As a responsible crypto investor, you must understand the differences between utility tokens vs security tokens. These tokens serve different purposes in the cryptospace. Their processes differ during trading and issuance. These contrasts make security tokens unique to their utility counterparts.
Why Do We Have Security Tokens?
The ICO market continues to expand. According to a report from Business Insider, companies raised over $5.6 billion in 2017. While this number seems impressive, the ICO activity of this year already eclipsed it. By May 2018, the ICO market expanded to $6.3 billion. This record growth and the growing appeal of ICOs makes this unique crowdfunding strategy a favorite among tech startups.
The record growth of the ICO sector led to increased scrutiny from regulators such as the Securities and Exchange Commission (SEC). The task of developing regulations for the growing ICO market falls on this organization depending on how the token’s use. The SEC decided that when a token represents ownership, voting rights, or entitles the holder to share of future profits, it’s a security token.
Utility Tokens vs Security Tokens – How can I Tell the Difference
It isn’t always that easy to determine if a coin is a security or utility token. In many instances, a token starts off as a security during an ICO but later evolves into a utility token. This scenario is the case for the hugely popular cryptocurrency Ethereum (ETH). In a June ruling, the SEC determined that Ethereum operated as a security initially, but today it’s a utility token.
To make matters more complicated, a utility token such as ETH can have security tokens issued on its platform. Ethereum’s ERC-20 protocol is the most popular token launching protocol in the cryptospace. New tokens issued on the platform are security tokens if they fail the “Howey Test.”
The “Howey Test” is a brief questionnaire created by the Supreme Court for determining whether a transaction qualifies as an investment contract. The test became famous during the 1946 Supreme Court case SEC V. Howey. The case revolved around a Howey, Florida-based orange juice company that offered large parts of its land for sale to investors with the intent of having the new owners lease the property back to the citrus developer, who would continue developing the area with the newly acquired funds.
The SEC sued the defendants in this transaction for violating the Securities regulations. The SEC determined that because the investors put forth funds in the hopes of making a profit from the efforts of the citrus farm, the deal was an investment contract. Therefore, the agreement falls under securities regulations.
The Supreme Court developed a simple test to prove the theory. The Howey Test asks investors four critical questions. These questions can be applied to tokens to determine if they are security tokens:
- Are You are Investing Money?
- Do You Expect Profits from Your Investment?
- Are You Investing in A Common Enterprise?
- Will You Profit from the Efforts of a Promoter or Third Party?
Utility tokens serve a use within a platform. In most cases, companies host ICOs to issue utility tokens. These tokens are essential to the functionality of their platforms. Additionally, they do not give token holders rights to the company’s future development or profits. These tokens transfer without regulations, and any company can offer utility tokens without meeting SEC regulations. The open nature of these tokens made them a favorite amongst investors and startups.
Security tokens operate in a much different manner, and under different requirements. A company cannot just host a security token offering (STO) without fulfilling specific conditions. Companies must provide investors with a plethora of information including the company’s actual address, the names of all board members, and open financial records. These requirements protect investors from fraudulent activity.
On top of the company regulations, investors meet stringent security regulations as well. Companies cannot sell security tokens to anonymous individuals. You will need to provide and prove your identity when investing in these tokens. Know Your Customer (KYC), and Anti-Money Laundering (AML) laws must be adhered to when moving security tokens between owners.
Added Security – Added Investment Funds
While some early crypto investors undoubtedly see security tokens as a burden on the cryptospace, many believe these tokens to provide an essential bridge between traditional investment funds and the cryptomarket. Analysts have predicted a rise in traditional investment firms entering the cryptospace.
These firms require added protection due to the substantial nature of their investments. Security tokens provide them with the protections they need to avoid future financial and legal problems.
Utility Tokens vs Security Tokens
Now that you better understand the differences between these tokens, you are ready to comprehend STOs and what makes them different than their ICO counterparts. Security tokens play an important, and ever-growing, role in the cryptospace. You should expect more platforms entering the cryptomarket using this type of token over the coming months.
What are Digital Securities?
Digital securities continue to see further adoption by traditional investment firms for many reasons. These tokens remove many of the barriers encountered by investors and streamline the entire security process from issuance to oversight. Additionally, they provide new market opportunities to nonliquidable investments. For all these reasons and many more, security tokens are here to stay.
Digital securities, or security tokens, come in many forms. All of these forms share one thing in common, they are digital representations of securities, and therefore, subject to traditional securities laws. Importantly, not all digital assets are security tokens.
