The Security Token thesis: What are Security Tokens?
Decentralization, Tokenization, Fractionalization. And now Securitization. The modern financial world is really on a ride today. Just like most of the blockchain enthusiasts out there, we have been looking for the answer of much asked question, ‘What are security tokens?”
This blog is aimed at answering the very same question.
ICO’s are all the rage in 2018. They have been outperforming venture capital funding for the best part of 2017, and show no signs of slowing down. The ICOs are not only characterized by the product they offer, but also by the tokens on sale. Tokens represent various entities such as currency, shares or equities, investment, or incentives. Now, the issue with ICOs is that many of them offer tokens as securities under the utility token moniker, hence violating securities laws. True, there is little to no regulation when it comes to ICOs, crypto and the blockchain, but when tokens are offered up as securities, authoritative bodies can step in. Let us start by talking about the different types of tokens, what are security tokens, securitization, how security tokens work and how it is different from the other type.
In order to get a grasp of the answer to the “what are security tokens” question, understanding what the utility tokens are and how they operate is important.
To understand utility tokens, the best example would be gift cards of various companies like Sony/Microsoft, Amazon, Steam etc. Utility tokens are a measure of future access to the services provided by the company offering the token, much like filecoin, which raised USD 257 million by selling tokens to provide its users with decentralized cloud storage in the future.
What makes them unique is that if they are well-structured, they can be exempt from the various laws that govern securities. Lack of adhering to the rules is exactly the problem which was discussed before, a big reason as to why most ICOs fall under the legal scanner. To avoid this, companies offering utility tokens usually refer to ICOs as token generation or sale events.
Let us begin to talk about what this article is based around: What are security tokens. Read on to understand what are security tokens.
These tokens are mainly employed in use cases where the motive is future profits and benefits in the form of dividends, price appreciation or share of revenue. Tokens become security tokens when they derive their value from an external tradeable asset. This means that they now fall under the federal security rules and regulations, and must abide by them in order to avoid any kind of legal action. Due to the increasingly complex regulations, it becomes difficult for startups and companies adhering to the rules, but, if done correctly, it represents a tremendous opportunity for growth. The most promising growth opportunity is the availability of tokens that represent company stock or shares. Due to this very nature, security tokens are called what they are. Now, how to differentiate between the two, and solve the aforementioned problem?
How to understand if a given token is utility or security?
On first sight, it can be a little tricky to determine whether a token being offered by a company is utility or security. The question “What are security tokens?” can prove to be a tough nut to crack. But, the Securities and Exchange Commission of the US employs a simple test in order to figure this out. Called the Howey test, it basically asks a series of questions about the token, which must be answered in a ‘yes’ for the token to qualify as a security. When this happens, the token comes under all the appropriate legal jurisdiction and regulations. The US agency uses the howey test to figure out what are security tokens. Let’s have a look at it.
The Howey test
Established in 1946, the Howey test helps one figure out whether a token is a security or a utility, and answer the question“what are security tokens”. Although the test is a bit more in-depth than described below, the following questions will still give you a great idea of what the test is all about.
- Utility or investment: is the token being sold as the latter?
If buyers are anticipating price appreciation or future profits in the form of dividends or revenue, then the answer to this question is a ‘yes’. We need to identify whether the token is providing any kind of use-value to the buyer, and if buyers expect more money than what they pay.
- Is there an intermediary, a person upon whom buyers are dependent?
Another thing that needs to be checked is if the value provided to the token is created by a single entity or a network of people/organisations. If the issuer creates that value, then this question is answered positively.
According to the two questions above, if the token is viewed as an investment, and the value to the token is provided by the issuer, then the token has a very high chance of qualifying as a security. Again, as stated before, the Howey test is more specific than just these two yes/no questions. That being said, the aforementioned criteria do give us the big picture of what the Howey test is all about.
Examples of what are security tokens according to the Howey test are SAFT for filecoin, any tokenized VC funding, or a gold-backed coin.
So, this is how SEC determines what are security tokens and what aren’t.
What are security tokens, according to the Security Token Thesis?
According to Stephen McKeon’s ‘The Security Token Thesis’, there exist a few fundamental features of security tokens and securitization that give it the desired characteristics. In order to improve upon the adoption of security tokens in the market, the following features/principles/axioms must be followed by all security tokens. This would only help in widespread acceptance of the tokenization process and outcome across all asset classes. Here are a few of those principles, according to the Security Token thesis.
When someone tries to answer what are security tokens, it is very important to keep in mind that the traditional stock markets aren’t always open, which is an issue as discussed here. The issue with current market states is the operating hours. If we take the example of the USA, stock markets are operational from 9.30 am to 4 pm, every weekday. Therefore, there is a 65 hour period on the weekends where no trading can take place. This window is even longer during holiday times. What around the clock trading hours will do is accommodate all time zones, as this isn’t just a nation or region-specific problem. Companies and firms usually look to take advantage of this fact, by releasing new information after the closing bell of the regional stock exchange. With round-the-clock market hours, security tokens and securitization would definitely be more widely accepted than they would be in the current market scenario. Blockchain presents us with a great use case here, as it can be really helpful in implementing 24/7 trading and regulation of token economy.
