation. Many investors will purchase tokens in the hopes that they will appreciate in price as the ecosystem develops. Should the project fail, there is little by way of protection for the holders.

Security tokens are issued in a fashion similar to utility tokens, though the distribution event is referred to as a Security Token Offering (STO). From an investment standpoint, however, both kinds of tokens represent vastly different instruments.

Even though they’re issued on a blockchain, security tokens are still securities. As such, they’re heavily-regulated to protect investors and prevent fraud. In this regard, an STO is much more akin to an IPO than an ICO.

Typically, when investors purchase a security token, they are buying equity, bonds, or derivatives. Their tokens effectively serve as investment contracts and guarantee ownership rights over off-chain assets.

What makes a token a security?

As it stands, the blockchain industry lacks some much-needed clarity on the legal front. Regulators around the globe are still playing catch-up with a flood of new financial technologies. There have been cases where issuers believed themselves to be issuing utility tokens, which were later deemed to be securities by the Securities and Exchange Commission (SEC).

Perhaps the most famous metric for attempting to determine whether a transaction amounts to an ‘investment contract’ is the Howey Test. In short, it seeks to ascertain whether an individual who invests in a common enterprise expects to profit as a result of the promoter (or a third party’s) efforts.

The test was produced by the US courts long before the advent of blockchain technology. It’s therefore difficult to apply it to the myriad of new tokens. That said, it remains a popular tool for regulators attempting to classify digital assets.

Each jurisdiction, of course, will adopt a different framework, but many follow similar logic.

Security tokens and programmable finance

Given the size of the markets today, tokenization could radically transform the traditional financial realm. Investors and institutions in the space would benefit immensely from a fully-digital approach to financial instruments.

Over the years, an ecosystem of centralized databases has created a great deal of friction. Institutions need to dedicate resources to administrative processes to manage external data that is incompatible with their own systems. A lack of industry-wide standardization adds costs to businesses and significantly delays settlement.

A blockchain is a shared database that any user or business can easily interact with. The functions previously handled by institutions’ servers could now be outsourced to a ledger used by the rest of the industry. By tokenizing securities, we can plug them into an interoperable network enabling rapid settlement times and global compatibility.

From there, automation can handle otherwise time-consuming processes. For instance, KYC/AML compliance, locking up investments for set amounts of time, and many other functions can be handled by code running on the blockchain.

If you’d like to read more about the subject, check out How Blockchain Technology Will Impact the Banking Industry.

Closing thoughts

Security tokens appear to be a logical progression for the financial industry. Despite their use of blockchain technology, they’re much closer to traditional securities than cryptocurrencies or even other tokens.

There is still some work to be done on the regulatory front, however. With assets that can be easily transferred around the globe, authorities must find ways to effectively regulate their issuance and flow. Some speculate that this, too, can be automated with smart contracts that encode certain rules. Projects like Ravencoin, Liquid, and Polymath already facilitate the issuance of security tokens.

Should the promise of security tokens come to fruition, the operations of financial institutions could be significantly streamlined. In time, the use of blockchain-based tokens in place of traditional instruments may very well catalyze the merging of legacy and cryptocurrency markets.