What Is A Security Token? A Thorough Guide To Security Tokens

What started with Bitcoin as the very first blockchain and example of a cryptocurrency, has blossomed into an entire industry and a technological and financial revolution. After Bitcoin came altcoins and developers have since added new layers to blockchain technology.

Ethereum is an example of a layer 1 blockchain technology in which additional layers can be built using smart contracts. Since the debut of Ethereum, other competing technologies have since appeared.

Much of the rest of the altcoin market is built on the back of Ethereum’s blockchain. NFTs, DeFi, and more all typically rely on Ethereum. Previously, before a regulatory crackdown, Ethereum was also heavily used for ICOs, leading to the further innovation of tokens, particularly utility tokens. 

 Utility tokens are often compared to security tokens, but there are some distinct ways of distinghusighing between the two types of assets. Understanding the difference between utility tokens and security tokens is paramount to proper adherence to certain regulatory guidelines – as security tokens fall under the jurisdiction of the Securities and Exchange Commission, otherwise known as the SEC, and are subject to heavy regulatory scrutiny.

This guide will compare and contrast utility tokens with security tokens to demonstrate the key differences between the two and help clear things up for investors once and for all in terms of regulatory compliance.

What Is A Security Token? Security Token Definition And Meaning Explained

Security tokens are a new type of financial asset based on the traditional market. Security tokens are in essence tokenized securities that rely on blockchain technology for easier asset management. Like decentralized cryptocurrencies, these assets transact across a public or private digital ledger to authenticate transactions and ensure transparency. Also like other digital assets, a private key identifier and digital signature are involved in cryptographic transactions.

The Howey Test

In our introduction, we referenced a financial regulatory authority named the Securities and Exchange commission. This branch of the United States government oversees financial markets and regulates any assets it deems a security. 

A security is defined as such if it fits any of the parameters of something called The Howey Test.

According to the Tokenist, the test itself was created in 1946 over an investment scheme involving a citrus grove. At the time, The Howey Company sought to sell investors a plot of land, with an added promise from the company would work the land and pay profits to those investing. The SEC blocked the sale, seeking to protect investors. As part of Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946), the Howey Test was created to define a security.

Therefore, as translated for the crypto market and the tokenization of securities, a token is a security if:

• 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 Howey Test is regularly used even today, more than 50 years later and could use an update based on the emerging digital asset industry. The same parameters from 1946 are unlikely to apply the same way today.

At one point, the SEC made a fake Howey Coin website to use as an example of what a cryptocurrency project that fails the Howey Test would look like. The website included all kinds of false claims, promises of profits, and would accept credit cards as investment potentially putting people in debt. If you encounter an investment scheme of a similar narrative, it is best to avoid and stay away.

Comparison: Utility Tokens Vs Security Tokens

During the 2016 and 2017 cryptocurrency market bull cycle, dozens of new coins were launched without any regulatory scrutiny or oversight. This led to the creation of genuine utility tokens, tokens that are better defined as security tokens, and then outright scams which the SEC seeks to protect users from encountering. 

Both utility tokens and security tokens are commonly offered to early investors as part of a public offering. Depending on how this is offered and if certain promises are made or regulations followed will determine if the token is a utility token and a security token.

By definition, a utility token gives users access to a token that is later used within a cryptocurrency ecosystem, rather than as an investment vehicle. All tokens have value, so token holders might buy a utility token as an investment, but its purpose and what it was promoted as must be tied to a cryptocurrency ecosystem or a product ot service.

All tokens have value, so token holders might buy a utility token as an investment

Utility tokens give users certain benefits or rights within a specific ecosystem and any utility token developers or creators make no claims to the token’s value or any promises related to future profit potential.

Creators of utility tokens must be clear that the usage is designed for us in such ecosystem and must supply information that verifies the tokens will be used in such manner. The problem is that several startups don’t yet have a working product.

Utilities include a trading fee discount for strategy mangaers, while utilities for followers include an improved profit share, increased follower limits, and an elinination of new follower entry fees.

Because the line between utility tokens and security tokens can be thin, it has led to some confusion which we’ll seek to clear up using the comparison table below.

Cryptocurrencies that have been around for some time, like XRP, have recently been dubbed unregistered securities by the SEC and have charged exucutives at Ripple for related crimes. XRP was once the third-ranked cryptocurrency by market cap, but after a wide delisting from exchanges, the token’s reputation has taken a clear hit. 

