5 Key Details Every Crypto Trader Should Know About Security Tokens
Security token offerings (STO) made waves last year as a new, regulated form of blockchain-based funding mechanism promising to transform how traditional securities can be traded.
What are the key details that every investor should know about security tokens and STOs? How will they impact the blockchain industry if they become the primary token fundraising model in the future?
1. What Are Security Tokens?
Security tokens get their name from securities. In the finance world, securities are defined as tradable financial assets that retain value. Debt, equity, and derivatives are the three main security types, each with its own properties and characteristics.
Organizations, including governments, use securities to raise capital for their operations. Investors who buy and hold these assets sometimes receive dividends based on the company’s profits. Other times, security holders may get to vote on company affairs (some stocks) and/or simply hope the value of securities they hold will increase over time. The stock market is one example of a public securities market, as listed companies are required to publish their quarterly reports to inform investors of their earnings.
Take all the properties above and apply them to cryptoassets — that’s what a security token is. Security tokens work like real-world securities, from paying dividends to storing value, except they’re recorded on a blockchain.
This helps overcome the liquidity problem found in traditional assets since cryptocurrencies are digital, divisible, and easily traded at any time (provided there’s market demand, of course). Assets are distributed to investors within seconds while all transactions are stored on the blockchain for public viewing, increasing transparency and shareholder confidence.
Security tokens are legal if they adhere to securities laws. How do you tell if a token is a security token? If they pass the Howey Test. The Howey Test is a list of requirements created by the U.S. Supreme Court to determine if an asset is a security, which, of course, also applies to tokens.
A security token can only pass the test if all four of the following conditions are met:
- It is an investment of money.
- There is an expectation of profits from the investment.
- The investment of money is in a common enterprise.
- All profit comes from the efforts of a promoter or third party.
2. How Are Security Tokens Issued?
Security tokens are issued on the blockchain based on the company’s issuance terms and any legal requirements. For example, security tokens representing company equity are beholden to regular equities laws and are a type of book-entry only share (uncertificated) — a fancy way to say a digital share recorded in a ledger. The difference is, security tokens use smart contracts and are recorded on a decentralized ledger, which grants them the properties of immutability, divisibility, and transparency. Each security token is bound to a real-world asset like shares, bonds, or even physical materials like gold.
Since security tokens are assets written in code, they can be programmed to automatically execute actions when certain terms are met. For example, a company can set its token to automatically pay out dividends to investor wallets on the 14th of every month. This is not possible with traditional assets.
You can learn more about tokenization and how it relates to security tokens in our in-depth guide here.
3. What Are the Advantages of Security Tokens?
The blockchain enables crypto markets to work 24/7, unlike traditional securities markets that only open from Monday to Friday during business hours. Liquidity becomes a huge issue as investors can’t trade when the market is closed. If important news is released during the weekend, investors can only capitalize on it when the stock market opens. Some companies abuse this by disclosing unfavorable financial details before the market closes, leaving investors with little time to react.
The biggest advantage of security tokens, however, comes from divisible assets. Think of expensive assets like property or rare art pieces. These assets often cost millions, which alienates the average investor, leading to low liquidity and a small pool of traders.
With the blockchain, companies can tokenize and divide their assets to enable fractionalized ownership. Rather than splurging with half a million dollars on a property, investors can buy a portion of it for, say $5,000, and own a fraction of the asset. Now, anyone can invest in the property since they are no longer restricted by huge initial capital requirements.
This increases liquidity and market involvement since the number of buyers has increased exponentially. Higher liquidity will not only contribute to the growth of security token markets, but will also be good for the blockchain industry as well due to greater public awareness and institutional involvement.
4. Why Are Security Tokens Important for the Future of Cryptoassets?
Many corporations and financial giants have expressed interest in working with security tokens. This will stimulate the flow of institutional money into the market while also raising public confidence and awareness in cryptoassets. A notable example in recent times is the launch of Bakkt, a digital assets platform backed by the Intercontinental Exchange.
Leading firms in the security tokens space are hoping to link the massive liquidity of traditional markets with the high-tech benefits of the blockchain. This will see securities experience a total facelift, ushering the industry into an era of decentralization and hyper-efficient finance.
That said, making the jump from traditional markets to security tokens is not easy. Many legal and compliance implications need to be addressed before security tokens are even considered as viable financial vehicles. Existing financial infrastructures also need to be revamped to accommodate the use of the blockchain.
With $256 trillion worth of real-world assets locked in traditional finance, blockchain companies have all the reasons in the world to overcome these challenges with innovative solutions. The opportunity for the blockchain to revolutionize global finance is just too big to ignore. Expect security tokens to develop further in the coming years.
5. The Top Security Token Platforms to Look out For
Token issuance platforms are growing in demand along with the popularity of security tokens. These platforms handle everything token-related, from tokenization to dealing with compliance, so companies can start issuing security tokens immediately. Think of them as developers, consultants, and legal advisors all in one.
Keep an eye out for these five platforms as they race to become the industry leader in the security tokens sector:
- Polymath
- Securrency
- Swarm
- tZero
- Harbor
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