What Are Security Tokens and Why You Should Consider Using Them

Digital tokens issued on the blockchain are part of digital assets that can be applied for a number of use cases including as a form of payment within blockchain networks, to give users access to various goods and services on the networks and to act as a way through which users can participate in the networks, and in the creating of unique incentive schemes to enable people to perform specific actions within an ecosystem (with some compensation).

A good example of token incentive models is tokens that encourage people to use renewable energy: these can track and report data on energy expended using IOT devices and those using the energy can receive compensation in form of tokens through the blockchain network.

Token categorization basics 

Tokens are generally categorized as either utility or security tokens. Security tokens are investment contracts that represent ownership of a physical or digital asset -- it can be artwork, ETFs or real estate that have been verified on the blockchain.

Most of the blockchains today issue tokens that cannot be classified as security tokens mainly due to structure. Basically, these are perceived as utility tokens structured as to serve as a future access to a product or service. In that case, the network participation of all contributors in a decentralized manner is what creates value or the increase in value of the product or service. However, there are a few that specify theirs to be security tokens and even platforms that let companies launch security tokens. The main reason for contributors buying security tokens is anticipation to get future profits in the form of dividends, revenue share or (most commonly) price appreciation.

Another important test that determines categorization of tokens as securities is that those buying these tokens or contributors to the project have to rely on efforts of a person or an entity or a small group of entities to create value of product/service or gain interest.

Before security tokens, companies used to sign Simple Agreement for Future Tokens (SAFT) to ensure compliant with U.S. securities law. These contracts allow companies to buy contracts during a token offering for which they will be rewarded with newly-issued tokens when the company develops a functioning utility token actively being used in the project's platform. These agreements are based on the idea behind SAFE (Simple Agreement for Future Equity) contracts spearheaded by San Francisco-based tech accelerator Y Combinator as an alternative to convertible notes. These allow companies to invest in a start-up and they can then receive shares once a specific trigger event has happened — such as a new funding round or the sale of the company.

Therefore, in addition to the old security tokens that basically are tokens previously issued as utility tokens through ICOs but now categorized as security tokens due to their structure; in current terms, security tokens refer to tokenized traditional financial assets ( stocks, bonds, and other traditional equities); tokenized non-traditional financial assets including assets that have been difficult to trade (such as shares or revenue rights to VC funds); tokenized non-traditional assets such as real estate or art that are illiquid and often prohibitively expensive to own entire units and transfer ownership rights and where fractional shares in token form make them easier to buy and trade; tokenized rights and schema that include revenue share agreements, royalties, voting rights, and synthetic derivatives.

Why a company would desire to launch security tokens

Like any other digital assets (others include crypto coins), utility and security tokens can be exchanged for fiat via smart contracts, bought and traded on cryptocurrency exchanges, or used as collateral for loans or fractionalized to store in different digital wallets. A great advantage with security tokens is in their application in tokenization of asset which has completely changed the way asset ownership is defined and made assets that were traditionally only available to wealthy people more accessible to anyone with a little capital to own.

Security tokens also enable anyone from all around the world to buy into assets with ease regardless of the location of the asset for as far as the owner wants to sell. Tokenization enables ownership through portions and owners can collect dividends from the investments as the asset value and/or they can sell the tokens as their value appreciates. That means they can act as a steadier and more reliable income stream.

Tokenization also allows an asset to be separated into multiple layers of value; whether it's ownership, voting, or rights to future profit, each layer can be parsed out and repackaged in token form.

Tokenization is a big thing on blockchain because it enables realization of value of ideally anything with value on blockchain-- equity, rewards, real estate, personal brands and other kinds of assets. To expound on this, the assets can be variant: cash assets denominated in cash currencies where it is not possible to tokenize them without making investments outside of the cash asset wallet; equity assets that give ownership rights over physical or digital entities where this ownership is now tokenized on blockchain; fixed income assets explained by way of fixed deposits and loans -- a class that gives you fixed income (interest income) after fixed duration; real estate assets; and commodities assets where the pool is used to buy a rare material/service and ownership of the material/service tokenized (this material/service can also be rented).

Therefore, tokenization -- and thus the security tokens -- can be used ideally by any type and kind of company, product or fund even those outside of blockchain for as long as the underlying asset being tokenized has got some value. This expands the options for investors in terms of offering access to multiple asset classes. Also, so far, many companies have been and are able to get onto blockchain via security tokens and they facilitate adoption of cryptocurrencies.

When it comes to security tokens, they can help eliminate scams because the companies that release them have to go through significantly more regulatory hurdles before their tokens can be released and sold to public in an ICO.

Security tokens also do provide more liquidity. Previously, it would take months for a person to sell a house and get access to the funds especially if it is across the border. The token is ideally faster to sell (for instance when many people are buying into the property) and you can receive the funds much faster. Besides, security tokens enable startups to access fund from a global network of investors through security token offerings and the startups or their founders do not have to go through traditional angel or VC funding sources to raise funds.

