What are security tokens? What are the advantages and disadvantages of security tokens? Should you invest in security tokens? This post is aimed at providing you with answers to these questions and everything else you need to know about security tokens.
The eyes of the world are opening up to the numerous potentials of blockchain technology, also commonly referred to as the decentralized ledger technology (DLT), as its decentralized nature of immutability, transparency, and security continues to wow them, even in the financial and economic sectors.
The value brought to the table by this technology can not be ignored by anyone, not even the Capital Markets which Investopedia defined as a place where savings and investments are moved between capital suppliers and capital seekers. Simply put, a venue where financial entities can trade capital in the form of securities. Commonly known capital markets include the stock market, bond market etcetera. Usually named after the transacted security.
Securities are financial assets or instruments which have fungibility characteristics of money and can be traded as well. They include shares, stocks, bonds, debentures etcetera. If an asset or instrument would be considered a security or not depends on the country, as securities are highly regulated.
This realization has led the market to seek ways to integrate the blockchain into its dealings. One of the commonly known ways it has achieved this is through tokenization. The process of representing a hard asset, retaining all its characteristics, with a digital token.
The process of the tokenization of securities simply involves the transfer of the right to ownership of security into a digital token. This process gives rise to a new alternative class of crypto-asset called “security tokens”.
What Are Security Tokens?
Security tokens are financial derivatives. This means that the tokens “derives” its value from the underlying asset, securities, which it represents. Therefore, it is bound too by the laws, policies, and regulations which bind the asset.
Based on the above, one can say that security tokens are financial instruments, in the form of digital tokens, issued on the blockchain to stand as a right of ownership or position in an enterprise or organization.
Security tokens are of primary importance because of the new abilities it integrates into securities and the Capital market as a whole including improvement of liquidity, embedded rules within the tokens program, fractional ownership, and more which will be discussed as well in this article. They act as a bridge between traditional securities and the blockchain and this is what makes the division of asset ownership feasible.
Tokenization must sound like an easy word to pronounce, but the process is by far the opposite of easy. Besides the technical processes of token development, the legal processes are quite cumbersome.
To put tokenization and security tokens into perspective, Consider owning a car worth $1million. With tokenization, as the owner, you could represent this car with, say, 2,000,000 CAR tokens. Anyone who purchases this token now owns a portion of the car. Someone who purchases 1,000,000 CAR tokens now owns 50% of your Car.
The legal agreements behind this process of tokenization determine what happens to the car. If it would be sawed in two or not, if one owner gets to keep the tyres and the other the seats.
Security tokens differ from utility tokens. Utility tokens are “supposed” to be purchased to use an already existing platform or access, in the future, some of its services – without any right, a voice in the running of the platform, or benefits from it just because the token is held.
Ideally, a token should either be a utility or a security token, but this is not the case in reality. There are cases where a single coin is held for investment reasons and because of its use case simultaneously.
Hence, the nature of a token can be described as being somewhere in the utility-security spectrum. There is a test designed to determine if the nature of the token is at the security end of the spectrum or not.
When is a Token Referred To As A Security – The Howey Test
The speculation of blockchain and cryptocurrency being a bubble seems to be fading away already, hence regulations around cryptocurrency are taking solid stands now more than it had taken in the earlier years.
Although the regulations are still a debate, the Securities and Exchange Commission (SEC) has declared that any token which tests positive to the Howey Test is a security token.
Tokens are issued at the launch of a blockchain project’s Initial Coin Offering (ICO). If issued as a utility token is not for investments and holds no value outside the project’s ecosystem. It is simply meant to be a key or access to the project’s service or product.
However, because these tokens are usually listed on an exchange, with the tendency of having its price increase, speculators decide to buy and HODL, to profit from the increase in price.
The Howey test uses some simple questions for this classification. If the answers to ALL the questions end up as yes, then that particular token is a security.
Some of these questions include;
- Is the money invested?
- Are the tokens from a common enterprise?
- Are there profit expectations?
- Does the profit expectation come from the efforts of a promoter or a third party?
