Payment tokens are designed to function as a currency and are used for payments. Utility tokens, meanwhile, give users the permission to participate in a specific application or purpose. Security tokens are blockchain-based regulated securities. They are a cross between cryptocurrencies and traditional financial instruments, and they will be the focus of this article.
While security tokens are just a slice of the overall cryptocurrency ecosystem, they are a force within themselves, with the group having generated returns of 46.5% in 2020, outperforming the traditional financial markets. According to the Security Token Alliance, tokenized securities have the potential to balloon into a USD 10 trillion market.
Security tokens were up 46.5% in 2020— Jonah Schulman 💎 (@jschul24) January 18, 2021
Security tokens are one use case of the blockchain. They are a type of digital asset that operates in a regulatory compliant way, boasting features like efficiency for fundraising and transactions. Security tokens can be used to digitize assets like real estate as well as equity or debt without having to rely on too many third-parties to operate and can be traded around the clock. You could also think of tokenized securities as the bridge between cryptocurrencies and traditional financial products.
FINMA, the Swiss Financial Market Supervisory Authority, describes security tokens, which it calls asset tokens, as representing “real physical underlyings, companies, or earnings streams” that are entitled to dividends or interest payments. As far as their economic function, they are “analogous to equities, bonds or derivatives,” the supervisor says.
A differentiating feature among security tokens is that they adhere to Know Your Customer (KYC) and anti-money laundering (AML) standards. As a result, individual and institutional investors must prove their identity before buying the asset.
Perhaps the best way to understand a security token is to see one in action. Video game publisher Exordium, which is behind the sci-fi game Infinite Fleet, launched a security token offering on the STOKR platform, which is a Luxembourg-based startup. Investors were able to participate with as little as USD 100 to buy EXO security tokens, which also gave them equity in the company as well as future profit-sharing opportunities.
It would've been easier for us to crowdfund - far less legal overhead. However, I believe security tokens will drive a reformation of capital markets & deliver more value to investors. Traditional equity raises are also illiquid - EXO is liquid from day one (pardon the pun).— Samson Mow (@Excellion) January 19, 2021
Exordium said it chose an STO due to the “regulatory grey area” surrounding utility tokens. The company says its security token gives holders “non-voting equity with profit-sharing from the publisher of Infinite Fleet, Exordium Limited.” They add that the “token is fully compliant” and “in the process of being registered with the SEC (US) and CSSF Luxembourg (EU).”
You could say that security tokens pick up where utility tokens leave off. They are the answer to the unregulated nature of tokens issued by ICOs, or initial coin offerings. While many of the ICO-powered tokens were billed as utility tokens, most of the projects never saw the light of day or turned out to be scams. Regulators eventually labeled many of the so-called utility tokens as unregulated securities, which wreaked havoc on the industry.
In 2017, the Praetorian Group and PAX coin, a real estate focused project, was the first security token offering to file with the U.S. Securities and Exchange Commission (SEC). And in 2018, the project became the maiden STO. Real estate is one example but basically any asset class can be tokenized.
According to Deloitte, security tokens are recognized globally by academics and security authorities alike. In Europe, they are subject to securities rules including the “prospectus regulation, MiFID, EMIR, CSDR, MAR, UCITS, and/or AIFMD.”
Security tokens are generally issued through security token offerings, or STOs, which is kind of a cross between an ICO and an initial public offering, or IPO. While STOs have greater oversight than ICOs, they are less regulatory intensive than IPOs in the capital markets. STOs are capital raising events that are compliant with regulation. From there, the tokens can generally be traded 24/7 on security token trading platforms. Investors can custody their own assets in digital wallets.
In an STO, a company offers its token for sale to investors in an attempt to raise funds for the project. The tokens are generally sold at a discount — say 80 cents on the dollar, for example — so that investors have an opportunity to profit from being an early backer down the line if the project turns out to be a success. The risk is that the project never comes to life.
While a utility token is designed for the future use of a product or service, security tokens are tradable financial assets and they are designed to be used as an investment. A security token might pay dividends, give investors a chance profit sharing or pay interest, for example. They were born in response to the Wild West environment that existed in ICOs as investors lost money and complained to regulators.
Tokenized securities bring some heft to the blockchain industry given their regulatory oversight, which was lacking in the ICO market where scams abounded. The regulatory oversight gives market players and investors including institutions a greater sense of ease when issuing or trading them.
Security tokens give issuers a way to raise capital by issuing tokens without having a target on their back considering they are registered with the SEC. On the flip side, investors don’t have to worry that the securities regulator is going to change its mind about a utility token and suddenly label it as a security, which has consequences for the issuing company as well as investors and traders alike.
In a sense, security tokens are the best of both worlds — cryptocurrencies and traditional financial securities — as they offer greater efficiency than legacy products — lower costs and faster transactions — yet have the oversight that other cryptocurrencies are lacking. As Anthony Pompliano, founder and partner at Morgan Creek Digital Assets, stated.
“The removal of middlemen leads to lower fees, faster deal execution, free market exposure, larger potential investor base, automated service functions, and lack of financial institution manipulation.”
You will find an entire ecosystem dedicated to the proliferation of tokenized securities. These include blockchain projects, exchanges, traders and more. Below are some of the key players operating in various roles in the security token industry, though it is not an exhaustive list.
Tokenized securities remain in the early innings and continue to evolve as regulation takes shape and players settle into their respective roles in the market. In the interim, there are plenty of ways to get involved, whether by issuing tokenized securities or trading them on one of the aforementioned exchanges. There are also a number of resources available in addition to Coinscrum to dig a bit deeper into the space.
Follow accounts such as Security Token Market on Twitter for the latest security token market data. One of the best educators in the space is Andreas M. Antonopoulos, the author of five books on blockchain and digital currencies. Antonopoulos also offers free workshops through which users can learn at their own pace. His has become a go-to resource for all-things crypto and blockchain, and you can access Andreas’ YouTube channel for all the latest videos here.
Individual countries have their own sets of rules for security tokens. Keep up with how countries around the world define and treat security tokens here.