Ripple is fighting the SEC in court, but could be facing an uphill battle againt the court and legal system. The SEC seeks to make an example out of Ripple and XRP for the rest of the industry that issues tokens without utility to investors without following certain regulatory compliance.

How Are Security Tokens Created?

Security tokens exist via smart contracts, and are typically launched via a public offering called a security token offering or STO. The STO is very similar to a stock market IPO in which venture capital gets the most value proposition by getting in early to a project or offering of any kind. The STO has also replaced the initial coin offering or ICO in the marketplace. 

How Do Security Tokens Work?

Smart contrasts are used to digitize traditional financial market securities such as stocks, bonds, or otherwise. The token code dictates the conditions of the security, which must adhere to federal security laws.

Security tokens otherwise work similar to other digital assets or token types. Transactions are broadcast across a blockchain network and recorded via a disgtributed ledger. 

Why Are Security Tokens Important?

Because a security token is launched under such strict regulatory conditions, the investment contract offers a level of legal protection that decentralized cryptocurrencies simply cannot. For example, Bitcoin is considered a crypto-commodity by the CFTC and is not regulated under security code or the SEC.

The Return Of Crypto Market Crediblity 

The ICO market was extremely damaging to the fabric of the cryptocurrency market. Too many scams resulted and the practice is since frowned upon. Security tokens follow a regulatory process that brings back a layer of credibility to early investors. It also will help the crypto market gain wider acceptance from Wall Street as more regulations occur.

Reinventing Mainstream Finance

The stock market has been the same for the last fifty years and since online trading first started taking over. This brings traditional finance to the digital age and helps to improve financial inclusion, reduce fees, and more.

Increasing Finance Industry Efficiency

The current financia institution models of moving money across middlemen is broken, slow, and costly. By adapting security tokens and blockchain instead, costs can be reduced and speed an be increased.

Exposure to Free Market

Security tokens can exist globally as part of the crypto landscape giving more users across the world more access to the free market than ever before. No longer are investors stuck investing in US-based companies only.

Increasing Reach And Audience Capacity

By shifting to the internet, securities can in theory expand the reach of investments in general by tapping into an entirely new audience worldwide.

Reducing Legal Fees And Lawyer Service

Legal fees are hefty and can cripple a company just getting its footing. Ensuring the proper regulatory compliance is maintained through security tokens can help to reduce future legal fees and lawyer service related to legal battles.

Protection From Institutional Manipulation

Without financial middlemen, there is far less chance of manipulation or other forms of corruption along the chain of involved financial institutions. Distributed ledger technology and transparent transactions also help to reduce evidence of manipulation.

Easier Liquidation And Storage

Security tokens can be moved via the blockchain and then traded or exchanged via a security tokens exchange or trading platform. 

Types Of Security Tokens

Security tokens can represent many different types of investment contracts. But are most commonly issued as equity tokens, debt tokens, and real asset tokens. Below we’ll explain the different between the various token types.

Equity Token

An equity token represents tokenized shares issued by a company on the blockchain. These are in essence nothing more than tokenized stock market shares that record ownership through the blockchain instead of a centralized solution. It can be used as a new fundraising model for early startups, while also enabling compliance with securities law and protecting investors.

Debt Token

These tokens represent real-world debt instruments like real estate mortgages and corporate bonds. The token value is dictated by risk and dividend. A smart contract of a debt security should conclude repayment terms and a dividend model.

Real Asset Tokens

Real asset tokens represent ownership over real estate, art, commodities, and more. Anything with real-world value in essence could be tokenzied into shares and distributed among investors as security tokens.

Security Token Advantages

Although things like speed and bringing traditional assets into the digital age have been heavily discussed throughout this guide, there are still several advantages that haven’t been touched on. For example, fractionalization of assets is a primary example of how tokenization of assets is helpful and can boost traditional markets. 

Tokenization of assets is helpful and can boost traditional markets

In this case, there could be only on Van Gogh painting, however, if tokenized users can own fractional shares of the same art piece. Similar to how Bitcoin users can own a fractionalized share of Bitcoin called a satoshi. Such fractionalization will be possible with stocks, and other forms of security tokens.

Security Token Vulnerabilities 

Security tokens of course have vulnerabilities and like all things some of the weaknesses have also been presented as strengths. For example, without middlemen, there is less risk of manipulation and less fees overall, however, without middlemen there is less incentive for flawless infrastructure and less security.

