What are security tokens and how can they be used?
Security tokens represent investment contracts providing their purchasers with some sort of guarantee of future profits. How do these tokens function, what makes them different from other types of blockchain-based assets, and what benefits they provide both to investors and issuing companies? Read this article to find out.
New technologies come with new risks
Despite the warnings against the high risks of investing in ICOs at the end of 2017, the cryptocurrency industry managed to raise more money within a month than ever before. How has such an unstable technology managed to achieve such great success?
An Initial Coin Offering or a token sale has become a good alternative to IPOs (Initial Public offerings) and the most popular way to raise capital for IT startups. According to the research data published by Coindesk, eager crypto investors spent a staggering sum of 3,23 billion US dollars on token sales in the last quarter of 2017, paying with Bitcoin and other crypto coins for the tokens. The hype around the ICOs and cryptocurrencies made investors blind to potential risks and careless about the consequences.
However, the favorable situation was quickly undermined when companies failed to fulfill their promises. Investors didn’t receive any guarantees of profits from the issuing companies. In fact, many projects that conducted token sales mismanaged the funds they received. Moreover, there were many avid fraudsters and manipulators among ICO organizers who came to the cryptocurrency industry to get quick bucks and disappear with customers’ funds forever.
According to the information revealed by Satis Group, approximately 80% of all ICOs that took place in 2017 turned out to be a scam. Despite this negative moment, it gave huge impetus for the crypto industry and created new conditions for fundraising in the following years. Much of what we witness nowadays wouldn’t be possible without that ICO boom.
This is how market demand for better regulations appeared. As a result, security tokens have come into view, while ICOs were transformed into STOs (Security Token Offerings).
What are tokens?
A token is an asset that serves as a presentation of a voting right, stake, or value in a definite ecosystem with a possibility to perform different functions. Tokens should be clearly distinguished from cryptocurrency coins that don’t depend upon any specific platform. By design, digital tokens can be divided into two big groups: utility and security.
As a rule, utility tokens are created for the support of their native eco-systems. They don’t have any value outside of this system and they are not legally regulated. The decisions on their use and their features can be taken by the members of the corresponding eco-system. That was the main feature that allowed crypto startups to get away so easily back in 2017. Without any legal protection, investors just didn’t have any means to influence unscrupulous companies which led to significant losses.
What are security tokens?
Being digital analogs of securities, such tokens certify ownership providing users with the opportunity to implement their investment interests recorded in a smart contract. At this, security tokens are eligible for trading on Bitcoin exchanges.
Anthony Pompliano, a Managing Partner at Morgan Creek Capital, delivered the following definition of the security tokens. He called them a kind of programmable ownership. This type of ownership can be applied to any asset whether it’s a monetary obligation, real estate, crypto, public capital, or something else.
Security tokens became a solution to the largest ICO problem, which is the lack of guarantee to compensate expenses in case of failure or fraud of the organizers. Besides, security tokens are presented as a risk-hedging tool for an investment strategy SAFT (Simple Agreement for Future Tokens). This is a safer computer model as the investors can buy the tokens after the launch of the project.
The Howey Test helps to define security tokens
In the financial industry, there is a so-called Howey Test, that helps to classify a transaction as an investment contract. According to this test, the investor should answer ‘yes’ to the following four questions:
- Is there a fact of investing money?
- Is there an expectation of making profits?
- Is the money invested in a common enterprise?
- Do the profits and their size depend not on the efforts of the investor, but on the efforts of the counterparty or the third party (promoter) as well?
The SEC applies the Howey Test today to startups willing to raise funds with the help of STOs. If an affirmative answer is given to all these questions, it means that investors are going to contribute to security tokens.
Security tokens vs. utility tokens
Security tokens differ considerably from utility tokens. In contrast to them, security tokens are tied to real securities and thus represent a financial investment. If you think about similarities with equity tokens, they won’t be the same either as they represent the shares of the company.
It is considered that STOs (the Security Token Offerings) are the next evolutionary step after the boom of ICOs as they are going to add better regulation and transparency to the market. The companies issuing security tokens are subjected to additional regulatory requirements including the necessity of reporting. In addition, unlike ICOs where anyone could participate, STOs accept only accredited investors.
