Security Tokens

Overview

The noticeable fall in token sales over the final half of 2018 has attributions to the overall unpredictable pricing of popular cryptocurrency companies from earlier in the year. Additionally, compounding questions about the fundamentals of utility tokens as well as concerns around regulatory issues has continued to follow despite many cryptocurrency sectors using this model for the majority of projects.

Still, with market uncertainty, many predict 2019 token sales will enjoy an increase in the market. Startups are anticipating the emergence of fundraising and IPO opportunities this year, but attitudes towards STO are still skeptical. As companies discuss the issues that security tokens face on the market, not much action has been taken advancements towards uniformity for this important investor product.

What is a Security Token?

A security token is an investment product in the blockchain market that takes value from a company’s success and creates a tangible profit. As a digital asset that represents the shares of a company’s stock, these tokens are an investment where holders receive more coins whenever the issuing company earns a profit. Investors also use blockchain as a platform to vote during company decision-making processes. Sometimes, also referred to as an equity token, investors can buy and sell this value for a profit later, much like the traditional stock market.

Working as a blockchain investment option, these tokens allow an investor to gain profit from a company but not actual ownership within it. This will enable investors to anticipate valued increases and sell when it is profitable, much like the traditional stock market. Creating a tangible value from company performance and undergoing heavy regulation by the government, sets this token apart from those of the utility market, as they fall under SEC management as a security by the standards of the Howey test. The Security Act of 1933 seeks to prevent misrepresentation and other fraudulent behavior, as well as requiring companies that offer securities to provide all necessary financial and other critical information to their investors.

Value is determined by a metric that relates to business performance and could be paid out in several ways, including a share of profits or how a corporation performs in the overall market. Because of this flexibility, not all cryptocurrencies can bear a security token status. This is especially true of companies that deal in market movements and not the company itself.

How Security Tokens Differ from Utility Tokens

The most significant difference between security tokens and utility tokens focuses on utilization. Security tokens represent investments in a company’s value that can be traded or sold for profit. Whereas, investments in utility tokens are usually app based; investors receive access to an app or service from the company they are backing. This has caused considerable debate, and re-evaluation of governmental oversight as utility tokens hold no economic value.

How good or bad the current outlook for utility tokens is for future digital investment depends on the perspective of those offering these products and those investing in them. Security tokens bring convenience and accessibility inherent within blockchain markets while maintaining legal protections. One cannot deny the stronger defenses against fraud or misrepresented selling practices that come with blockchain, as well. Overall, companies will use tokens as a representation of assets, a benefit, or value.

How Security Tokens Differ from Traditional Securities

To examine the difference between security tokens and traditional securities, one has to understand the different forms in which they are represented and compare the regulation and utilization of these products.  

Much like a traditional stock asset, equity token holders have some type of investment ownership. Their tokens represent a percentage of ownership they possess in a third-party asset, venture, or property. Some of the typical forms you may see an equity token represent:

  • Futures
  • Tokenized real estate
  • Stocks
  • Options contracts
  • Tokenized ventures

Crowdfunding platforms in the real estate market like Relex or Atlant use equity tokens the most. Investors have the opportunity to more easily spread their funds across the market on these type of platforms.

Those holding security tokens are guaranteed a percentage of generated profits though they don’t have ownership rights from the issuing company. Common forms of security tokens include:

  • Digital ETFs
  • Digital mutual funds
  • Securities

Some of the most well-known security token platforms today include companies like Polymath and Harbor. Valuations of their security tokens are derived from the performance of their business supplying an investment payout like profit sharing in the form of dividends or interest

What Issues Can Security Tokens Solve?

As previously discussed, the most persuasive arguments in favor of security tokens are the overcoming of weak regulatory policy regarding utility tokens and the outdated processes of the traditional securities market. Security tokenization drives innovation within long-established securities markets that are not up-to-date and vulnerable due to obsolete policy and technology. Investors demand improved regulatory oversight and improved compliance within the cryptocurrency markets, and security tokens accomplish this.

When one compares tokenization of securities against the traditional market, there are also large improvements to the overall transaction process. Traditional security transactions have minimal transparency and take days to settle, whereas tokenized securities allow for more transparency and the ability to allow instant trading twenty-four hours a day. Where traditional markets may have illiquidity, security tokens can make it liquid and allow access to a larger breadth of investors.

