Security tokens have been getting a lot of attention lately, but most people are still confused on what security tokens are. No worries, we’re here to clear the dark and give you the most simple and easy to understand guide on what security tokens are.
To understand what security tokens are, we have to start off by understanding what securities are.
Securities are tradable financial assets such as bonds, debentures, notes, options, shares (stocks), and warrants.
Just like stocks, companies and governments use securities to raise money from capital markets from various investors. And then these investors are promised a return back in the form of dividends or some profit from the company’s revenue.
Security tokens are considered by the community as an investment contract similar to that of traditional security investment. And just like those assets, if an investor hopes to gain profit from the token through revenues, dividends, and/or favorable price movements then it is a security.
When these things are done through a cryptographic token, it is called a ‘Security Token’.
In simpler terms, security tokens are digital tokens that pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders. Think of it as a traditional ETF.
Why not traditional securities?
So you might think, why would I want to invest in a security token over a traditional bond when the reward is quite similar?
The main problem with investing in traditional security assets is the liquidity problem.
With traditional paper backed assets like company’s shares or bonds or real estate, liquidity was a problem, but the crypto version representation of all these things in a token form can take care of that issue.
All these problems can be solved with security token by leveraging smart contracts.
All these programmabilities can bring in a lot of automation and perfection to the whole process because after all, you are creating programmable security. And this type of security can do all things that a traditional form can but even more.
Pros of a security tokens
There are a few reasons why there are a lot of benefits for an investor when it comes to security tokens.
- Security tokens brings in the proper regulation in the market required for tokens.
- As a result, such projects will have more support from the investors and will have their trust.
- This will bring more liquidity to the securities market.
- Will be more cost-effective, secure, & fast in trading.
- Will bring more automation to the securities market where human errors can occur.
- The main idea of a security token is to remove the middleman in a transaction. This middleman is the main cause of risk, fees and delays in non-peer-to-peer transactions.
Examples of security tokens
As security tokens and tokenized assets gain steam in the crypto ecosystem, clear infrastructure begins to form. Let’s take a quick look at some examples of companies in the security token space.
Polymath wants to be the Ethereum platform of security tokens. They ambitiously hope to deliver the same kind of success by creating cryptocurrency’s first security token standard, ST-20. There is a very real need to protect investors from certain kinds of ICO scams. And Polymath working together with regulators just might be the answer.
The polymath protocols build into any token the possibility for only verified investors to buy, sell and exchange value.
tZero, on the other hand, wants to build a platform which allows the trading of crypto securities. As you know, there are already plenty of cryptocurrency exchanges out there yet tZero aims to be one of the first SEC-regulated exchanges.
With the emergence of “crypto” alt assets and the industry shift towards a ledger based book-entry process, the need for standardization and interoperability with alternative assets is greater than ever.
Open Finance’s system is designed for traditional alternative assets and token-based securities and allows for a streamlined complaint process for secondary market trading.
Direct integrations with financial institutions such as broker-dealers, custodians and transfer agents provide a bridge to the on-chain crypto capital markets.
Issuance platforms enable issuers to tokenize and issue their assets, making them available for sale. These platforms offer tokenization features for a wide range of assets including real estate, debt, equity, and art.
Tokenized assets can operate on a number of different blockchains including Ethereum, Bitcoin, and Ravencoin. All tokenized assets are pegged to an underlying asset, whether that is something like the Empire State Building or Van Gogh’s “Irises.”
If the market changes its perception of the price of the asset, the tokens should move in value as well.
The Howey Test
When people talk about security tokens, we often hear “The Howey Test” as apart of the conversation, but what exactly is it?
The “Howey Test” is a test created by the Supreme Court for determining whether certain transactions qualify as “investment contracts.”
If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.
A security is found to exist when all four of these elements exist:
- Investment of money
- In a common enterprise
- With an expectation of profits
- From the efforts of others
In a recent ruling, the SEC concluded that both Bitcoin and Ethereum were not considered to be securities. This ruling, however, raises some real questions about the token definitions we took a look at earlier. Many investors hold Bitcoin purely as a store of value and/or to speculate on price movements. It seems then that an official definition of what is a security token may depend solely on the opinion of the SEC and other regulators.
Similar to other crypto assets and blockchain solutions, a security token’s goal is to remove the middleman for transactions. Security tokens also come with many benefits for regulators. Issuers can, for example, code lock-up periods right into the security token. This makes the violation of lock-up period times physically impossible.
Of course, we’re still in the early stages of crypto assets and blockchain, but it is a good alternative to look into compared to traditional security assets.