What the FAQ are Security Tokens?

Jun 4, 2018 · 7 min read

In this article we will be identifying the current landscape behind security tokens, defining what they are, understanding their purpose in the economy, and then completing a security token offering of our own to really make it all sink in.

The Surge of Crypto Capital

With World Blockchain Forum’s Securities Tokens and ICOs event coming down the pipeline, I've been receiving a lot of questions concerning security tokens. Most of these conversations are hinged on the differences between utility versus securities, and how the crypto capital explosion of Initial Coin Offerings (ICOs) will effect their investments as regulators start to figure out what’s going on under the hood.

To put the capital raising taking place in the cryptocurrency markets into perspective, ICOs raised over $6 billion in 2017, and have since exceeded that figure in 2018 alone. For a market with very little working products, there sure is a lot of capital being poured into it!

What’s this have to do with security tokens?

Earlier this year during a congressional hearing on cryptocurrency, the chairman of the US Securities and Exchange Commission stated that he didn’t believe there was a single ICO he saw that he wouldn’t classify as a security.

That said, some blockchain proponents like to believe they’re not technically considered securities because they’re products. Since they are products, the act of pooring money into them can’t be considered an investment from a regulatory perspective.

Now let’s be real here. We can argue semantics all day about what ICOs are, but the reality is that tokens, as they stand today, are both security and utility tokens. You don’t see people investing in Kickstarter projects then flipping them for billions of dollars on unregulated global exchanges. Half of the awe behind participating in ICOs is in the potential for financial growth and for blockchain enthusiasts to brush that off as not important is clearly dishonest.

We can’t possibly ignore the thousands of Telegram users self declaring themselves “ICO investors” as they flood the chat groups of blockchain startups demanding updates to road maps and news of when their token will be listed on “X” exchange.

Even better is how these startups refuse to give information about exchange listings out of fear of being labeled a security. Most of these companies launched their tokens as “utility tokens” because they are easier to launch than security tokens and allow them the ability to market, crowdsale from anonymous investors, and avoid the heavy costs and regulatory burdens associated with registering securities.

Who could blame them? It’s not like current regulations make much sense towards these new digital assets anyway.

Should we be concerned?

Despite all of this, there really isn’t much cause for concern in the ICO space, as the problem here is that cryptocurrencies do in fact present utility unseen by securities. This is the reason why you don’t see mass enforcement going on in the blockchain industry. Most regulators are focused on giving warnings for the time being while they figure it all out. That said, we have seen quick enforcement actions where if a company has defrauded investors, they are quickly shut down.

I’m looking at you Bitconnect…

The real innovation taking place to eliminate this problem, is with the increasingly more refined meanings behind security tokens versus utility tokens, and the systems being put in place to make security tokens legal.

Since most tokens could be classified as both, it’s important we have a way to technically separate the two.

Security vs Utility | Basic Definitions

There are many significant differences to be aware of between security tokens and utility tokens, however for simplicity you could explain the main difference using the following definitions.

  • A utility cyptocurrency is one that is essential to the usage of a product or service.
  • A security cryptocurrency is one that is not essential to the usage of a product or service.

If the token that was purchased wasn’t needed for the product or service, then the only logical reason for it existing is to acquire funding. It is highly likely that if a token has no use, then it is going to fail the “Howey Test” or other comparable regulatory framework for determining what is and isn’t a security.

If a token is needed to fulfill the service, like how Bitcoin is used as a financial incentive to secure and process transactions, then there is clear utility for the cryptocurrency to exist.

Security Tokens Explained

Purchasing traditional shares in a company typically grants you a set of rights and obligations that you are entitled to by the nature of the investor contract. Typical examples would include shareholder dividends and voting rights in the organization.

When you buy tokens in ICOs, which are branded as selling “utility tokens”, the companies aren’t granting you any of these entitlements. You send them cryptocurrency and receive a token in return that grants you access to their products and services.

Security tokens on the other hand are actual financial securities, meaning your tokens are backed by tangibles like the revenue, assets, and profits of a company. Just like stocks you can trade them or keep them as you wish.

These security tokens have the potential to transform equity in the same ways cryptocurrencies are attempting to transform payments and access to services around the world. Some typical features of these tokens include:

  • Programmable Equity
  • 24/7 Liquidity
  • Integrated KYC
  • Digitized Ownership Stakes
  • Universally Transferable Financial Products

There will soon be a merging of centralized and bureaucratically downtrodden assets with more secure, liquid, and transparent tokenized assets on blockchains.

Compare this to stocks today

Stocks and other financial products are typically sold online with user friendly brokers who are licensed to operate in the locale.

The use of these platforms come with trading and membership fees and the equities you purchase aren’t globally transferable on platform, meaning you can’t just send your stocks from one exchange to another with the click of a button. You also can’t just trade your assets and send cash to the bank within the same day. Furthermore, traditional markets aren’t open 24/7.

Already you can see the difference in what security tokens can bring to the traditional financial markets, and that’s not even touching on all of the non public financial products we can apply to them.

This is about a 40 trillion dollar market for those wondering.

Every public company in the world could potentially convert ownership of their assets, products, and equities into security tokens and make them available in a globally accessible and real time settlement network using a blockchain based system.

Anything from property rights to pensions could be represented and managed in a security token format.

Security Token Platforms

These are platforms that provide the ability to create and invest in security tokens. They come with KYC already built in and manage the entire issuance process on the blockchain for convenient and streamlined equity management.

To provide an example of how these platforms work, I ran through an issuance of my own security token on the Polymath network using the Ethereum Rinkeby testnet.

This is not an endorsement of their platform, and should only be taken as an educational demonstration at the point in time this article was originally published.

Guide to Security Token Offerings with Polymath

In this security token offering demo, I will be creating an organization and a security token called My Company’s Security Token on the Polymath platform, then pushing a Security Token Offering public tothe Ethereum Rinkeby test network. These tokens will represent shares in my organization, and are purely for funding.

  • Start Date — June 4, 2018
  • End Date — June 30, 2018
  • Conversion Rate — 1 ETH = 100 MCST
  • Hard Cap — 500,000 ACBT

Getting Started

Download Metamask and create an account on the Rinkeby testnet.

You will then need to get your test ether from the Rinkeby faucet by going to: https://www.rinkeby.io/#faucet

Once you are there, click on one of the social media links in the description and replace the address in the post with yours. Afterwards, copy your post’s URL into the input box back on the faucet website.

You will receive the funds within a minute or two, and now have your first test Ether!

To spare you a bunch of redundant dialogue, I just did a screen cast walking through the process of creating and launching security token offering. It’s about 6 minutes long to complete the entire process and will give you a good idea of how businesses are intending to make securities function on the blockchain.

From beginning to end we provided our KYC, reserved our token ticker, connected with advisers, registered our security token, launched an STO, and white listed our key partners and investors. Even though we didn’t use real money, information, advisers, and tokens here, it’s clear that this issuance process is extremely fast, flexible, and simple to complete for anybody who needs a security token as a method of raising capital.

I don’t know about you, but if this process turns out to be as regulation compliant and secure as we hope, then moving ownership stakes over to the blockchain is only a matter of when, not why.

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