In essence the test checks for tokens which have share-like properties and tags them as securities. The most well-known cryptocurrency to get this tag is the DAO. NEO is another cryptocurrency that is structured this way.
This knowledge has led projects to structure their tokens in a utility manner to avoid the regulations.
The Merits Of Security Tokens
Security tokens hold a great degree of advantages that enables it to revolutionize the financial space, regardless of the heavy SEC regulations. Some of which are;
- Division of Ownership
With the existence of a countless number of industries today, it is still very much inaccessible to the public to invest in them. However, readily accessible to the upper-class citizens in the world of finance. With the advent of tokenization, it can be further split into smaller fractions and made accessible to the general public with just a few dollars and internet connection.
- Valuation Efficiency (Less Cost, More Speed)
As a result of utilizing the blockchain technology and smart contract, security tokens get to succeed from the technology’s several built-in properties. Security token plays a unique role in eliminating the need for a middleman and unwanted delays when transferring assets.
This consequently reduces cost, complicatedness, and simultaneously enhances the time for execution for the distribution of a security token through a smart contract.
- Rapid Settlement
Assets are bound to change hands during the transfer of ownership, such process is regarded settlement. During settlement, the underlying document processing is often executed slowly and takes quite sometime before the ownership is fully transferred from the moment of transfer execution. Most brokers fulfill this change of hands two days after the execution.
Unlike traditional trades processes, the blockchain tends to speeds up trades in just a few moments. The blockchain successfully records every detail from the transfer of ownership, down to payment between the seller and the buyer.
- Enhanced Asset Liquidity
It becomes a difficult task for the owner of a rare or expensive asset to put it out for sale to investor(s). Investors are more attracted to such an asset if fractions of it are readily available rather than the entire asset.
The division of ownership of security tokens has given rise to increased liquidity in the market. So as more people are able to purchase smaller stakes, the more liquid the asset becomes.
- Round the clock free market
The capital market, most especially the stock market does not operate on weekends and even at night, putting a stop to trading at these times. Unlike those markets, the borderless and unrestricted cryptocurrency market is not disturbed by time zones. It is timeless, allowing 24/7 trading. This also improves liquidity.
- Interoperability Of Asset
With the possibility of all assets, securities to be tokenized, It becomes very convenient to trade between one another and store them on the same exchanges or same wallets. A securities investor could own a single asset wallet that they could use to hold a tokenized car, house, stocks, and more.
The blockchain having a fully auditable and valid ledger of transactions makes it a hundred percent transparent. This automatic feature of the blockchain improves the current market system. Users can easily verify, track, and declare ownership of securities.
Shortcomings Of Security Tokens
The following are the problems associated with security tokens:
- Expensive STOs
Security Token Offerings are similar to Initial Coin Offerings where these tokens are sold to the public. Although launching an STO is relatively cheap compared to Initial Public Offerings (IPOs), it still costs more than hosting an ICO because of the regulatory bodies that the project has to involve. These regulators are not cheap to please.
- Restricted Trading
Unlike utility tokens, secondary markets where Security tokens must be traded must be licensed. It can’t be traded on just any digital asset exchange. In addition to this, these tokens must be programmed to comply with the rules governing the security including the maximum number of tokens “ownable”.
- Investment Limitations
It is required that anyone who holds a security token be an accredited investor. This means that a US investor must earn at least $200,000 per year or have at least a million dollars in the bank. This is one of the major shortcomings of the securities market.
- Infant Market
Security Tokens are essentially a new concept, even to the SEC. Hence the market is yet to be fully formed and regulations now are still open-ended – meaning they could be changed. This raises the risk for both businesses and investors alike, as any new changes could cause them to lose all their holdings.
Outlined above is practically everything about security tokens you’d find on the internet and embedded within it too is why you should care, being an investor or a cryptoprepreneur with an eye of launching a security token soon.
The advantages of issuing Security tokens applies to both investors and the concerned company and should be taken note of, however, the shortcomings must not be disregarded as they would provide guidance towards creating strategies to hedge against risks from regulations or otherwise.
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