In a nutshell, the table below gives a brief comparison of ICOs vs STOs by their key aspects:
| Initial Coin Offering (ICO) | Security Token Offering (STO) | |
| Who can participate | Anyone | Only accredited investors |
| Regulation | Little to no regulation | High regulation |
| Investors get | Tokens | Ownership rights |
| Level of risk | High | Medium |
| Cost of launch compared to IPOs | Low | Medium |
Pros of security tokens
The main advantage of security tokens over traditional financial products is the removal of intermediaries such as banks, financial organizations, etc. This allows creating a new investment environment and conducting new types of computer-based deals. Deals can be concluded faster and without extra expenditures. Security tokens can be traded anywhere without geographical limitations at any time round-the-clock. All this simplifies the exchange and trading of such assets.
If we compare security tokens with their utility analogs, they help crypto investors feel legally protected. The Security Token Offerings involve the issuance of digital assets complying with the frames of securities legislation. This gives better protection for investors removing regulatory risks for the entities issuing tokens. The turnover of security tokens occurs under the legal regulations of local authorities of different countries such as the US Securities and Exchange Commission (SEC) or the Swiss Financial Markets Authority (FINMA).
Security tokens also help to improve the liquidity of the crypto markets. Such factors as the capability of fractional ownership and the automation of compliance procedures along with programmable payouts contribute to it as well making this market very alluring for cryptocurrency investors.
Cons of security tokens
Despite legal protection and better guarantees, security tokens come with their own flaw as well. As stated above, only professional accredited investors can participate in the offering. The requirements to become one may serve as a significant obstacle for usual people as meeting all of them is a real challenge. Here’s what you should keep in mind is you want to participate in an STO:
- The requirements for professional investors in the US presuppose annual income over 200 thousand USD per person or 300 thousand USD per married couple maintained for 2 years at least.
- The value of net assets should exceed a million USD without the value of the real estate where the person lives permanently.
- As far as an organization is concerned, it should have assets worth 5 million USD at least, for instance, a trust fund, venture capital, etc.
- All members of the company should be accredited investors. Also, a range of technical details should be observed when an investment is made. This is an important part of the right participation in the Security Token Offering, meaning that the funds should be raised in a proper way to make the process legitimate.
The threshold is still too high for small investors, but it gives way to those with medium-sized capital helping startups cover a broader selection of investment opportunities.
As for the European markets, the situation is much brighter there as the regulations are much more friendly. According to the European Securities and Markets Authority (ESMA), companies may issue security tokens without a prospectus which is common for companies issuing securities. This rule is applicable to startups that issue security tokens up to the value of €1 million. Thus, the European legislation creates much more favorable conditions for small and medium-sized businesses.
Possible future of security tokens
With all the benefits that Security tokens provide, it is obvious that they are here to stay. There are still many obstacles that prevent them from getting higher traction, such as a small number of trading platforms that support security tokens and the lack of general education.
However, the outlook is quite bright. The industry doesn’t stand still, startups invent new solutions, and it’s just a question of time when the world of big finance turns towards blockchain technologies. Security tokens may not be able to fully replace traditional means of fundraising, but they are sure to become one of the solid alternatives both to startups and investors.
Frequently Asked Questions
What are security tokens?
Security tokens are tokenized, digital forms of traditional securities that represent a share in the issuing company.
How much does it cost to launch an STO?
The budget needed to launch a Security Token Offering can vary from 15 to 75 thousand USD depending on the complexity of the technology on the basis of the blockchain project. The technology development can cost you from 25 to 50 thousand USD, while the legal side is estimated from 100 to 200 thousand USD. The development of the token sale system is estimated at 65-100 thousand USD if you get a white label solution.
The in-house development of the platform is more expensive. The crypto security management protecting privacy and security of user accounts costs about 40 thousand USD. These are only initial expenditures for the launch of an STO. The prices on the promotion of crypto projects also vary depending upon the jurisdiction.
What are examples of projects issuing security tokens?
The following security tokens are attracting huge investors’ interest:
- blockchain community Polymath, which is considered the Coinbase of asset tokenization
- Swarm, open infrastructure for digital securities
- Capexmove, a platform to draft and digitize debt financing documents
- Bankex, a platform that supports various security tokens protocols
- BlockRules, the comprehensive blockchain securities platform.