What are security tokens?

If ICOs and utility tokens were the cryptocurrency trend of 2017, then the scene is set for security tokens to take center stage in 2019.

Thanks to improved regulatory environments worldwide — and particularly in the US — security tokens have finally gotten the green light to enter the marketplace like never before.

Disclaimer: This page is not financial advice or an endorsement of digital assets, providers or services. Digital assets are volatile and risky, and past performance is no guarantee of future results. Potential regulations or policies can affect their availability and services provided. Talk with a financial professional before making a decision. Finder or the author may own cryptocurrency discussed on this page.

What are security tokens?

Security tokens refer to financial securities whose ownership is attached to a crypto token and hosted on a blockchain. Because security tokens represent a more traditional type of asset than value-based cryptocurrencies or utility tokens, they’re sometimes called digital assets, rather than cryptocurrency.

These tokens are revolutionary because they allow for such securities as stocks, bonds and derivatives, as well as commodities and real estate, to be hosted on the blockchain in a tokenized format.

In the US, securities are classified depending on whether they pass the Howey Test. If a product conforms to these four criteria, then the SEC is likely to define it as a security:

• People invest money into the product.
• People expect profits from the investment.
• The act of investing is a common enterprise — in other words, people or groups of people can share in the investment.
• Profits depend on who issues the investment — an 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 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.

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, the SEC retrospectively classified DAO token as a security in July 2017. The report that led to the ruling, called the DAO Report, has 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. Several existing tokens have been reclassified as securities since the release of the Dao Report, and more are likely to follow. Of those tokens considered securities, not all were sold through compliant methods or registered with the SEC. Further, not all exchanges that trade security tokens are permitted to do so, which is why our exchanges guide lists only those legally registered to trade securities.

Security tokens are still in their early stages, but their future appears clear. They are increasingly 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 specialized security token exchanges will provide 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 lies with the exchange, rather than the user, smoothing the experience that cryptocurrency traders are familiar with.

5 advantages of security tokens

Why are people so excited about security tokens? Security tokens allow for all of the advantages that come with trading on the blockchain.

1. Transparency and traceability

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 to audit those transactions.

2. Speed

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 typically require a middleman.

3. Built-in compliance

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 are able to trade it.

4. New investors and markets

Part of the blockchain revolution has come with opening up financial markets to those who otherwise wouldn’t 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.

5. Fractional ownership

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 multiples parties, real estate divided among thousands and even rare artifacts and precious rainforests safeguarded by the public.

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 a result, existing cryptocurrency exchanges are exploring the addition of 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 cryptocurrency.

• Exchanges that currently support security tokens
• Exchanges looking to add security tokens in the future

Note that some exchanges already trade security tokens. However, they may not be legally allowed to in 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, 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.

• Compare and learn about decentralized exchanges.

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.

Utility tokens

A utility token gives the holder specific 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 before buying or selling 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 amount, often less than $1 per token. ICOs are conducted in many 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.

Security tokens

A security token is a tokenized version of a real-world asset or security that can exist outside of the blockchain. Assets 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 than ICOs and airdrops. Securities have strict laws that 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, among other legislation. While many ICOs now implement KYC and AML, it wasn’t always the case, 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 detailed legal procedures than ICOs or airdrops. As a result, you’ll find several new platforms developed to help with 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’s Neufund, a token-issuance platform based in the EU that’s developed the Equity Token Offering, a hybrid model that combines features of ICOs, IPOs and venture capital funding.

STOs are a new concept, so it is likely their operation, legal status and availability will change over the coming months and years. Because they focus on laws within a select jurisdiction, it’s also likely that eligibility will vary.

Must read: STOs vs. ICOs

In the context of startup fundraising, STOs are often considered a more equitable way to raise capital than with the 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 makes 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.

Furthermore, ICOs are vulnerable to exit scams, because the company issuing the utility token has no shareholders to which they’re 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. Security tokens may even entitle the holder to dividends.

But remember that a security token can be almost anything tangible, such as precious 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 action 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 like the US Securities and Exchange Commission.

As a result, it’s unlikely that one type of token will dominate. Instead, companies looking to fundraise now have the option of deciding which type of token best suits their product.

It’s still up to savvy consumers to make sure they’re getting the best deal, which involve thinking critically about whether a security or utility token is best suited to the product.

Are security tokens legal?

In Australia, the Australian Securities and Investments Commission (ASIC) is the federal body responsible for securities, whereas in Canada securities law is managed by the states and provinces, rather than federal government. Users in the UK may look to the Financial Services Authority (FSA) for guidance.Back to top

In a nutshell

Pros

• Efficient and oriented to the future. A more efficient way to trade securities, it blurs the lines between cryptocurrency markets and legacy markets.
• Regulated and legitimate. It’s to local laws and regulations that offer levels of consumer protection, and exchanges further legitimize blockchain markets.
• Compliant. Regulatory compliance can be programmed into the token.
• Driver of liquidity. Blockchain leads to more democratic involvement in financial markets, which is anticipated to increase liquidity over the long term.
• Innovative. Fractional ownership opens up new investment pathways.
• Traceable. Increased traceability means stolen funds could potentially be returned to the user.
• Encouraging new tokens. Security tokens offer a more traditional form of investment than utility tokens.

Cons

• Developing. It’s an emerging market with limited availability of tradable securities and assets.
• Complex. It’s restricted by laws and regulations, which makes trading more complex than utility tokens or cryptocurrency.
• Not always legal. It may not comply with the laws where you live.
• Relies on personal responsibility. It requires more accountability on the user to know the products and markets they can legally interact with, especially on a decentralized exchange.
• Potentially not secure. Blockchain security is still a developing field and is vulnerable to hacking and phishing.

Frequently asked questions

Is XRP a security?

The SEC has not provided a legal ruling on whether XRP is a security, so it depends on who you ask. Ripple, which originally issued XRP and has since distanced itself from the token, argues unequivocally that it is not a security. However, it continues to fend off multiple lawsuits that hinge on XRP’s status as a security.

What would happen to ERC20 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 considered securities. Perhaps most important, the SEC added that it’s possible for coins or tokens to change status depending on how they operate.

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.