Why Security Tokens Matter

. 4 min read

After the ICO storm of 2017 and the early part of 2018, there’s been a noticeable calm. Investment in ICOs has dropped off significantly, with only $500 million raised during December 2018, compared to the $5 billion that was raised just six months earlier. While this has provoked some debate about whether cryptocurrencies were in a perpetual downtrend, others are looking forward with anticipation, forecasting that 2019 will be the year of the security token.

But if ICOs were just a passing fad, why do security tokens matter?

With plenty of jargon swirling around the token universe, it’s worth defining the concept of a security token. The idea of tokens being offered as securities arose as a result of the US Securities and Exchange Commission (SEC) ruling on the issuance of tokens by an Ethereum-based venture fund called The DAO. The SEC deemed that the tokens issued in an ICO held by The DAO were securities, based on the application of the Howey Test, which is used to determine if a particular transaction represents an investment offering. If the transaction is an investment of funds, in a common enterprise, with an expectation of profits arising from the efforts of a promoter or third party, then the transaction will be classified by the SEC to be an offering of securities.

Since the SEC ruling on The DAO in July 2017, a number of more recent ICOs have tried to push their offerings as utility tokens, arguing that the token itself represents no ownership of the underlying company and can only be used to access the services of the particular platform. However, the SEC has been firm in cracking down on ICOs which flout regulation.

At the same time, other jurisdictions popular for blockchain startups, such as Switzerland, have issued their own regulatory guidance on what may constitute a tokenized security offering.

That being said, the definition of a security token can actually be answered by asking whether or not the regulators in a jurisdiction where a token is offered or sold would consider it as a security under their own rules.

Why Do Security Tokens Matter?

Despite the definition above, the excitement about security tokens doesn’t stem from the maturation of ICOs into Security Token Offerings (STOs). Only now, the financial world is waking up to the notion that trading in blockchain-based digital tokens could potentially revolutionize trading in existing securities and other real-world assets. The era is dawning where security tokens could represent equity, physical assets, debts or other financial instruments, such as derivatives.

This is an exciting proposition, as security tokens offer significant benefits, such as:

  1. Global Exposure:
    Today, global investing transactions are fraught with many limitations as investors traditionally seek investment on their home soil for reasons of regulation and convenience. Through the use of security tokens, on the other hand, issuers can market their deals to virtually any reputable person on the internet. Security tokens can be marketed and sold to anyone, anywhere in the world, provided the relevant local laws are followed. As a result, frictionless investment over international boundaries becomes much more feasible and this exposure to global free market helps in increasing asset valuation.

  2. Coded Compliance:
    One of the greatest benefits of a security token is the coded compliance functionality. This is a great advantage for token issuers who are now required to stay continually compliant in the highly regulated primary and secondary markets. Smart contracts can now dictate how the token can be bought, sold, and traded in a compliant way.

  3. Low Cost:
    Another benefit of security tokens is the reduced fees and relatively low-cost nature of these tokenized assets compared to other economic models for investing. These tokens come with zero administrative costs of buying and selling, allowing people to generate a greater amount of returns on their investments.

  4. Token Automation:
    Today, traditional securities are managed by a combination of excel spreadsheets, lawyers, paper certificates, custodians, transfer agents, and accountants which takes up a lot of time and money, not to mention the potential for human error. With automation built into the workflow security tokens are in a better position to remain as efficient and accurate as possible. This allows these tokens to automatically execute any events associated with holding the security, such as distributions, stock splits, voting, and buybacks.

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Greater Flexibility for Stakeholders

Venture investors usually find their funds are tied up for years, until the company is profitable, and then they end up getting bought out. Using security tokens, any investor can sell a part of their digital asset to the highest bidder.

Being a shareholder also comes with particular rights, such as voting on the election of new board members or other significant events affecting the company. With programmable smart contracts, these rights can be coded into a security token, meaning that annual general meetings could be held virtually with no need for physical presence.

Looking forward

To sum it up, security tokens don’t need to be limited to blockchain-based startups in the same way as ICO tokens. An existing company could tokenize its shares and offer them up as equity as a way of funding new ventures or projects.

Various blockchain initiatives have started offering tokens linked to real-world assets, such as gold and real estate. Commodities could be tokenized and traded without having to move physical goods until they are needed, and traditional exchanges could soon offer the digitized trading of a wide range of existing instruments. Security tokens are opening the door to a digital revolution in the world of finance.