For example, tokenized assets are at risk of hacks like crypto assets, when you never hear of a stock market exchange being hacked. Security tokens currently lack the infrastructure necessary to completely replace the current financial system but the technology is improving by the day.

What Issues Are Holding Back Security Token Adoption?

Lack of clarity around security tokens and guidance from financial regulators are the biggest reason for security token adoption to be moving at a snail’s pace compared to the rest of the blockchain industry. Innovation is moving faster than regulators can act, but it is at this point preventing innovation since regulators started sticking their nose into some subjects, without issuing enough clarity around such assets.

A lack of regulatory framework is deterring developers, startups, and investors alike. More clarity is needed for this potentially disruptive technology to get off the ground.

What Regulations Are Security Tokens Subjected To?

Security tokens are subject to certain types of regulation under financial law and accoriding to the Securities and Exchange Commission. 

Regulation D

Regulation D will allow any such offering to avoid being registered by the SEC provided a “Form D” has been filled by the creators or company involved post securities sale. The individual or company who is offering this security may solicit offerings from investors in compliance with Section 506C. Section 506C verifies that the investors are properly accredited and any information which has been providing during investment solicitation is “free from false or misleading statements” such as a promise of profits or certain returns within a specific timeframe.

Regulation A+

Regulation A+ allows the creator or company to offer an SEC-approved security to non-accredited investors through a general investment solicitation for up to $50 million in total investment.The Regulation A+ is a notably longer, more challenging, and expensive process and is often avoided for this reason.

Regulation S

Regulation S occurs when any security offering is executed outside of the US. Any such security offerings are not subjected to the registration requirement under section 5 of the 1993 Act. The creators or company are still required to follow the security regulations of the country where they are claimed to be executed.

How Security Tokens Can Change The Market

Exclusive data from Inwara demonstrates that STOs were on track to grow year over year starting in 2019, and with 2020 being the year of digital assets due to the COVID pandemic, the data has only trended higher since.

The above security token ecosystem infographic shows just how vast the industry already is although it is still so very young. However, here are other ways security tokens can change the market forever and for the better.

Unlocking Liquidity

With greater access from the entire global financial ecosystem, there will be deeper market liquidity unlocked for all. This benefit extends to all users.

Opening Up Capital to Global Markets

Capital globally is highly centralized around the United States and other financial super powers. Capital is even further centralized in areas like Wall Street and other finance meccas. By putting localized assets on the global market, capital can be spread around globally.

24/7 Trading

The stock market closes at 4PM each day and then futures take over. Cryptocurrencies trade 24/7, 365 days a year, even on holidays, weekends, and overnight. This makes for an always on opportunity and 24/7 trading.

Asset Interoperability

Asset interoperativlity isn’t something that is considered currently across traditional finance, but by having stocks and other assets tokenized and stored in the same blockchain wallet, assets can be condensed for safe keeping and storage.

Automated Compliance

The underlying blockchain protocol used and the smart contract code can be developed to automate compliance and save companies a fortune on compliance officers, procedures, and challenges.

Programmable Assets and Securities

Like the statement above, smart contracts can be coded or programmed to have certain attributes, make certain token requests, and more, such as the ability to specific dividends, or the contract expire if certain conditions are met.

Fractional Ownership and Increased Market Depth

Although there are only 21 million BTC, investors can buy a fraction of Bitcoin called a Satoshi. Digital assets all work in a similar fashion, and by tokenzing company shares fractionalized shares and ownership are possible. This will in turn increase market depth by allowing more owners overall.

Summary: Everything You Need To Know About Security Tokens

Market research shows that security tokens are becoming an increasingly important piece of the financial landscape. It is yet another way cryptocurrencies are disrupting everything from the stock market to online banking.

For now, trading cryptocurrencies using PrimeXBT can keep profits flowing until security tokens are ready for prime-time. PrimeXBT is an award-winning magin trading platform offering crypto, forex, stocks, commodities, and more.

There is an easy to use client interface with built-in charting tools, long and short positions, and much more. Registration is simple and takes nothing more than an email address and password. Accounts are protected by security measures like two-factor authentication to prevent any unauthorized access to funds. This means a user must use an authentication app to obtain a six-digit code separately from completing a username and password combo.

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Because security tokens are relatively new and still emerging as the financial industry changes, there are still plenty of questions investors often have. The following list of commonly asked questions about security tokens will help to clear up any remaining confusion.