This is the first article in the five-part Security Tokens Series where we analyze the key characteristics of security tokens and how they will impact the future of digital assets.
Until recently, blockchain technology enthusiasts focused on such concepts as utility tokens and initial coin offerings (ICO). Now, many see security tokens and security token offerings (STO) as the logical next step in the development of crypto assets.
Put simply, security tokens are a completely different type of asset than utility tokens. Although they often get lumped together in the general category of tokens or cryptocurrencies, security tokens are basically digital analogs of securities that confirm ownership and give verified token holders the right to participate in their investment. In effect, they have a claim on the profits, stocks, dividends, financial inflows, debt payments, voting rights, and more.
These tokenized digital assets are, in essence, backed by a real-world asset or cash flow. As such, they are considered a financial investment according to the Howey Test and are therefore subjected to additional regulatory requirements, including reporting and auditing among others. Security tokens circulate in accordance with the legal regulations of financial regulators of various countries, for example, the U.S. Securities and Exchange Commission (SEC) or the Swiss Financial Market Supervisory Authority (FINMA). Like traditional securities, tokens are interchangeable (sometimes referred to as fungible) and negotiable instruments that, theoretically, enjoy improved prospects for cash liquidity.
STOs and Smart Contracts
It follows, the company must issue its digital securities tokens to fulfill the STO. All the rights are recorded in a smart contract, and the tokens themselves are traded on exchanges, while rights of the one/s who invested in utility-tokens are limited to selling and using them within a relevant system. With a more detailed consideration of the process, a company can move in two directions when developing a new asset for the security-token. The first method is the issuance of real securities and their subsequent tokenization through various platforms using a distributed registry as a repository for all transactions. Thanks to blockchain, securities will be easier to manage, but this approach still requires considerable legal work to register securities.
Another way to issue such tokens is to securitize them by their nature but not in real terms. This means that for such assets, the value lies in the coded rules that these tokens comply with. Such STO tokens do not require any legal work but require significant activity from the technical side of development since all the rules must be precisely and correctly defined.
Security Token Offerings: Solving the Problems with ICOs
Security tokens solve one of the biggest problems of ICOs — the lack of compensation guarantees in the event of a project failure or fraud by the managers. On the other hand, the main advantage of security tokens compared to traditional financial products is the elimination of intermediation in the face of banks and other organizations. This leads to a creation of a completely different environment for investing and concluding deals. No wonder STO is perceived as the next evolutionary step after the Initial Coin Offering (ICO) boom, which defines the industry’s development vector towards a more regulated and transparent market.
First of all, STOs intend to issue digital assets in full compliance with the requirements of securities legislation. This should provide a higher degree of protection of investor rights and lower regulatory risks for token issuers. In addition, STOs are aimed at a different target audience — only accredited investors can participate in this process.
On the contrary, to enter the ICO, it is enough to comply with the requirements of the specific jurisdiction where the company is planned to be registered. In fact, any user can purchase utility tokens sold during the ICO. It is enough to find out through which exchange the tokens will be sold, register, make a deposit and purchase the desired number of tokens, which can then be used or sold.
The lack of clear rules in the crypto sector creates not only risks for investors but it also damages investment funds and venture capital. Thus, many invest in a project at the pre-ICO stage or sign a standard share investment agreement with blockchain companies. In addition, investors resort to an investment risk hedging strategy such as the Simple Agreement for Future Tokens (SAFT).
SAFT is a contract that allows accredited investors to acquire tokens after the launch of the ecosystem. Although this model is considered safer, it is still associated with certain risks: the one invests not in tokens, but in a promise to receive them in the future. Therefore, investors are still at risk of losing their investment if the project does not start.
STOs are the Future
Taking into account all features of security-tokens mentioned above, we can summarize that they offer a logical solution to the problem both from the regulatory point of view and from the point of view of risk mitigation. STOs pave the way for the implementation of many of the goals of the early stage of blockchain development.
Tokenization and fractionalization of securities can lead to the widespread dissemination of these mechanisms. The list of assets that can be potentially tokenized is indefinite: equity, real estate, debt, fine wines, art, vintage cars, and much more. One way or another, STOs can provide the business issuing such securities with an effective way to attract financing.