The implications of this path bring a host of promises for new opportunities within the token space. With talk of added security of government oversight coupled with blockchain accessibility and inherent security, investors already have begun to show further interest in more advanced security tokenization options. These innovations include solutions to long-time issues that have plagued the market for several years. Notably for startups without enough historical background or available resources, it was impossible to raise funds through IPO shares efficiently. By offering security tokens based on company performance in exchange for investment, startups can tap into a more natural method of raising capital that appeals to investors leary of unestablished businesses. This creates a new market for security tokenization to simplify conversion of liquid assets and diversification companies and their investors. Mergers and acquisitions could become more accurate and divisible by tokenizing assets in this way.

Challenges that Security Tokens Face

Markets for security tokens typically appeal to traditional securities consumers, which means future token design must appeal to this investor group while attracting newer groups with an eye on alternative futures.

Compliance for tokenization utilizes a regulatory structure that may offer definitive direction for security tokens while leaving much to interpretation for utility token holders. These regulations define the rules for sales and distribution, standards for managing token holders, custody rules, and heavy trade restrictions. Distributed ledgers do not begin to bring conformity to each class of token in the market today, and companies must rely on legal services to accurately plan and execute one.

Beyond regulatory compliance, the future tokenizing of other investment methods needs to be embraced as an opportunity, but the challenge is to find a way to avoid doing away with utility tokens or traditional securities altogether and instead innovate them. The potential to incorporate utility features within that of conventional securities shows promise of expanding the potential investor pool and further secure ties with classic capital service providers.

Security token issuers don’t always fit the mold of a traditional company and seek other ways to automate their processes in different directions without sacrificing legality or their secured protocol networks. The development of these technologies within the security token market is entirely dependent upon thoroughly researched token design studies based on a broad range of market ecosystems. With the regulation around these types of innovative tokenization efforts sometimes leaving gray areas, the investor pool can be limited at first due to hesitation.

The Future of Security Token Infrastructure

Security tokens are a recognized investment which has increased its investor pool but due to uncertainty and ‘newness’ investors are aware of the potential but have yet to engage in the STO market more robustly. This hesitation is a direct result of security token infrastructure not having a clear exit strategy. Institutional investors and STO retailers need a clear path out of the traditional market of illiquidity until a liquidity event. Blockchain disrupts this model and investors may trade their tokens sooner rather than later to another investor within a secondary market. Until the market develops its security framework with clear entrance and exit pathways like this, the significant volume of investors will continue to stand on the sidelines and wait.

The future of security tokens relies on this build-out to meet regulatory demands on its marketplace. A circular investment infrastructure would resolve this situation and bring in liquidity because consumers are not trapped in a dead end path of illiquidity. Also called “cross-ownership”, circular infrastructure involves strengthening business relationships by owning stocks in the companies one does business. This usually involves three or more companies and each company invests in each other so that it creates a circular investment model. Company A invests into company B, who invests in company C, who then invests in Company A, thus completing the circle.

Security tokens markets haven’t launched any platforms yet to create this crucial circuit, and while some exchanges do offer regulated secondary trading, lack of access is stunting the market.  Many STOs face similar frustrations as they also are without a way to properly sell or exchange their tokens; they have no liquidity.

Successful Security Token Offerings

Though utility tokens have received a lot of market space and focus despite many being traded on unregistered or unregulated exchanges, security tokens have become more attractive for investors, who appreciate the additional security and regulatory frameworks that protect their interests (vs. the interests of the STOs).

Firstly, the trading of security tokens within the United States can only take place on registered market exchanges or Alternative Trading Systems (ATSs). These exchanges must meet the ATS requirements, which offers oversight and set out rules for the market environment. It is true that national markets and those on the ATS are not the same, but at their core of best practices, they share a standard rule set which encourages market integrity. By insisting on these shared values, consumers and investors have come to expect a higher level of fiduciary responsibility, management of funding, and overall fair trade practices.  

Security tokens are finding success in this new network registration requirement, which is encouraging more investors and consumers from broader demographics. This emphasis on proper oversight and security has attracted similarly related audiences who are making decisions about the utility token versus security token markets.

Conclusion

While the era of security tokens seems an almost impossible evolution of blockchain and cryptocurrency technologies, without the necessary infrastructure to bolster it for consumer confidence and corporate liquidity, there are many unknowns still in its future. Harnessing innovative ways to develop a track that encourages investors from many industries can only be accomplished by taking note of the subtleties across its business and consumer pools.

Creating a healthy ecosystem that utilizes differences in creating a more attractive security token experience also drives the importance of continuous improvement and exploration of ideas. Directing some of the steadily growing interest from both traditional and utility token offerings and gearing it toward crafting security token exchanges will improve liquidity while offering a level of security that government and new investors expect from blockchain related investment products.

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