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What are Security Tokens?

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What are Security Tokens?

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

Security vs. Utility Token

There are currently two types of tokens in the cryptospace – security tokens and utility tokens. It’s important to learn the differences between these two types of tokens. You should also understand that some tokens start off as security tokens during their ICO, but later develop into utility tokens following the development of the platform.

Many investors prefer security tokens because the coins 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 the SEC’s current IPO requirements. These regulations include the implementation of Know Your Customer (KYC) protocols. KYC laws require all investors to reveal their identity 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. All valuable pieces of data to be sure about before making any investment. While utility token investments can provide this information, they are not legally required to currently.

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

Fraud in the Cryptospace via Bloomberg

Fraud in the Cryptospace via Bloomberg

Due to the unregulated nature of the cryptomarket, there are a significant amount of fraudsters in the space. These individuals prey on new investor’s 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 cryptomarket, it’s 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 the Section 3 of the Securities Exchange Act of 1924. 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 aren’t the only one benefiting from security tokens. A business that chooses to offer security tokens gains the confidence of knowing that they will not be subject to later legal, or financial, ramifications resulting from their ICO. Their tokens are in line with the SEC regulations and, therefore, the company can operate with greater confidence.

Utility Tokens

Utility tokens serve a specific purpose within the 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 Ethereum. In July, the SEC ruled that Ethereum (ETH) is not a security. One senior SEC official stated that Ethereum was a security during its initial coin offering (ICO), but that in its current status it’s a utility token.

The Howie Test

It isn’t always easy to determine if a coin is a security or utility token. Also, it’s important to remember that the SEC could alter their language and consider even utility tokens as falling under security laws in the future. Despite the uncertainty of the market, you can employ the Howie 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 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 Howie Test originated during the Supreme Court case SEC v. W.J. Howey Co.  The SEC alleged that the Howie 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 they could develop the rest of their land into more citrus fields.

SEC Head Jay Clayton via The Wallstreet Journal

SEC Head Jay Clayton via The Wallstreet Journal

The Supreme Court determined that because the investors had no “knowledge, skill, and equipment necessary for the care and cultivation of citrus trees” that 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 Howie 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 the reduced liquidity. You can’t send a security token to just anyone without complying with KYC protocols. These restrictions add another level of operations to your fundraising requirements.

Companies need full transparency to host a Securities Coin Offering (SCO). The SEC requires a treasure trove of information from companies looking to host SCOs 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 cryptomarket. 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.

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David Hamilton is a full-time journalist and a long-time bitcoinist. He specializes in writing articles on the blockchain. His articles have been published in multiple bitcoin publications including Bitcoinlightning.com

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This risk is higher with Cryptocurrencies due to markets being decentralized and non-regulated. You should be aware that you may lose a significant portion of your portfolio.

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