Security tokens are cementing their place in the financial industry as a programmable vehicle for investment in any asset that already has value, like real estate, a car, or corporate stock. By December of 2021, the total market cap of Security Token Offerings, or STOs, was just a shade under 1 billion dollars.
But what exactly is a security token, and how do they operate in real life? This guide will give examples of security tokens, a summary of their strengths and weaknesses, and provide additional details to help you better understand how security tokens work.
In Web3, tokens are used to refer to programmable stores of value that are stored in a blockchain. These tokens come in many shapes and flavors. Some tokens are merely updated versions of traditional finance instruments, other tokens enable for completely new ways of sharing value between people and groups. Security tokens, specifically, are an innovation on traditional securities.
In particular, security tokens enable issuers to code an 'asset' according to certain criteria. These criteria are programmed into a blockchain, and the resulting tokens that are issued can be used to track the performance of an investment, to distribute dividends, and provide valuable features like vesting and lockups. Security tokens function in the same way that securities can operate in traditional finance (aka, TradFi).
As it is with traditional securities, security token holders are entitled to certain rights. The difference here is that instead of being written in a legal document, the rules for a security token are coded into a smart contract.
Security tokens are typically issued via a Security Token Offering, also called an STO. In the United States, STOs come in different flavors based on the applicable set of securities laws. These laws limit which type(s) of investors can participate in the sale of the token. A summary of Regulation D, Regulation CF, Regulation A, and Regulation S securities laws exemptions are listed below.
These laws apply to any token that resembles a security, regardless of whether you call it a security token. A smart way to judge if a token offering is a security is to use the Howey Test, which was an output of a U.S. Supreme Court case that had to decide if a transaction qualifies as an investment contract. The test was a guideline for determining what qualifies as an investment contract, which, if so, then it would fall under U.S. securities laws.
You can read more about the Howey Test in our article “Taxonomy of Tokens: Security Tokens vs. Utility Tokens.”
Two of the primary types of tokens that are often compared and contrasted are utility and security tokens.
Utility tokens, often called consumer or incentive tokens, are another type of token designed for a specific use case within an ecosystem. Most utility tokens are used to raise capital or purchase a company’s product or service.
While security and utility tokens can serve similar purposes, security tokens have more set parameters than utility tokens and perform a more specific function. The best way to differentiate them is to think of utility tokens as something to be utilized, i.e., to make purchases or to have access to a platform or protocol. In contrast, security tokens are primarily used for investment reasons, as they represent an ownership stake in a business or project.
You can learn more about the difference between security and utility tokens in our article, “Taxonomy of Tokens: Security Tokens vs. Utility Tokens.”
Companies that issue security tokens can see a lot of benefits.
Security tokens can help companies access funds faster because they more easily integrate with financial markets like security token trading platforms. Plus, security tokens are easier to audit and track as there is more transparency regarding transaction history and investment locations.
However, one of the biggest perks of security tokens is that it doesn’t require a company to change its business from private to public. Companies can save millions of dollars on an IPO by issuing security tokens in their place.
The disadvantage of security tokens is that they can be energy intensive, increasing expenses. If a security issuance has a bug, there are limited methods to recover money. Unlike Upside, most existing user interfaces for security tokens can be challenging to operate.
Another vulnerability of security tokens is that because cryptocurrency is in a constant state of flux, SEC establishing guidelines are done more by the prosecution of those seen as transgressing pre-digital security laws, and less by establishing clear lines and regulations directed at digital security tokens.
Just as investors vet an IPO or private placement, STOs should be thoroughly researched before investing money. You can set Google Alerts for STOs to stay on top of the latest news regarding security tokens and other security laws affecting potential investments. Or, subscribe to our newsletter for the latest updates, information, and content.
To better help you understand security tokens, the following are real-life examples of companies that created Security Tokens for fundraising and other objectives.
Security tokens are a new way for companies to raise funds and allocate ownership interests using blockchain technology. By using a blockchain, Security tokens can reduce the time it takes to distribute assets, with fewer hoops for investors and issuers to jump through; while also providing potentially broader access to the public at large.
Where traditional securities are susceptible to manipulation and distribution fraud from human intermediaries, security tokens rely on blockchain technology. These various immutable ledgers allow people to transfer value from one address to another according to a set of criteria that are programmed into a smart contract.
Security tokens are worth an investigation for those looking to revolutionize both the access and the future of investing.
