What Are Security Tokens? A Guide to Digital Assets

Security tokens function as investment contracts wherein the purchaser anticipates future profits from dividends, revenue share, or market appreciation. Security tokens differ from utility tokens in a couple of ways. The main difference between these tokens is that security tokens follow strict guidelines regarding who can purchase them and how they are transferred.

Security vs. Utility Token

There are currently two types of tokens in the blockchain space: security tokens and utility tokens. It is important to learn the differences between these two types of digital assets. You should also understand that some tokens start as security tokens during their initial offering, but later develop into utility tokens following the development of the platform.

Many investors prefer security tokens because the assets adhere to the SEC’s legal restrictions. Security tokens are the direct result of a desire by investors and businesses to utilize a blockchain-based crowdfunding system that conforms to current IPO requirements. These regulations include the implementation of Know Your Customer (KYC) protocols. KYC laws require all investors to reveal their identities before they can participate in the crowdfunding event.

Security Tokens Benefits

Security tokens provide participants with a more transparent investment experience. Startups offering security tokens must provide investors with a plethora of legally required information, such as the company location, financial statements, business purposes, and management. These are all valuable pieces of data to verify before making any investment. While utility token investments can provide this information, it is not currently legally required.

Additionally, there are a few examples of ramifications for utility token providers who falsified provided information. These laws offer valuable protection to all parties involved, and many in the industry believe them to be critical in curbing fraud and spurring wide-scale crypto adoption.

Due to the unregulated nature of the early crypto market, there was a significant amount of fraudsters in the space. These individuals prey on new investors’ doubts and misgivings to make a profit. One study put the number of fraudulent ICOs in 2017 at eighty percent. Given the amount of fraudulent activity in the market, it is no surprise that investors seek a more secure alternative to the status quo.

Large Scale Investors

Security tokens attract more large-scale investments because they are subject to legislation that protects investors, such as the Securities Act of 1933 and Section 3 of the Securities Exchange Act of 1934. These protections are necessary to prevent fraudulent activity from occurring in the market. This added security provides a safer transaction for both investors and corporations looking to utilize blockchain fundraising strategies.

More Security for Your Corporation

Users are not the only ones benefiting from security tokens. A business that chooses to offer security tokens gains the confidence of knowing that it will not be subject to later legal or financial ramifications resulting from its offering. Its tokens are in line with SEC regulations and, therefore, the company can operate with greater confidence.

Utility Tokens

Utility tokens serve a specific purpose within a platform. Additionally, they do not pay investors any dividends or revenue share for holding the coin. A perfect example of a well-known utility coin is the Ethereum (ETH -4.72%) network. In July 2018, the SEC ruled that Ethereum was not a security. One senior SEC official stated that while Ethereum may have been a security during its initial coin offering (ICO), in its current status, it functions as a utility token.

The Howey Test

It is not always easy to determine if a coin is a security or a utility token. Also, it is important to remember that the SEC could alter its language and consider even utility tokens as falling under security laws in the future. Despite the uncertainty of the market, you can employ the Howey Test to self-verify a token’s standing in most scenarios.

• Are You Investing Money?
• Do You Expect Profits in Return for Your Investment?
• Are You Investing in a Common Enterprise?
• Will Your Profits come from the Efforts of a Promoter or Third-party?

The token you are researching is likely a security token if you answered yes to these questions. Additionally, if the profit received from the investment is entirely outside of your control, the chances are good that the token in question falls under security laws. The Howey Test originated during the Supreme Court case SEC v. W.J. Howey Co. The SEC alleged that the Howey Company of Florida violated Securities Laws when it failed to register a land investment agreement with the SEC. The deal involved an investor purchasing half of the company’s unused land so that it could develop the rest of the land into more citrus fields.

The Supreme Court determined that because the investors had no “knowledge, skill, and equipment necessary for the care and cultivation of citrus trees,” they were acting as speculators. In other words, they invested in the land with the hopes of making a profit from the efforts of someone else.

The SEC determined that the investments made were not for the land but instead for the opportunity to share in the future profits of the large citrus fruit enterprise. The Howey test works when applied to cryptocurrencies, but given the shifting nature of tokens, not all coins can be precisely defined using this technique.

Disadvantages of Security Tokens

There are also some disadvantages provided by security tokens. The main obstacle to this type of token is reduced liquidity. You cannot send a security token to just anyone without complying with KYC protocols. These restrictions add another level of complexity to fundraising requirements.

Companies need full transparency to host a Security Token Offering (STO). The SEC requires a treasure trove of information from companies looking to host STOs, including complete financial statements. The organization only approves companies that meet these stringent guidelines one hundred percent.

A More Secure Option

Security tokens fill a much-needed niche in the market. The added transparency provided by these tokens should help to spur increased investment. While many love the anonymity provided by many platforms in the decentralized economy, large investors seek the stability required by the current financial systems in place. Security tokens accomplish this task perfectly.