List of contents

  • Introduction

  • What are security tokens?

  • What are the uses of security tokens?

    • Transparency

    • Quick solution

    • Uptime

    • Can be shared

  • Security tokens vs. Utility tokens – what's the difference?

  • What makes a token a security?

  • Programmable securities and financial tokens

  • Closing


Introduction

Securities are financial instruments that have value and can be traded. Based on this definition, many of the instruments we encounter every day – stocks, bonds, options – can be considered securities.

In a legal context, the definition is narrower, and varies from one jurisdiction to another. If an instrument includes securities according to certain country criteria, then the instrument will be closely monitored by the regulator.

In this article, we will discuss how blockhain technology is poised to streamline legacy financial markets with security tokens.


What are security tokens?

A security token is a token, issued on a blockchain, that represents ownership in some company or external asset. These tokens can be issued by parties such as businesses or governments and serve the same purpose as existing similar assets (stocks, bonds, etc.).


What are the uses of security tokens?

To understand more easily, try to imagine a company wants to distribute shares to investors in the form of tokens. These tokens can be designed with exactly the same benefits as ordinary shares – especially in terms of voting rights and dividends.

The advantages of this approach are numerous. As with cryptocurrencies and other forms of tokens, security tokens benefit from the properties of the blockchain on which these assets are issued. These properties include transparency, fast turnaround, no downtime, and shareability.

Transparency

In a public ledger, participants' identities are abstracted, but everything else can be audited. Anyone is free to view the smart contracts that manage tokens or track issuance and ownership.

Quick solution

Clearing and settlement have long been considered a bottleneck when carrying out the asset transfer process. While trades can be made almost instantly, transferring ownership often takes time. On blockchain, the process is automatic and can be completed in minutes.

Uptime

The current financial market is still limited in terms of uptime. On weekdays, they operate within a certain time frame, and are closed on weekends. Digital asset markets, on the other hand, are active at all times, every day of the year.

Can be shared

Art, real estate and other high-value assets, once tokenized, can be opened up to investors who may not have been able to invest before. For example, we have a painting worth $5 million that can be converted into 5,000 pieces, making them worth $1,000 each. This will dramatically increase accessibility, while also increasing the level of investment granularity.

It should also be noted, however, that some security tokens may have limitations in this nature. In some cases, if voting rights or dividends are granted as equity shares, there may be a limit on the distribution of tokens for execution purposes.


Security tokens vs. Utility tokens – what's the difference?

Security tokens and utility tokens have many similarities. Technically, what these two types of tokens offer is identical. Managed by smart contracts, can be sent to a blockchain address, and traded on exchanges or via peer-to-peer transactions.

The main difference is in the underlying economics and regulations. Both can be issued in an Initial Coin Offering (ICO) or Initial Exchange Offering (IEO), so that startups or projects being built can raise funds for the development of their ecosystem.

By providing funds, users receive these digital tokens, which provide the right to participate (either immediately or in the future) in the project network. These tokens can provide voting rights to holders, or serve as a special currency for the protocol to access products or services.

Utility tokens are not intrinsically valuable. If a project develops and is successful, investors are not entitled to a portion of the profits, as is the case with some traditional securities. We can analogize the role of tokens to loyalty points. These tokens can be used to buy goods (or can be sold), but do not offer shares or ownership in the business that distributes them.

As a result, their value is often determined by speculation. Many investors will buy tokens in the hope that their prices will soar as the ecosystem develops. If the project fails, there is little protection for the holders.

Security tokens are issued in a similar way to utility tokens, but with a slightly different distribution process, referred to as a Security Token Offering (STO). From an investment point of view, each token represents a very different instrument.

Even though both are issued on the blockchain, security tokens are still securities, which means they are closely guarded by regulations to protect investors and prevent fraud. In this respect, STOs tend to be more similar to IPOs than ICOs.

Generally, when investors buy security tokens, they are buying equities, bonds, or derivatives. Their tokens effectively act as investment contracts and guarantee ownership rights to off-chain assets.


What makes a token a security?

At the moment, the blockchain industry lacks much-needed legal clarity. Regulators around the world are still playing catch-up with new financial technologies that continue to emerge. There have been cases where an issuer has the confidence to issue a utility token, which is then considered a security by the United States Securities and Exchange Commission (SEC).

Perhaps the most well-known metric for trying to determine whether a transaction is more likely to be an ‘investment contract’ is the Howey Test. In essence, this test seeks to ascertain whether someone investing in a common enterprise expects a profit as a result of the promoter's (or third party's) efforts.

The Howey Test was issued by US courts long before the advent of blockchain technology. Therefore, it is difficult to apply it to a multitude of new tokens. Nevertheless, the test remains a popular tool for regulators seeking to classify digital assets.

Each jurisdiction will of course adopt a different framework, but most follow the same logic.


Programmable securities and financial tokens

Given the current market size, tokenization could radically change the realm of traditional finance. Investors and institutions will benefit greatly from a fully digital approach to financial instruments.

Over the years, centralized database ecosystems created a lot of friction. Institutions must dedicate resources to administrative processes for managing external data that is incompatible with their own systems. A lack of standardization across the industry adds costs to businesses, and significantly delays resolution.

Blockchain is a shared database that users or businesses can easily interact with. Functions previously handled by institutional servers can now be outsourced to ledgers used by other industries. By tokenizing securities, we can connect them to a network that multiple systems can interoperate with, which speeds settlement times and increases compatibility globally.

From this point, automation can handle processes that previously took a lot of time. For example, KYC/AML, locking investments for a set amount of time, and many other functions can be handled with code running on the blockchain.

If you are interested in reading more on this topic, check out our article entitled How Blockchain Technology Is Impacting the Banking Industry.


Closing

Security tokens seem to be one of the logical products of the development of the financial industry. Despite using blockchain technology, this type of asset leans much more towards traditional securities than towards cryptocurrencies or even other tokens.

However, there is still some work to be done on the regulatory front. With assets that can be easily transferred around the world, authorities must find ways to regulate their issuance and circulation effectively. Some people speculate that this could also be automated with smart contracts that encode certain rules. Projects such as Ravencoin, Liquid, and Polymath already facilitate the issuance of security tokens.

If security tokens start to bear fruit, then operations of financial institutions could be streamlined significantly. In time, the use of blockchain-based tokens as a replacement for traditional instruments could catalyze the merger of traditional markets and cryptocurrencies.