What are Security Tokens?

What are Security Tokens?

There is a new buzzword trending in the cryptocurrency space these days – Security Token Offerings, or STOs as they are popularly called. Unlike the common Initial Coin Offerings or ICOs, STOs are based on tokens that act as “securities.” This essentially brings them under the purview of the existing securities laws and regulations for investor protection.

Experts predict that 2019 will be the year of the STO, when the crypto industry will get a formal regulatory structure, rightfully deserved by it. But first, we need to understand what “security tokens” are.

The Concept of Security Tokens

If we are to ascertain the exact definition of a “token,” it is a digital asset that represents something of value within an ecosystem. This could be voting rights, access to a service or dividend payouts; the list is endless. This asset or utility-representing token is put up for sale to investors via ICOs. Initial Coin Offerings are a type of crowd-funding initiative, where investors put money into a project in return for future advantages on the platform.

The concept of STOs brings significant parity between the two terms – tokens and cryptocurrency coins. Cryptocurrency coins like Bitcoin (BTC) or Ether (ETH) can be mostly used as a transactional medium, even outside their native platforms. On the other hand, a token represents functionalities only within a particular ecosystem, until it gets listed on exchanges.

So, in short, a token could provide multiple ways in which investors benefit monetarily. In the past, ICO owners got into trouble with token offerings that were essentially investment contracts. The US SEC termed these tokens as “securities” in disguise that should actually fall under the purview of securities regulations. Security tokens embrace the idea of being treated like securities, and their offerings should be structured in a manner that is beneficial to both the issuing company and the investor.

The Howey Test

The infamous Howey Test was a result of a 1946 legal battle with the US Supreme Court. Howey, a Florida based real-estate company, was sued by the US SEC, on grounds that their land contracts provided monetary benefits to investors, and, therefore, should be termed as “securities.”

Today, the Howey Test is a benchmark for ascertaining whether a particular transaction is an investment contract or not. When the DAO tokens failed to pass this test in 2016, and were classified as securities by the US SEC, a common framework was put in place, in partnership with FINMA, to judge whether a token was a security token or a utility token. So, a token that passes the Howey Test is deemed a security token, subject to US federal laws.

Broadly speaking, in the Howey Test, for a financial instrument to be classified as securities and fall under the US SEC jurisdiction, it has to fulfill certain conditions, including:

  • Investment of money is necessary.
  • There has to be profit expectations at the end of the transaction.
  • Both these above points have to take place in a common enterprise.
  • Profits have to be generated through a third party.

Security token issuers in USA need to comply with specific guidelines for registration, such as:

1.      Regulation A+

SEC-approved securities can be offered to non-accredited investors with investment of up to $50 million.

2.      Regulation D

A company’s token offering will be exempt from being registered by the US SEC, provided that Form D is submitted by the token creators after the token launch. A company that gets this exemption may offer their securities to investors under Section 506C.

3.      Regulation S

This regulation is for token offerings that occur outside the US. The securities regulations of the country in which the sale is taking place will come into play.

The Importance of Security Tokens

Through tokenised securities, companies will no longer try to circumvent regulations, which will help bring down instances of the sale of illegal and unregistered security tokens. This, in turn, will instill investor confidence in the digital asset industry, which has long been riddled with scams and security threats.

Through STOs, companies will be able to structure “programmable ownership,” with all material information programmed within the software, with the option for modification at a later time. This will be a great way to attract institutional investors, who mostly stay away from the crypto space due to vague token economies and real tangible rights. They will now be able to ascertain what their interests will be in an STO company, at any given time.

“The tokenization of the economy, for me, is real. Cryptocurrencies are real but not in the current form.” These words were recently said by JP Morgan’s co-president, Daniel Pinto, who stressed on the importance of regulatory frameworks for crypto assets to flourish. The presence of institutional investors is necessary in the crypto markets, for the digital asset class to be considered a viable part of the global economy.

Apart from bringing credibility back into the industry, security tokens will also improve traditional financial transactions, without the need for middlemen. STO companies will be able to offer their tokens to investors in any country, enhancing free market exposure. This will lead to a significant increase in crypto-asset valuations and enhanced liquidity in the market place. Through the licensed security token trading platforms, investors will find it easier to liquidate their holdings. STOs will provide an opportunity to make the securities market more transparent and transferable.

With links to smart registries, security tokens will lessen a lot of unnecessary documentation and expenses in the public capital markets. Service provider functions, like those provided by law firms, can be automated. This will also reduce legal fees.

Security tokens could rise as an alternative form of blockchain funding. This is good for the financial industry, considering the amount of scrutiny that ICOs are being subjected to at present. A lot of negativity concerning ICOs surfaced in 2018, following the revelation of rampant scams. Security tokens might prove to be a viable alternative.

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