Security tokens emerged at the tail end of the 2017 bull market run in response to the rising amount of fraud in the space. Investors lost billions on Ponzi schemes such as Bitconnect. Real projects needed a way to distinguish their tokens from the scamsters and traditional investment firms needed to utilize blockchain technology in a regulated manner.
Digital Securities are Born
Digital securities can represent all types of assets including investment contracts, shares of a corporation, a portion of a note, debt security, or even a fractionalized interest. Basically, any electronically registered and transferable debt, equity, or asset that issues or trades using blockchain technology is a security token.
Benefits of Digital Securities
The benefits blockchain technology brings to the sector are immense. For one, ownership is verified and recorded on a distributed ledger. This provides a more secure alternative than traditional methods. Additionally, blockchain technology allows for the transfer of private and non-listed alternative assets. Consequently, security tokens provide more opportunity, efficiency, and liquidity in the market.
Security tokens wouldn’t exist if smart contracts never entered the scene. These preprogrammed protocols can be developed directly into the token. This strategy allows for the automatic enforcement of all regulations. Basically, smart contracts help eliminate much of the redundant paper-based processes currently in use.
Types of Digital Securities
Today, there are more types of security tokens than ever before. The market continues to develop as more advantageous tokenization concepts emerge. You should expect to see this trend continue as security tokens lend themselves perfectly to many markets. Below are the most common types of digital securities in use today.
The real estate sector experienced an explosion of tokenization strategies over the last year. Both developers and tokenization platforms went all-in on tokenizing property. Tokenized real estate has some clear advantages. For one, it allows for the sale to be fractionalized. This strategy lowers the entry-level for investors and provides more opportunities for diversification.
The tokenization platform Polymath made headlines in September 2018 after inking a partnership with the real estate development firm BlockEstate. As part of the strategy, the Block Estate Alpha Token, or BEAT was born. This token utilized Polymaths unique Ethereum token standard ST-20 to ensure that the project remained compliant. Each token represented a share in the ownership of the fund.
Perhaps one of the most popular ways in which digital securities see use is venture capital. Security token offerings (STOs) provide business with all the benefits of blockchain technology such as global reach, added security, and instant trackability. Additionally, STOs allow companies to stay within the regulatory guidelines of their industry and region when hosting a crowdfunding event.
Private equity is another type of security token that continues to see more adoption in the space. These security tokens can also go by the name equity tokens. Equity token offerings (ETO) are more popular than ever before because tokenized equity provides more liquidity in the market.
One of the best features of tokenization is that it can be applied to so many types of assets. Real assets such as gold or diamonds already live on the blockchain. Not surprisingly, these tokens were among the first type of security tokens to emerge.
While the concept of tokenizing assets like gold isn’t anything new to the market per se, the ramifications of these maneuvers are evident. For one, tokenization platforms now seek to not just tokenize gold but to utilize the gold tethered token as a new form of stablecoin.
Stablecoins are coin tethered to real-world assets such as the USD, or in this scenario, gold. These tokens allow users to get the benefits of cryptocurrency but avoid all of the volatility found in the market today.
Tokenized hedge funds are another perfect example of digital securities. Hedge funds are a great way to diversify your portfolio. Traditional hedge funds are restricted in their trading times and the methods used to transfer these assets are outdated. Tokenized hedge funds create a frictionless experience for investors.
The Protos Hedge Fund includes a number of the top cryptocurrencies in existence. The fund sold $6.5 million during its primary issuance. Notably, Protos was the first licensed tokenized hedge fund to trade on an Alternative Trading System (ATS) in the US.
Digital Securities – A Bright Future
Now that you understand what digital securities are, its easy to see why they continue to see adoption in the market. These new-age financial tools provide more investment opportunities and reduce the workload and costs usually associated with these transactions. You can expect to see security tokens become more popular as these advantages become common investment knowledge.
Titles and Designations Among Industry Participants
Those that follow developments within the digital securities sector may have come across a variety of titles/designations given to industry participants. While a select few companies have set their sights on attaining a full scope of designations, most specialize in one area or another. This necessitates a high level of cooperation among companies, as issuing digital securities requires utilizing various services.
With Securitize recently attaining the title of ‘transfer agent’, now is as good a time as any to take a brief look at what positions, such as this, entail. Here are a few designations typically associated with digital securities, and a superficial look at the roles which they play.
Companies tasked with completing the roles of a placement agent typically function as a conduit for raising capital. A placement agent is usually hired by a company looking to raise capital through an STO/DSO or some other means of fundraising. Throughout this process, the placement agent will attempt to connect appropriate, and interested, parties (issuers & investors). In doing so, investors gain access to pre-vetted opportunities in their ‘wheelhouse’, while issuers benefit from access to a larger pool of investors.
