Estimated reading: 6 mins

Security Tokens Explained: Everything You Should Know

Some believe security tokens to be the next big thing in the crypto space, especially given all the talk about them in recent times. In this article, we look at what security tokens are, how they're classified, and when your business should consider a security token offering.

Let’s delve in and explore.

 

What is a Security Token Offering?

To get a better understanding of what a security token offering is, let’s start by defining a security.

A security is a certification with an intrinsic monetary value. Securities can either be traded from peer-to-peer or through exchanges that act as intermediaries.

There are two main types of securities: equity and debt securities.

Equity securities represent the investor’s ownership interest in the issuing company, while a debt security represents borrowed money that needs repaying.

Companies use securities to raise capital from investors. The investors are promised returns in the form of a share in the company’s profit or through dividends or interest rates.

 

What Is a Security Token?

A security token is simply a digital or electronic security. Being electronic means that the tokens are easier to trade and comply with relevant rules.

Businesses use security tokens to lock in funds from investors while still giving the investors the freedom to trade the tokens on secondary markets. The investors can get their money back by selling off the tokens, but the business will not lose the funding.

 

How Do Security Tokens Work?

On a high level, all security tokenisation companies work similarly. The token issuer issues the tokenised securities, which represent an ownership claim in their company. The issuer then creates a whitelist of the wallet addresses of all the investors.

All whitelisted individuals must prove that they comply with all the restrictions for that security. These restrictions will, at the bare minimum, involve anti-money laundering laws (AML), and know your customer (KYC). Investors will also have to prove that they are accredited investors.

Since a security token protocol can't accommodate the regulations of all jurisdictions, companies restrict who can own the token using a whitelist.

The issuing company can outsource the creation of a whitelist to a third party, such as a centralised exchange. In this case, the whitelist also serves as a ‘liquidity pool’ allowing listed parties to trade with each other since they're already approved.

Issuers also allow the third parties to conduct AML and KYC checks on investors so that exchanges don’t have to go the issuer every time the investor wants to trade their security tokens. This makes the security token more liquid, therefore increasing its value as well as the value of the underlying asset.

You can trade your tokenised securities anytime you want as long as your counterparty is whitelisted. Some of the exchanges that allow trading of security tokens include Blocktrade, tZero, and Openfinance.

security tokens explained
IMAGE SOURCE: Jesus Rodriguez.

 

How Are Tokens Classified as Security Tokens?

According to the federal securities law, all companies that wish to sell security tokens must register with SEC. To classify as security tokens, they have to qualify for the Howey test.

 

The Howey Test

The Howey test was established by the US supreme court to determine whether or not a transaction represents an investment contract. A transaction is considered an investment contract if it meets the following conditions:

  • It is a money investment
  • The investment is expected to produce profits
  • The money investment should be within a common enterprise. A common enterprise, according to federal courts, is an organisation where investors can pool money or assets together to invest in a project
  • The profit comes from the efforts of a third party or promoter

In addition to meeting the conditions in the Howey Test, a security token should also meet several other regulations.

 

STO Regulations

Security tokens in the United States of America are subject to the following regulations.

Regulation D

This is an exchange commission and securities regulation that allows startups and small companies to use debt securities or the sale of equity to raise funds without having to register the securities with SEC. Companies must file a Form D with details of the offering, including names and addresses of the directors.

Regulation S

This regulation provides the US and non-US companies with an SEC-compliant method of raising funds outside the USA. A company based in the United States does not have to use regulation S. Offerings that are subject to this regulation should follow the security regulations of the countries where they are executed. Regulation S allows for the issuance of both equity and debt securities.

Regulation A+

This regulation allows the issuer to provide SEC approved securities to non-credited investors through a general solicitation for an investment of not more than $50 million. Regulation A+ allows Canadian and US companies to combine private funding with public funding to create a massive round of fundraising.

 

Features of Security Tokens

  • Regulated - unlike utility tokens, security tokens are subject to securities trading regulations meaning that the law protects the investor. The only difference between security tokens and other securities is the use of blockchain technology
  • International - security tokens enable companies to get funding from all over the world. Investors also get a chance to invest in global companies
  • Affordable - since security tokens are on the blockchain, this eliminates the role of intermediaries and drastically cuts costs for both investors and the issuing company
  • Transparent - since traditional securities have to go through numerous intermediaries, the market lacks transparency. Security tokens, on the other hand, are issued through the blockchain, therefore ensuring that everything is transparent
  • Fraud resistant - with security tokens, the investor’s property rights are stored on the blockchain using a smart contract, which is immutable
  • Allow for fractionalisation of assets- security tokens support fractional ownership
  • Less volatile - since security tokens have an underlying value such as real estate, shares, or commodities, they are less speculative and, therefore, less volatile
  • Innovative - security tokens offerings are made possible by innovations such as blockchain and smart contracts. They also attract innovational investors who initiate new developments such as apps for the security token market
  • Security tokens are multifunctional - an investor can use a security token to purchase shares or use them to buy a product or service
  • They are liquid - security tokens bring liquidity to previously illiquid sectors such as real estate
  • Easy to trade - unlike traditional assets that only trade on specific days and times, security tokens can change ownership on a 24/7 basis
  • Accurate - fully automated process for issuing security tokens and their associated legal compliance, hence ensuring accurate and reliable data

When Should Your Business Consider a Security Token Offering?

If you are looking to raise a lot of capital for your business, you can consider launching a security token offering. Your company also needs to align with the following factors.

A turnover of more than 10 million per year

For your company to successfully raise funds with an STO, it has to generate a high valuation.

The higher your turnover and profits or your organisation, the higher the valuation of your company. With a significant valuation, you will get more capital for the percentage of your company.

Running a global business

To expand the potential of security token offering and raise more capital, you should market to a worldwide audience.

Funding methods that attract your current customer base

Don't ignore your existing customer base when you are trying to raise capital for your venture. Use a funding method that appeals to them and issue easily transferable assets.

Willingness to take a risk

Regulations governing security token offerings can change anytime. Should countries with high spending power tighten their laws, it may place your investment source at risk. Such countries include the United States, South Korea, the United Kingdom, and Russia. This is a small risk, but you would be wise to prepare for it.

 

Final Word on Security Tokens

Security tokens have plenty of advantages, and they are here to stay. We might not know how long, but for now, they offer an excellent way for organisations to raise capital.  Also, now that investors know that blockchain-issued security tokens can provide the right to own an equity share in companies, the STO market is a hot space to watch.

If you have any questions about security tokens, feel free to leave a comment below.

 

What's Next?

Learn all about ICO's here.

 

 

 


About the author:

Jay Jackson is a blockchain enthusiast and a freelance writer at topcryptowriter.com. He works closely with brands (people, businesses and startups) in the crypto sphere. He currently writes Blog posts, Guides, Press releases, ICO reviews, eBooks & Whitepapers. You can find him on LinkedIn.

Disclaimer:

The above references an opinion and is for informational purposes only. Do not take this as personalised financial advice or investment advice. The views expressed by the author do not necessarily represent the opinion of BitPrime.

Last updated: 13/12/2019

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