What are security tokens?

If ICOs and utility tokens were the big cryptocurrency trend of the past few years, 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, 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 tokenized 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. In Canada, this test is known as the Pacific Coin and is based off the same criteria as its American counterpart. 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 (US Securities and Exchange Commission):

• 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.

The DAO token

It is important to remember that security tokens also include things outside the traditional world of finance, such as the DAO token which was attached to a purely crypto-economic 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 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 as a security token in 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. 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.

The future of security tokens

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 specialized 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.

• Transparency and traceability

  Blockchains are an immutable database of transactions which helps protect against fraud, malpractice and corruption. Furthermore, most blockchains keep a public ledger which is accessible by anyone, allowing anyone to audit the ledger.

• Speed

  While some blockchains are notoriously slow, others are tailored to financial markets and can process transactions at dazzling speeds. Furthermore, by using smart contracts, security tokens can automate the need for time-consuming tasks that normally require middlemen.

• In-built compliance

  As mentioned, smart contracts can help eliminate menial tasks which slow things down. Better yet, they can be pre-programmed to deal with many of the legal requirements of securities, such as allowing for KYC, AML, regulatory requirements, legal interpretation and be programmed into the token, meaning only those who are allowed to use the security will be able to trade it.

• New investors and markets

  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 is able to flow in from places and people that it previously couldn’t. Furthermore, 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.

• Fractional ownership

  Security tokens enable fractional ownership of assets that would have previously only belonged to one person or organization. For example, valuable art can be owned by multiples parties, real estate can be divided among thousands and even rare artefacts and precious rainforest can be safeguarded by the public. Fractional ownership also increases the liquidity of an asset, which is a valuable metric for traders.

  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, 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.

Exchanges that currently support security tokens

Exchanges looking to add security tokens in the future

• Binance (in accordance with Maltese law)
• Poloniex (in accordance with US law)
• Coinbase (in accordance with US law)

It’s important to note that some exchanges may already be trading security tokens. However, it may also be the case that they are not legally allowed to in certain jurisdictions or that the exchange is hosting a security token without knowing it. As such, we have made sure to only list exchanges with explicit legal permission to trade securities in their given jurisdiction.

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

Related: Learn more about decentralized exchanges

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 that 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 tokenized 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.

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, this has not always been the case and airdrops circumvent this practice altogether.

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. However, 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?

In Canada, securities law is managed by the provincial and territorial governments, rather than the federal government. Unlike other countries such as the US, the UK and Australia, Canada does not have a securities regulatory authority at the federal level.

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In a nutshell

Pros

• 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.

Cons

• • • 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 decentralized exchange.
    • Security: Blockchain security is still a developing field and is vulnerable to hacking and phishing.

FAQs

• Is XRP a security?

  On July 13, 2023, a federal judge provided legal ruling that when sold to the public, XRP is not a security.

  Ripple, which originally issued XRP (and has since distanced itself from the token), has argued unequivocally against the SEC that it is not a security. On July 13, 2023, a judge ruled that XRP is a security only when sold to institutional investors but not a security when sold to the general public. This lawsuit brings a conclusion to a long battle against Ripple Labs Inc. and the SEC.

• What would happen to ERC-20 tokens if Ethereum is declared a security?

  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 regarded as securities. Perhaps most importantly, the SEC added that it is possible for coins or tokens to change status depending on how they are operated.

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.