There are some other benefits of using security token structure. For instance, issuing these types of tokens under regulatory frameworks such as Issuing security tokens under regulatory frameworks such as Regulation D, Regulation S, Regulation A+, and Regulation Crowdfunding is faster and cheaper that conducting an initial public offering structured as utility tokens. It can also help to reduce risks.

Of course most companies issue security tokens specifically to avoid the security label related to controversies of whether a token is a security or utility. Thus they can offer the tokens like dividends, profit shares and voting rights without related legal or financial risks related to non-compliance. That's because the legal clarity and protection for both the company and the ICO contributors.

However, categorization of tokens as a security comes with some disadvantages that diminish the benefits of them being digital asset instruments as targeted by cryptocurrencies. One is the limitations about or regarding who can invest in or through them and how they can be exchanged on a crypto exchange. The secondary trading and liquidity for security tokens is greatly reduced and it is not possible to trade them freely on the market like other tokens. The effect of these limitations is likelihood of damaging network effects and the use of these tokens to build a widely adopted platform or protocol.

Again, for owners of the tokens, licensed security token trading platforms would be needed to secondary-trade these tokens and provide liquidity. For founders, these tokens are harder to structure compared to utility tokens because one would need to go through advisors, lawyers, regulators, and finally with technical platforms for the launch of the token for trading. It would take more time therefore. And given that the platforms where these tokens trade are not many, STO agencies charge more money (up to 10 times the fees charged by ICOs)/

Examples of security tokens and platforms 

tZERO tokens

tZERO is Overstock's licensed security token trading platform on which tZERO tokens are traded in accordance with SEC regulations. Holders of tZERO would be entitled to quarterly dividends derived from the profits of the tZERO platform.

The platform uses their 15c3-5 risk management software, and other software such as order management system, matching engine, and a plethora of proprietary technology to support the eventual trading of security tokens.

Examples of blockchain facilitating issuance of security tokens are as below; 

Polymath

With Polymath, which brands itself as Ethereum for security tokens, companies get the technical and legal solutions to securitize their stocks, bonds or other assets on a blockchain. The platform does have its own ST-20 token standard for it and also their native smart contracts.

Polymath also has industry partnerships with tZERO and other platforms in order to afford the much-needed liquidity for the security tokens launched on the blockchain.

The platform uses own POLY tokens as economic unit for all operations on the blockchain.

Securitize

Securitize is an end-to-end platform that uses the DS protocol that works with DS tokens (ERC-20 compliant tokens that work with existing Ethereum ecosystem), to allow assets including funds, a company or any other real form of asset to launch security tokens. They will manage the processing of the solicited investors from login to capital received, as well as issuance and management of security tokens throughout lifetime of the asset.

With the platform, the token issuer will register and go through all processes including KYC/AML, accreditation, and other legal requirements and the platform extends to issuance and delivery of the tokens to the contributors. The issuer is able to customize their smart contract to match their business model and they can also manage regulatory compliance.

Harbor

Harbor is a platform that, in addition to helping firms launch security tokens in compliance with existing regulatory framework, helps firms to transition traditional asset classes to move to blockchain.

The platform is ERC-20 compartible and works with the Ethereum ecosystem and enforces securities regulations across different platforms, KYC/AML policies, taxes rules,

The platform uses a regulated token system (R- Token), a permission token on Ethereum blockchain that allows for transfers to occur if an on-chain Regulator Service approves them.

Swarm

Swarm SRC20 protocol is a cryptographic standard for security tokens to tokenize assets such as real estates, renewables, agriculture, tech companies, crypto hedge funds, etc. Once the assets are launched, they become easily managed, governed and traded.

The platform has a specific standardization that needs to be met for security tokens to represent real-world assets and this assits developers to build applications that can use such security tokens.

These tokens can facilitate voting, secure a right to any revenue streams from the asset, and are tradable in a regulatory compliant manner.

The platform uses SWM tokens to facilitate economic activities on Swarm platform.

Securrency

Securrency platform features a simple drag & drop process for people to issue and distribute their own tokens with a single click. Users are able to use RegTex™ engine to conduct conduct KYC in 160+, conduct AML on both fiat accounts and cryptocurrency wallets, and to source funds and accredited investor verification.

They also provide APIs and abstraction layer called as Securrency’s flexible InfinXChange™ that allow users to choose blockchains of their choice.

David Kariuki

David Kariuki likes to regard himself as a freelance tech journalist who has written and writes widely about a variety of tech issues that affect our society daily, including cryptocurrencies (see cryptomorrow.com and coinpedia.org); climate change (cleanleap.com), OpenSim and virtual reality (see hypergridbusiness.com). He is currently pursuing a MSc in Environmental Management at Open University. He does write here not to offer any investment advise but with the intention of informing audience, and articles in here are of his own opinion. Anyone willing to use any opinion here as advise to invest in crypto should obviously take own responsibility and accountability of their losses (or benefits) thereof. You can reach me at eqariu@gmail.com or david@cryptomorrow.com