Businesses have always been plagued with fundraising, however, with the advent of cryptocurrencies, a difference in fundraising was introduced. First, cryptocurrency gifted the world with Initial Coin Offerings (ICO), a variety of Initial Public Offerings in the traditional business world. However, ICOs offered investors little protection because of the lack of a regulatory framework. On the other hand, Security tokens represent a share in the company that issues it and confers a tangible benefit for the investor. In this article, we shall take a detailed look into Security tokens and how they work.
Introduction to Security Tokens
Security tokens represent fragments of ownership or a share in an asset. Usually, a company issues this token and enables holders of the token to have a share in the profit of the asset. Security tokens are acquired during Security token offerings (STOs) which combine the security of traditional IPOs and crypto-based ICOs.
STOs are regulated smart contracts held on the blockchain which means investors would get the tokenized versions of the shares. These tokens are created with cryptographic methods used to verify ownership and transfer of tokens. Hashing functions are used to verify token data and private and public keys are created with asymmetric encryption. In other words, Security tokens are shares on the blockchain.
The Security and Exchange Commission (SEC) US has made it easier to identify STOs. According to an SEC report, investors can identify security tokens if they have the following features:
Characteristics of a security
Represents the asset of a company
Entitlements to interest, profit or dividends
Also using the Howey Test, a tool that dates back to 1946, a transaction that meets the following requirements will be classified as a Security.
There is an investment of money.
There is an expectation of profits.
The investment of money is in a common enterprise.
Any profit comes from the efforts of a promoter or third party.
The striking difference between Security Token and Utility Tokens
The connection between all tokens is the blockchain element and that's where most of the similarities end. Most crypto investors are familiar with utility tokens as they transact with them often and are more popular. With utility tokens, investors have no share in the company. They can transact with the tokens but they get no dividends in the company’s profit. A good example of this will be users of Google who do not own the company’s shares, they can use the platform but will get no profit from the profits made. Investors aim to get a use case out of utility tokens and some examples of utility tokens include Filecoin, golem, SIA, CIVIC, Basic Attention Token.
Utility tokens allow investors to transact in an ecosystem while security tokens allow you to own a fragment of the ecosystem. Security tokens are investment contracts verified on the blockchain and represent physical assets such as ETFs or real estate. When these tokens are verified, owners can trade them, store them in a wallet or use them as loan collateral.
Benefits of security tokens
Let's take a look at some of the benefits of security tokens
Fractionalisation: Since STOs are used to represent tokens, it enables investors to own fragments of a property. For instance, a building in Long Island, New York worth $50 million can be tokenised into 200 pieces and each token will cost $250,000. Giving each investor a share in the building.
Liquidity: Since Security tokens are fragmented, it makes them easy to access in the market thereby having round the clock liquidity provided for the token.
Lack of Governmental Interference: Security tokens represent the tokenised versions of real assets. Hence they have more stability than ICOs also, they are already SEC-compliant and would not have to suffer from intrusion from the government every now and then.
Flexible trading times compared to traditional trading: Since it is built on the blockchain, it can be accessed at any time, unlike traditional marketplaces that can only be accessed during weekdays and close at the end of the business day.
Why hasn’t security tokens become a major thing within the crypto economy?
Undoubtedly, Utility tokens are more popular than Security tokens and even ICOs more commonplace than STOs. So, why has security tokens not gained mainstream adoption? Some of the reasons include:
Subject to greater regulatory scrutiny than utility tokens: During the ICO boom of 2018, hundreds of projects were launched and a greater part of investors lost their funds to nefarious projects. Security tokens eliminate the lack of accountability that most crypto projects in the past had lacked using ICOs. Therefore more ICO projects were started than STO projects.
The ecosystem loves volatility- Most security tokens will guarantee some equity ownership and dividend earnings are unlikely to “moon”. What is crypto without the propensity to moon?
Future of security tokens
Security tokens offer a safety net for investors as they are more regulated and secure. They offer investors opportunities to own fragments of an asset. In more ways than one, they are safer than ICOs and cheaper to run than IPOs and may soon become the future of fundraising. Another angle that is often overlooked is the interest of institutional investors in the crypto blockchain space. Financial giants like Nasdaq are already providing data for decentralised trading. Earlier in May 2021, INX Limited, a blockchain-based trading platform, generated over $85 million in token sales after closing its first SEC-registered token IPO with over 7,200 institutional and retail investors participating.
Whilst more traditional institutions are beginning to trickle into security token trading, some teams are trying to circumvent having their tokens classed as securities. In reality, the Howey test has made it easier to distinguish coins that may likely be classed as Security Tokens. Factors such as providing utility to investors will disqualify some tokens; while a requirement for STOs will be generating profit from the work of others. In other words, some tokens will never be classified as Security tokens.