Beyond simply providing token issuers access to their contact book, placement agents are able to provide certain levels of clout to relatively unknown companies through mere affiliation. In addition, they are often tasked with helping develop marketing strategies for token issuers, to more efficiently connect appropriate parties.
The following companies are examples of participants within the digital securities sector which hold the title of a placement agent.
The entire process of selling and distributing digital securities is contingent on finding a competent issuance platform. Digital securities require specific traits to be built into their coding, as they are required to be compliant with securities laws imposed by regulatory bodies, such as the SEC. This is done when they are created, using issuance protocols based on blockchain technologies, such as Polymath’s well known ST-20.
The following companies are examples of participants within the digital securities sector which act as issuance platforms.
A broker-dealer refers to a licenced company which buys and sells securities. A broker-dealer has the ability to act on behalf of, either, themselves or a client. This is a fluctuating designation which is broken down as follows:
- When securities are traded on behalf of a client, the company is assuming the role of a broker.
- When securities are traded on behalf of the company, itself, the company is assuming the role of a dealer.
The following companies are examples of participants within the digital securities sector which hold the title of a broker-dealer.
In a world which is becoming increasingly connected, new challenges regarding security measures are arising every day. This places increased importance on companies assuming the roles of custodians.
Custodians within the digital securities sector are tasked with safely storing digital assets. While their means for achieving this may vary, their presence within the sector is extremely important.
Warranted or not, blockchain based assets are often viewed together. This means that when an unregulated exchange with poor security measures is hacked, it paints a bleak picture of similar assets. To continue the upwards trajectory of blockchain based assets (digital securities), regulated custodians are of key importance. Through stringent security measures, they are able to provide a safe home for valuable assets, as well as piece of mind for their holders.
The following companies are examples of participants within the digital securities sector which provide custodial services.
For participating parties to benefit from the oft-touted liquidity associated with digital securities, these assets need a place to call home. Marketplace providers offer this, as they facilitate secondary market trading of digital securities. By facilitating the buying/selling of digital securities, investors can now easily enter and exit their positions.
The following companies are examples of participants within the digital securities sector which act as Marketplace Providers.
For companies which undergo the tokenization process and distribute tokens, a transfer agent is vital. Companies which assume this role are typically tasked with accurately tracking the activity and ownership of distributed assets. This means providing token issuers with an accurate picture of who is in possession of their digital assets, and in some instances doling out dividends to holders.
The SEC breaks down the roles of a transfer agent into the following 3 main categories.
- Issue and cancel certificates to reflect changes in ownership.
- Act as an intermediary for the company.
- Handle lost, destroyed, or stolen certificates
The following companies are examples of participants, within the digital securities sector, which hold the title of a transfer agent.
Jockeying for Position
While there are many roles and designations within the sector, these are a few of the most prominent and important found in digital securities. With the digital securities sector still in a nascent stage of growth, there are various companies jockeying for position as the ‘go-to’ entity for their specialities.
In time, we will eventually see the cream rise to the top, as select companies stand out from the pack with the services they offer.
Security Tokens vs Tokenized Securities – Thought Leaders
Since crypto is a growing industry, there still are a lot of words and concepts that are unclear to a large audience. In fact, many users struggle due to the presence of confusing jargon.
Most people still do not know what blockchain is or why it is called a blockchain. While it can be a confusing term to understand, there’s no denying the fact that blockchain is massive.
Introduction To Security Tokens and Tokenized Securities
As confusing as may sound, both the terms refer to two very different concepts. I have read a lot of articles and news pieces regarding security tokens. From my understanding, the term refers to a wide variety of assets based on blockchain.
A consultation paper published by the Financial Conduct Authority in the UK verified the meaning of the term. The paper mainly discussed the regulation and classification of crypto assets defined ‘security token’ as a recognized investment or asset concept.
Now that the meaning of security token is clear, we need to move to tokenized securities. A lot of people believe these terms are interchangeable when in reality they are not.
They refer to two different concepts and using one in place of another can lead to confusion. They imply different regulations, investors, and constructs. Hence, it is important to be aware of the difference between the two so you make no mistakes in using the right term.
Security Token and Tokenized Security – The Difference
The difference doesn’t lie in grammar. It may look like a shift from active to passive but there’s more here.
Security Token: In this phrase, “security” is the adjective and “token” is the noun. It refers to a new technology that shares some qualities with traditional securities.
Technology is the main focus in this case. Not all tokens are referred to as securities. In fact, regulators appear to be confused about the classification of some new tokens due to their novel concepts.
