What Are Security Tokens?
Security tokens are programmable crypto assets that reap the regulatory protections associated with traditional securities.
Updated June 21, 2021 • 4 min read
Security tokens are a unique type of crypto asset designed to validate and ensure ownership rights and serve as value-transfer instruments for a specific asset, asset bundle, or set of rights. These tokens are imbued with the standard benefits inherent to other crypto assets, but are different in the sense that they can be programmed with unique characteristics and features in addition to receiving the regulatory protections associated with traditional securities. As a result, crypto security tokens have the potential to revolutionize the way we transfer value in financial markets and beyond — as long as financial regulators clarify and build upon existing policies.
Ownership on the Blockchain
Security tokens are a particular form of digital asset that serve as value-transfer instruments similar to cryptocurrencies, but maintain the regulatory protections associated with traditional securities. In this new age of blockchain, novel forms of digital assets like cryptocurrencies, tokens, security tokens, and tokenized securities are often conflated or discussed interchangeably, so it’s imperative to not just understand them clearly as standalone concepts, but also in relation to one another.
Here’s a refresher: While tokenized securities and security tokens are both a form of digital asset, tokenized securities are more straightforward in terms of both form and function. Simply put, a tokenized security is a digital representation of a traditional security with the purpose of broadening its market reach and enhancing market liquidity. Tokenized securities function the same way as traditional off-chain securities, except that they can be stored, sold, and exchanged on blockchain networks.
By contrast, security tokens combine Distributed Ledger Technology with new features that are dependent on the specific design of each particular token. In other words, these tokens have an additional feature that tokenized securities do not have — programmability. Security tokens also face a higher level of regulatory scrutiny, since they are considered financial securities and must therefore be issued, transacted, and processed in accordance with the relevant federal securities laws in the jurisdictions where they are permitted to be issued and sold. And, since security tokens can be programmed with unique characteristics and ownership rights, they exist within a relatively unexplored territory from both an innovation and regulatory standpoint.
In order to better understand blockchain security tokens’ unique benefits and regulatory challenges, let’s take a closer look at how these digital assets are redefining the way we transfer value.
How Security Tokens Are Reshaping Markets
Why would anyone prefer to have a security token instead of simply owning the underlying asset or a traditional equity stake in a company? In short, because security tokens are trustless, transparent, and programmable. This means that they can be more easily transferred, traded, and traced than the asset they represent, or programmed to feature more use cases than a standard company stock. This has implications for not only the financial services sector, but also in any other situation in which an asset of value is being transferred.
More specifically, crypto security tokens can help:
Unlock capital and market liquidity: Since security tokens can be traded and sold 24/7 on censorship-resistant blockchain networks spanning the entire globe, they can provide hitherto inaccessible investment opportunities to a broader range of investors. These tokens also allow investors to acquire fractional ownership of the token’s underlying assets, which helps to lower investment minimums and increase market liquidity.
Increase disintermediation: Security tokens also allow investors to bypass market intermediaries and other middlemen typically involved in most traditional asset management processes. This significantly reduces paperwork, simplifies reporting/auditing processes, and lowers issuance fees. This effectively reduces the costs and processing times of each transaction, thus enabling more streamlined, cost-efficient methods of transferring value.
Enhance transparency and traceability: Because security tokens live on the blockchain, users can easily trace their provenance and transaction history in a way that is cryptographically verifiable. Every transaction is automatically and transparently recorded on an immutable ledger, which effectively guarantees the authenticity of each token’s stated history. Because blockchain security tokens are effortlessly verifiable and traceable, they achieve a level of reliability that other security assets cannot match.
Automate complex processes: Unlike tokenized securities, security tokens are flexibly programmable and capable of executing complex tasks via smart contract protocols. This unique advantage unlocks a boundless array of opportunities in terms of automating traditional processes, combining multiple equity/stakeholder rights, and enabling new modes of cross-functional asset interoperability. For instance, security tokens representing an equity stake in a company can be programmed to automatically calculate and distribute dividends in a way that rewards long-term token holders at a higher percentage, thereby incentivizing more loyal shareholders. Additionally, compliance requirements can be baked right into security tokens so that they can only be traded by buyers and sellers who meet certain criteria, thereby circumventing the cumbersome, documentation-heavy verification processes prevalent in many modern-day financial exchanges. And going forward, security tokens representing vastly different types of assets will increasingly occupy the same blockchain networks simultaneously, allowing investors to consolidate and interact with all their existing assets via a unified, data-rich interface.
In summary, security tokens are expected to play a central role in making financial markets more efficient and accessible, and have the potential to enable entirely new forms of value creation. Given that security tokens are capable of conferring such a rich array of benefits, it’s therefore no surprise that more organizations are interested in making use of them.
Security Token Offering vs. Initial Coin Offering
While most traditional companies have historically conducted an Initial Public Offering (IPO) to raise capital, an increasing number of organizations are looking for faster, more cost-effective ways to fund growth and development. Security Token Offerings (STOs) are gradually gaining favor as an efficient means of raising capital, since they balance the benefits of blockchain-enabled crowdfunding with a reassuring level of regulatory oversight.
You may be familiar with the term Initial Coin Offering (ICO), which is a hybrid of crowdfunding and an IPO in the blockchain industry whereby an issuer sells crypto tokens as a means of funding operations or future development. These token sales can be open to anyone or only made available to select or accredited investors, and in most instances a token issuer will begin an ICO with a private sale for select insiders before opening it up to the public. From a procedural standpoint, STOs are identical to ICOs — the only difference is the fact that security tokens are subject to regulatory oversight.
As a result, only certain regulated organizations are eligible to conduct an STO and the investors to whom tokens are sold may be subject to certain regulatory restrictions. On the flipside, investors who participate in an STO have certain protections and rights due to the regulatory policies the STO operates under, which minimizes their risk of being swindled by low-quality projects and frauds, which were an unfortunately common occurrence during the 2017-18 Ethereum ICO boom.
The blockchain sector is filled with all types of projects, and not every organization is geared towards issuing security tokens and participating in well-regulated financial markets. And, where permitted, STOs are an invaluable tool for organizations that are intent on revamping their fundraising methods while staying within the bounds of the law.
Security Tokens Are Here to Stay
The fact that crypto tokens are easily transferable and effortlessly verifiable gives them an edge over many other traditional securities, and their flexible, programmable nature enables a wide range of exciting new possibilities. However, the fact that many crypto tokens defy conventional asset classifications raises complicated questions for the regulators tasked with overseeing this ever-evolving industry, and confuses innovators who want to push their limits while remaining legally compliant.
That being said, security tokens have proven their worth across a wide range of contexts, and there is no question that this exciting new technology is here to stay. Regulators around the world are making progress towards establishing forward-thinking policy frameworks that clarify existing issues, and even large-scale legacy institutions like the Intercontinental Exchange are creating new crypto-based marketplaces in anticipation of a more digital future.
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