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Securities 101

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.

Secure Investments

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.

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

Securities 101

Utility Tokens vs Security Tokens

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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.

Ethereum-founder Vitalik Buterin via Cryptovibes

Ethereum-founder Vitalik Buterin via Cryptovibes

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.”

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:

  1. Are You are Investing Money?
  2. Do You Expect Profits from Your Investment?
  3. Are You Investing in A Common Enterprise?
  4. Will You Profit from the Efforts of a Promoter or Third Party?

Utility Tokens

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

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.

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Securities 101

How Do Smart Contracts Work?

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What are Smart Contracts

Smart contracts enable automation of certain aspects of a platform’s functionality. These digital agreements self-execute predetermined actions upon receiving a digital asset or cryptocurrency. Today, smart contracts are used everywhere in the blockchain space, but this wasn’t always the case. Let’s take a second to examine how these helpful protocols first came to be, and how they function without the need for any third-party intervention.

The original smart contract concept predates cryptocurrencies by fourteen years. Ironically, the man credited with developing smart contracts is no other than well-known Bitcoinist Nick Szabo. Many people believe Nick to actually be Satoshi Nakamoto because of his previous works.

Nick famously theorized about value-storing bits utilizing a proof-of-work system five years before Bitcoin existed. He has always been a pioneer in the cryptospace. In 1994, Nick released his smart contract code to the public. He also coined the phrase “smart contract”.

Nick Szabo via TMNews

Nick Szabo via TMNews

What Do I Need to Create a Smart Contract?

Every smart contract contains four core principals. First, you need the subject of the contract. The subject is what gives your contract access to the goods or services that the contract governs. Second, you need digital signatures (private keys) from everyone involved in the contract. These signatures are what initiates the contract. Next, comes specification of the contract terms. This part is where you lay out the exact sequence of operations that commence when the contract executes. Finally, you need a decentralized platform. A blockchain network keeps the smart contract stored in redundancy and safe from alterations.

Smart Contract Components

  1. Subject of Contract
  2. Digital Signatures
  3. Contract Terms
  4. Decentralized Platform

How Do People Use Smart Contracts?

There are endless smart contract uses. Smart contracts help you to exchange digital and real-world assets. Smart contracts live on the blockchain and cannot be altered. This added security makes these digital agreements ideal for many business scenarios.

Smart Contracts in ICOs

Initial Coin Offerings (ICOs) utilize smart contract protocols during their crowdfunding events. The smart contracts automatically track, calculate, award, and distribute the funds sent between the company and the investor. The smart contract programming enables the automation of the entire process.

This automation allows companies to accept funding from a wider audience. The workload of the company is not increased, but the company’s fundraising exposure expands. The all-inclusive nature of this strategy helped push ICOs to record numbers this year. One report shows that ICO volume already doubled lasts year’s numbers by May.

Traditional Firms Look Towards Smart Contracts

Traditional firms continue entering the smart contract arena as blockchain integration continues. Today, platforms exist that utilize smart contracts for nearly everything including real estate, investments, royalties, elections, logistics, and much more.

Ethereum – Smart Contracts

The cryptocurrency, Ethereum, is best known for introducing the smart contract concept to the cryptospace. Ethereum’s ERC-20 protocol utilizes smart contracts to help automate token creation and distribution. ERC-20 is by far, the most widely used token issuance protocol in the market.

Ethereum Smart Contract Coding via Ethereum.org

Ethereum Smart Contract Coding via Ethereum.org

Vitalik Buterin, Ethereum’s developer describes smart contracts as a program that “automatically validates a condition and determines whether the asset should go to one person or back to the person who sent it or some combination.” Ethereum utilizes a second-layer protocol to accomplish smart contract capabilities without creating additional blockchain congestion.

Smart Contract Development

Since Ethereum raised smart contract awareness, more complex and advanced smart contract models entered the cryptospace. Platforms such as EOS, Steller, and NEO utilize less wasteful consensus mechanisms when compared to the Proof-of-Work system in place with Ethereum.

Say Good Bye to Lawyers

Smart contracts are removing the middleman from many of the most used business systems today. The trustless nature of these protocols allows businesses and investors the ability to increase efficiency and security simultaneously. You should expect further integration of this technology into traditional business systems as more platforms enter the market.

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Securities 101

How do Security Token Transactions Work?

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Security Token transactions

Security token transactions require you to meet certain regulatory standards prior to engaging in your transaction. The regulations are what makes security tokens different than traditional tokens. Understanding the lifecycle of these tokens will help you to better grasp the concept, including the current requirements, of a security token transaction.

Security Token Transactions – Issuance

Issuance is the first security coin transaction to take place. Security tokens are issued in a couple of different ways. In most instances, Investors acquire these tokens during a Security Token Offering (STO). The complex nature of the process led to alternatives forming in the crypto space. Recently, multiple security token launch firms steeped into the crypto space. These platforms integrate the SEC’s security requirements right into your token development. Platforms such as Polymath utilize their own protocol. This ensures compliance requirements remain intact throughout the entire process.

Polymath via Homepage

Polymath via Homepage

KYC / AML

Security tokens meet both, Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements. This legislation requires companies and investors to provide all relevant information regarding the transaction. These standards are common practice in the banking world. During an STO, Companies provide investors with information such as their company’s name, corporate address, the identities of the executives, and financial records.

This information gives investors more security. Unlike an ICO, an STO requires validation of every investor’s identity. This regulation also means that security tokens can’t be transferred to random or anonymous individuals. These requirements led to the development of security coin only exchanges.

Exchanges / Custodial Wallets

Exchange transfers are another form of security token transaction. Security coin exchanges differ from their counterparts in the fact that all participants follow the above-mentioned SEC guidelines. There are no anonymous accounts or privacy coins permitted on security exchanges. As a result, one of the main concerns regarding security tokens is how they are handled when on exchanges.

Since exchanges hold their users crypto, it creates a unique challenge for regulators and developers alike. Security exchanges use special formatted custodial wallets that adhere to the regulations regarding holding securities for clients in their attempt to integrate into the current legislation.

Security Token Transactions Agents

The complex nature of the securities legislation created the perfect opportunity for transfer agents. These professionals help investors transfer their security tokens properly. Recently, the transferring firm V Stock partnered with Polymath. The partnership provides Polymath users with more liquidity and security. The firm specializes in security token transfer compliance.

Polymath V Stock Partnership via Twitter

Polymath V Stock Partnership via Twitter

 

Security Token ProtocolsThere are many different emerging security token platforms. Of these platforms, Ethereum and Polymath are the most popular. Ethereum utilizes the ERC-725 and ERC-735 protocols. Polymath utilizes the T-20 protocol. These platforms integrate the necessary security token requirements directly into the protocol via smart contracts.

These smart contracts require compliance before full-filling any token transfer. By internalizing the security token requirements, these platforms protect both the consumer and their own interests. These protocols incorporate the benefits of blockchain technology flawlessly, through the use of smart contracts.

Security Token Transactions – A Work in Progress

There is still much to be decided in the coming months as the SEC mulls further integration of the cryptomarket. On the flip side, developers continue to host meetups to increase development in the security token sector. You should expect to see both parties stepping up their efforts in the coming months considering the growing popularity of security tokens. 

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