If it pays dividend then it’s considered a security. A security token does not necessarily have a utility. It offers tangible benefits and represents a share in the company behind the token. This is why security tokens are also known as equity tokens.
Moreover, security tokens are different from utility tokens. They are either filed under an exemption or registered with an authority. Due to this, security tokens can be used outside of blockchain projects.
Tokenized Security: In this phrase, “token” is an adjective, whereas “security” is the noun. It refers to a traditional security or asset that comes wrapped in the latest technology.
All tokens are considered securities in this case. They work quite like off-blockchain assets but use a different set of technology to work.
Here, the main focus is on ‘use case’ and not the technology used. This is why such tokens are easy to regulate.
After all, it is easy to understand and categorize a traditional security that’s traded differently.
Given the huge difference between the two, it would not be fair to confuse the names.
The Authorities Involved
The Security and Exchange Commission (SEC) regulates security tokens. However, the relationship between the SEC and digital coins seems to be a bit confusing.
A transaction will be considered a security if:
- Money is invested.
- Profit is expected.
- Efforts are required.
- A common enterprise is involved.
The situation became clear in 2016 when Ethereum lost about half its value due to a major hack. This caused a sit in the industry, forcing the SEC to think about the future of digital tokens.
Last year, the SEC sent a letter to Ted Budd talking about digital assets and how they should be dealt with. While the response to the letter cleared a few things, most experts agree that the position of digital securities is still not fully clear.
Many organizations are also jumping the bandwagon. The Swiss Exchange recently announced plans to build an exchange for tokenized securities. According to FINMA, the exchange will be properly regulated.
Most experts believe that the involvement of such big names is a good sign for the industry but we’re not yet sure of how this will play out.
Take a Step Ahead
Tokenized securities are designed to broaden the market while also enhancing liquidity. It’s the same as using a known asset and putting a digital wrapper around it.
It’s not a new product from the perspective of regulators. It’s merely a new distribution channel, which makes approval easier.
On the other hand, it’s a different ballgame when it comes to security tokens. They present a new challenge for investors and regulators as it is hard to figure out the risks and ramifications involved in dealing with them.
Tokenized securities are highly innovative and have their own place in the industry. We may see more such securities hit the market in the near future. It’s actually good for the industry as the huge supply will enable traders to get a grasp of things and understand how it works.
Advantages of Security Tokens and Tokenized Securities
You will realize that a lot of the benefits are similar in nature.
Security tokens offer more liquidity by enabling fractional ownership and lowering minimum investments. More people will be able to invest due to lower requirements. Businesses are also taking advantages. A good example would be Mayfair Gallery, which put its art collection for sale on the blockchain.
Similarly, tokenized securities are more efficient and scalable. Security tokens help reduce cost, simplify auditing, reduce paperwork, lower issuance fees, etc.
Other benefits include transparency and ease.
The Legal Aspect of Things
Since security tokens are subject to federal regulations, they are compliant. You need to be aware of three regulations:
Regulation A+: This allows investors to offer an SEC-qualified security to non-accredited investors (max $50,000,000). Due to registration requirements, such issuance can take longer and also cost more than other options. Plus, it requires qualification of a Form A-1. Moreover, the amount of money you raise is also considered revenue and hence is taxed unless it represents equity in the company.
Regulation D: This requires an electronic filing of “Form D” without needing registration with the SEC. The seller may solicit investors for offerings that meet the requirements found in Section 506c. This part of the law requires the offerer to be true and accredited.
Regulation S: This comes into play when a security is executed outside of the US and hence is not subjected to the 1993 Act. However, issuers are still required to follow the laws of the country where the security is offered.
What It Really Means
You can draw some analogies when it comes to tokenized securities. Think of print magazines and how they’re now available online. The format is the same but the reach has increased due to more access.
Security tokens work similarly. It’s a concept that nobody saw coming. At the end of the day, both concepts will change capital markets and improve access. However, only one will have a lasting impact and change how we look at capital markets.
Security tokens need space and support to stay strong. It’s important to be clear about what the term means. We’ll, however, not be able to enjoy the benefits of these concepts if we are not able to differentiate between the two. Beyond linguistic differences, what’s more important is vital aspects as liquidity and more institutional grade Reg A+ offerings which will bring more confidence to the market.
Education and investor protection are vital elements of the ecosystem, hence at ABOTMI we work a lot on providing more solutions to increase transparency in digital asset industry. Investors who risk with their time and money deserve a seamless discovery process connecting to the most reliable and trustworthy digital asset advisors across the globe.