Security tokens explained
13 Sept 2021
Security tokens are a crypto asset type that represents an ownership stake in an asset or a business. A security token essentially serves a similar role to traditional securities such as shares so it warrants the same regulatory scrutiny as those types of financial instruments. At the same time, they can bring the benefits of the blockchain revolution to traditional financial markets and help create liquidity in typically illiquid sectors. This makes security tokens a very powerful tool for bridging traditional finance and DLT-powered fintech. It also makes them an interesting case from a legal standpoint.
Security tokens and the evolution of crypto assets
Before we dive into the nitty gritty of security tokens, let’s have a quick refresher on how they came to be in the first place.
The early crypto landscape was far less crowded than today and was largely populated by traditional cryptocurrencies like Bitcoin and Litecoin, whose primary goal was to serve as payment instruments. But then Ethereum came along and made it possible for anyone to create their own tokens through smart contracts and the ERC-20 standard. Meanwhile, the advent of initial coin offerings (ICOs) created a strong financial incentive for people to do so. ICOs quickly became an easily accessible alternative to traditional fundraising schemes like initial public offerings (IPO) and many blockchain projects jumped on the opportunity to raise capital without having to deal with complicated legal procedures. The ICO boom of 2017 led to the rise of the utility token and the creation of a myriad of new crypto assets.
But while ICOs were an impressive display of blockchain-driven innovation, the ICO sector developed a controversial reputation for its propensity to attract dubious projects and malicious actors. And even though some of the biggest blockchain projects were kickstarted through ICOs, many token sales amounted to nothing more than get-rich-quick schemes and even outright scams. Naturally, this turned people off and invited significant regulatory scrutiny to the sector, as watchdogs around the world scrambled to make sure that ICOs provided sufficient investor protections. All this coincided with the infamous ‘crypto winter’ of 2018, which saw one of the worst crypto market crashes ever and brought down investor confidence in the sector to historic lows.
In that challenging environment, security tokens emerged as a way to answer the needs of a sector that had just come out of its honeymoon phase.
Why are security tokens needed?
While the ICO potential as an innovative fundraising mechanism was evident to many, the lack of regulation and the risk of fraud were also undeniable problems that could only be resolved by introducing adequate regulatory measures. However, as we’ve already discussed on these pages, coming up with robust regulation for such a novel and rapidly evolving space such as DLT and crypto is quite difficult. In that sense, the emergence of security tokens provided a much needed workaround.
Being positioned as, essentially, the blockchain equivalent of traditional securities, security tokens allowed for existing financial regulations to be applied to token sales. This made it possible for blockchain-driven projects to raise capital through Security Token Offerings (STOs) as long as they are compliant with the financial rules in their respective jurisdictions. At the same time, investors were provided with much needed protection against fraud, while token investments arguably became more valuable as they now held ownership rights and provided access to profit share though dividends.
It has to be noted that some regulators like the US Security and Exchange Commission (SEC) consider all token sales to be security offerings. This means that both ICOs and STOs have to adhere to existing financial rules in the US in order to get greenlit by the SEC.
Things are different in the European Union, where a distinction between security tokens and other types of crypto assets exists at the EU level.
Last year, the European Commission proposed a EU-wide regulatory framework titled Markets in Crypto Asset Regulation. The proposed regulation focuses on utility tokens and stablecoins, but does not deal with security tokens, which are defined as financial instruments or e-money under the Markets in Financial Instruments Directive (MiFID) and the Electronic Money Directive (EMD).
Advantages of security tokens
So other than regulatory clarity, what do security tokens bring to the table? Well, to put it simply, they bring the benefits of blockchain technology to traditional financial markets.
One of blockchain’s biggest strengths is that information recorded on blockchain-based systems cannot be manipulated and is publicly available for anyone to see. The high level of transparency helps to greatly improve the traceability of financial operations such as security token trades.
From a legal standpoint, it also improves auditability and makes it easier to prove regulatory compliance.
Market liquidity and accessibility
Since security tokens exist on blockchain platforms, token trades can be performed 24/7, does not require intermediaries and have faster settlement times. This makes security trading accessible to a broader range of investors and creates greater market liquidity. However, since security tokens are treated as traditional financial instruments, token trading must abide by the existing laws in a given jurisdiction.
Security tokens also enable fractional ownership of assets, which can further lower the barrier to entry for investors and create liquidity in typically less liquid sectors like real estate and art.
One of the most unique characteristics of security tokens is that they can be programmed to automatically execute various operations and even complex processes. Those may include royalty payments, dividend payouts to token holders and other profit-sharing schemes. Here, a potential pitfall that needs to be taken into account and that is that you need to make sure that the operations the token is programmed to execute are in line with existing rules and regulations. On the flip side, the programmable nature of security tokens can also be used to automatically take into account potential legal implications. For example, a token could be programmed to only be transferred to accounts that meet certain criteria. This essentially would ensure that the token can only be held by eligible investors.
While security tokens are currently some of the more underutilized products of blockchain technology, they are a useful tool that shouldn’t be overlooked. They are an earnest attempt to create blockchain-powered fundraising instruments devoid of the regulatory uncertainty surrounding earlier iterations of the technology. This, combined with the fact that you can tokenize any type of asset – including equity, debt, commodities and even real estate – and the significant benefits that tokenization brings to the table, leads to the conclusion that security tokens will be an important part of the blockchain ecosystem.
Choosing the right jurisdiction to set up shop is an important step for any starting business. This is especially true for businesses that are operating in the blockchain industry, which, itself, is still in its formative years and is often looked down upon by regulators across the world.
Generally speaking, the blockchain and crypto space has never had a good relationship with regulators. From the early years, when the fledgling industry was largely ignored, to more recent times, governments and regulators around the world have time and again demonstrated their inability to handle the sector. Some jurisdictions have reacted to the sector with open hostility, others have demonstrated a lack of understanding of the technology and willingness to adapt their legal frameworks to adequately meet the new requirements of the sector.
Regulation of the blockchain and crypto space has been notoriously hard to work out, especially after cryptocurrencies like Bitcoin and Ether rose to prominence and kicked off a larger crypto boom in the latter part of the previous decade.