What are security tokens? Here’s everything you need to know
Blockchain is a solid trend in fintech innovation that doesn’t only apply to cutting-edge implementations but also disrupts traditional banking companies. One of the recent blockchain trends is security tokens.
Security tokens have generated a lively debate in the financial services and crypto communities. While some enthusiasts speculate about the potential profits security tokens could generate, others believe it’s just a fad that actually carries significant risk. Interestingly, one of the reasons behind this divergence of opinions is that there exists some confusion as to what security tokens actually are.
The legal and compliance aspects make it more difficult to understand the differences between various types of tokens like security tokens, utility tokens, and other digital assets.
You may remember the initial hype that surrounded Initial Coin Offerings (ICOs) just a few years back. But with fraudulent activity coming to light, many people became suspicious of blockchain and likely to discard novelties like security tokens without even understanding what they are. They could be missing out on a significant opportunity. As ICOs gave way to Security Token Offerings (STOs), we saw new fundraising mechanisms designed to issue security tokens in a safer and more reliable way.
Read this article to learn everything you need to know about security tokens: what they are when to use them, and how they’re currently regulated in various countries.
What are security tokens?
When ICOs started to become popular a few years ago, the Securities and Exchange Commission (SEC) began to pay attention to them, noting an increasing number of fraudulent schemes.
Let’s stop here for a moment to explore the topic of securities. In general, we can define securities as tradable financial assets such as equities, options, bonds, and warrant. Security tokens meet these criteria and, as a result, belong to the same category of assets. To determine this, the United States Supreme Court created a special test called the Howey test to be used by the SEC.
According to the test, we can class a token as a security token if it meets the following criteria:
- The token works like a financial investment and has voting rights,
- The investment will go to a company/group of companies,
- The investor expects the acquisition of the token to bring them a profit,
- The profit will be generated by the work of third parties.
If a token meets all of the four criteria, then the company offering it needs to meet all of the requirements that apply to traditional securities. What are these requirements? For example, the company needs to meet:
- Prospectus requirements,
- Ad hoc reporting responsibilities,
- Liability for providing false information.
The Howey test serves as one of several tools that help qualify a token as a security or clearly state that securities laws and regulations don’t need to be applied to a given token.
All in all, security tokens serve as a digital representation of rights such as shares in a company or the ownership certificate of goods such as real estate, precious metals, or even artworks.
For example, OverFuture, an Italian-Swiss company based in Switzerland, recently got FINMA approval to conduct an IPO with Ethereum security tokens.
Advantages of security tokens
Here are the most important benefits of STOs for companies and investors:
- Trust – storing assets on a blockchain is safer than relying on centralized systems. Since security tokens are permanently stored on a blockchain, they’re immutable and fully traceable, no matter how many times it has been exchanged or how old it is.
- Transparency – security token transfers are transparent, and their owners can easily prove that they can exercise the rights attached to these tokens by showing that they have such tokens in their wallets.
- Fractional ownership – it’s possible to fraction security tokens into almost infinitesimal small units. For example, a real estate property that costs GBP 500,000 might not be an affordable investment for one person. But if this right to ownership is represented by 500,000 security tokens that can be fractioned, a company can offer the opportunity to many people where each of them invests a small amount of money in return for partial ownership of the property.
- Global adoption – security tokens can potentially enjoy fast worldwide adoption and become integrated into various distribution platforms, as long as they’re implemented using an interoperable standard. Naturally, compliance with different laws and regulations is a key aspect of the global expansion of security tokens.
- New opportunities on the market – until recently, traditional banks and financial services institutions held a monopoly over issuing of financial products. Since any licensed legal entity can issue security tokens, the market will open to new players, resulting in price competition, which will be beneficial for its participants.
- Lean settlement – since transactions are executed on a blockchain, there’s no need to rely on third parties and the expensive infrastructures they use to make such transactions possible.
Challenges of security tokens
Naturally, just like every other technology, security tokens come with a range of issues and challenges. Here are the most significant problems behind security tokens.
- Regulations – blockchain applications like security tokens still fall victim to lack of or unclear regulation. While in some jurisdictions, issuing and administration of security tokens can become problematic. However, governments and institutions are working on regulatory standards and their quick adoption, so the situation is bound to change in the near future.
- Lack of familiarity with blockchain and STO – many investors still don’t know how blockchain and its applications work. Since it’s the investor who holds security tokens and doesn’t use custodial services (for example, offered by a bank), that lack of familiarity with the technology is a serious issue. The barrier to entry might become high, and companies looking for launch an STO should remember about that.
- Lack of third-party support – since no intermediaries take part in STOs and security tokens don’t require third parties, their absence might be perceived by investors as a risk. In many cases, such third parties provide expertise and ensure a high level of security to the entire market.
Over the next few years, blockchain and its security offerings are bound to expand in Europe and other continents. As the existing laws and regulations continue to be modified with the goal of increasing the integration of distributed ledger technology, we can be sure that accessing security tokens will become easier and more commonplace.
As investors increasingly appreciate the transparency of security tokens and their regulatory ties, the future of this asset is bright.
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