In accordance with the security token thesis, fractional ownership is another crucial aspect of tokenization of securities, which can aid the regulation of token economy. Market efficiency for infrequently traded assets is bound to increase with fractional ownership. Another important piece in the security token puzzle, it opens up new investment opportunities at scale. Although this requires that a security token lending market be developed to facilitate it, it does also help in enhancing price discovery. The surprising part is that fractional ownership isn’t even a recent concept; it dates back to the Roman Republic. The absence of any provision for fractional ownership in the traditional markets has led people to wondering what are security tokens.
The difference between executing and settling a trade is important to understand here. Settlement means that the transfer of payment has been done from the buyer to the seller, the documents regarding transfer of ownership have been recorded and completed. Since normal fiat currency trades take days to settle, here is where the crypto scene offers tokenization of securitiesand securitization an advantage, and the security token thesis recognizes that. Trades in bitcoin or ether take only a few minutes to settle, as opposed to the days taken by NASDAQ trades. Although these security token trades would be much faster, they would also be much more complex, due to the large number of intermediary parties involved. This could make regulation of token economy a tricky job to do.The effective increase in settlement speed will be eventually determined by the extent of automation of all processes using smart contracts. Rapid settlements, and what comes with them is important to the answer of what are security tokens.
Tokenization of securities and securitization may make the process of compliance all the more easy. By compliance, we mean adhering to the rules and regulations which govern securities, across all factors such as asset type, area of jurisdiction, and such. Typically, compliance is documented through ledgers, which adds delay to the process.
All you need to know is what are security tokens, and then figure out how can you make one from your business model.
Due to the programmability of security tokens, automated compliance can be introduced, which means that securities would then be tradable across all areas and regions, at all times, as mentioned duly in the security token thesis. There may also be a possibility that security tokens make compliance so convenient, that they are made mandatory by regulators for compliance, to ultimately help in regulation of token economy.
According to the security token thesis, “The thesis underpinning the idea that everything will be tokenized is grounded in the aspiration that everything will be interoperable.” What he means by this is that interoperability must be incorporated into the present market in order to fully achieve tokenization of all securities. This means that we could gather up different kinds of securities under the same platform, and we could also see self-custody of these equities in the same single hardware wallet.
For the right answer to What are security tokens, it is important for all the stakeholders in token economy to understand interoperability. It is of prime importance to understand that most of the benefits offered by tokenization of securities and securitization are reliant on the interoperability of computers. Although we do not have much of our assets on paper, the issue remains that the digital asset systems do not interact well with each other. This is exactly the opposite of interoperability, and exactly what we hope to avoid. Interoperability also makes distribution of tokenized securities easy and helps in regulation of token economy.
Building blocks of the security token ecosystem
In order to successfully build a safe, solid and secure security token ecosystem, and to aid in the regulation of token economy,there exist some elements that must act as building blocks. Off-chain enforcers, liquidity providers, exchanges, tokenization and securitizationplatforms and regulators are just some of the many blocks that we need to design as the foundation of security token ecosystems. All these building blocks must interoperate to make sure that the principal features of the security token thesis are all adhered to.
As with crypto exchanges, we need security token exchanges to trade with our tokenized assets. tZero and OpenFinance have already set off on the path to security token stardom, with their trading and listing services for security tokens one of the very few being offered as of now. Without exchanges, there will be no point of tokenization of securities, as there will be no viable method of transfer of ownership for these security tokens, hence leading to reduction in the regulation of token economy.
This should probably be the first and foremost building block of any security token ecosystem. Creating tokens out of securitiesand securitization is what forms the basis of the security token thesis, and Polymath and Securitize are on their way to build tokenization platforms to tokenize financial assets in the real world.
In the early stages, security tokens are bound to operate inefficiently. This can be a cause for concern when it comes to the liquidity of these tokens. What should be done is, security token platforms should build liquidity provider services right into their system, by joining hands with platforms like BnkToTheFuture and Bancor.
Security tokens do not exist only on the blockchain. Validation, transfer of ownership, and payment of dividends are all processes that need to be executed in the real world. For that, security token ecosystems should have off-chain enforcers such as auditors, law firms, KYC companies and the likes in order to ensure that all the aforementioned activities are performed as needed.
What would the world be without standards and rules? In a state of turmoil, right? That’s exactly what would happen to the security token ecosystem if there are no standards enforced. Regulation of behaviour of entities, and the regulation of token economy is crucial for the security token ecosystem to function in the desired manner.
SEC is a prime example of the off-chain regulators. For smooth functioning and securitization, security token systems should work in conjunction with these regulators, since this will only help in them becoming mainstream, and in better regulation of token economy. What these regulators come up as an answer to the question of what are security tokens is pivotal for the token economy
There you have it! Hope we’ve answered your question of “what are security tokens” well enough. Converting tokens into securities, what it takes, what it should have, and what it offers! Securitization of tokens is one such area of tech, which, if employed correctly, can be extremely rewarding for all parties involved. Will security tokens become mainstream? Financial markets have truly been in a state of turmoil as security tokens have arrived. Will regulation of token economy be achieved? Will the S-word prove to be king? Let’s wait and watch.
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