Security Tokens: An emerging trend as ICO alternative

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Security Token is the latest development in the ever-changing Blockchain landscape that seems to be providing investors a new way of investing in companies of their choice. In addition, utility tokens is another emerging spectacle in the blockchain and cryptocurrency scene that also continues to send shockwaves.

While similar in one way or another, Security tokens and utility tokens differ a great deal given their structure and purpose in the industry.

What is a security Token?

In layman terms, a security token is a type of crypto token issued to investors in a token sale (STO) or Initial Coin Offering (ICO). It can also be envisioned’ as a digital asset issued on a blockchain, to represent financial security.

The emergence of security tokens has provided companies a new way of raising funds, in addition to the Initial Public Offering route, through the issuance of a regulated digital share of equity. Security tokens are backed’ by tangible assets such as real estate, shares in a company or fine art.

Given that security token offerings (STOs) combine some of the attributes of Initial Public Offering, they are most of the time subject to federal security regulations. Security token offerings must adhere to security laws in jurisdiction they are listed’ or face the risk of government regulatory scrutiny.

 Security Tokens Purpose

A security token could be used’ to represent a share in a company as well as an interest in a fund. In some instances, such tokens allow investors to own a member share in an LLC. They also act as investment contracts, whereby people invest, in anticipation of their value increasing with time. Such investment contracts also provide a way to take advantage of dividends and profits on offer.

Such form of investments thus provides another way for investors to unlock some value more so from illiquid assets. Bringing liquidity to private assets is another attribute that makes security tokens stand out.

Blockchain Capital conducted the very first ever security token offering in 2017 as it sought to raise funds as part of a financing round. Ever since a number of firms have carried out security token ICOs as the tokenization economy continues to explode.

Requirements for Security Tokens

For a token to be a security tokens it must:

  • Be purchased through an investment of money
  • Be related to a common enterprise
  • Promise potential profits or dividends to investors

Why Tokenize Securities

Private securities are tokenized’ to make them tradable on secondary markets by essentially eliminating most of the administrative burdens of traditional private securities. In addition to enhancing the liquidity of such assets, security tokens also promise additional benefits such as eliminating intermediaries as well as enhancing faster deal execution.

Security Token Classification

Token offerings are at times categorized’ as donations, whereby those who contribute are deemed’ to have charitably contributed to a foundation of a nonprofit entity. In the U.S, for something to qualify as a security token, it must pass the Howey Test, which boils down to two questions as part of the Howey Test.

Q1: Is the token on offer an investment?

For something to qualify as a security token in the U.S, it must act as an investment whereby investors anticipate price increases. The token should thus be desirable when it comes to profits and price appreciation.

Q2: Is there a person that Investors rely on

A security token must have a network of people or entities working behind the scenes to ramp up its value. For example, Microsoft is the single entity for the Windows software product. The company does everything at its disposal to ensure the software works all the time and generate value for the company.

Security Token Issuance

Tokenization is the process of converting rights of any asset into a digital token on a blockchain and issuing the same to the public. Given that security token offerings come into being for the sole purpose of providing investors another investment vehicle, they ought to be compliant with necessary security regulations from day one.

Issuance of security tokens to the public is thus a multi-month process that pools together lawyers and advisors.

Top Security Token Issuance Platforms

Security tokens need special infrastructure to trade in the market given that they are different from utility tokens. A good number of companies have done an excellent job in lessening the cumbersome process of launching security tokens ICO, in a bid to make them accessible to publicly listed companies.

1. Polymath

Polymath has made a name for itself as a reputable platform for ethereum based security tokens. The platform strives to provide all the technical and legal solutions needed to security token ICOs of stocks as well as bonds and other blockchain based assets.

The platform comes with native ST-20 token as well as smart contracts. Companies using the platform to secure their assets can also take advantage of partnerships with the likes of tZero, designed to provide much-needed liquidity for security tokens launched on the platform.

2. Swarm

Powered by blockchain, Swarm utilizes SRC20 protocol, which is a cryptographic standard for security tokens. The protocol defines a set of rules that security tokens must incorporate for the tokenization process to occur. The standardization process also helps in the building of apps that can use such tokens

Some of the items the platform has successfully tokenized include real estates as well as renewables agriculture and tech companies. SRC20 security tokens can represent ownership of an object or an asset. They can also allow holders to manage any asset through voting in addition to securing a right to revenue streams.

3. Securitize

Securitize provides an end to end platform for tokenization of assets. Assets up for tokenization in the platform include standalone fund companies or any other real form of asset. Securitize manages everything entailing tokenization of assets, right from creating logins for its clients to receiving capital and managing the security tokens throughout the lifetime of assets

The platform carries out its operations through DS Protocol which works with DS tokens.

4. Harbor

Harbor helps firms launch security tokens in addition to ensuring they comply with all the necessary regulatory frameworks. The firm behind the platform also helps companies transition their traditional asset classes to blockchain in a bid to enhance their tokenization.

Harbor relies on regulated token system R-token which is a permission token on the ethereum blockchain that enables transfers to occur.

Security Tokens Benefits

People invest in security tokens for the sole purpose of generating some value from them when their price appreciates. There are very few security tokens with no investment characteristics in the market. One of the reasons behind this is that most people, as well as regulatory agencies, tend to pay more attention to substance rather than form.

Issuance of security tokens under Regulation A+. Regulation D, Regulation S and Regulation Crowdfunding also tends to be significantly cheaper and faster, than conducting Initial public offerings.

Entities issuing security token offerings in compliance with stipulated regulations also do stand a better chance of staying clear of scrutiny from authorities.  Security tokens are increasingly inheriting a wealth of legal precedence, a development that has enabled the illumination of buyer rights, protection as well as expectations.

Tokens classified as securities tend to provide investors another option of generating dividends as well as profits and voting rights as is the case with owning shares of publicly traded companies.

Security Tokens Pros

Just like other traditional models of investments, tokenized securities also do come with their fair share of pros and cons.

Cost Effective

Unlike other financial models for investing, security tokens come with zero administrative costs of buying and selling.  Reduced costs essentially allow people to generate a substantial amount of returns on investments.

Fast

The process of buying and selling security tokens to accredited investors also tends to be a little bit fast thanks to automation of Know your customer and AML checks.

Global Trading Capability

Security tokens tend to enjoy high levels of liquidity as they are eligible for trading on the global scene, allowing for anyone around the world to access them. Acceptance as financial instruments as well as increased adoption has also helped bolster liquidity levels.

24/7 Trading

Ability to trade security tokens any time or day also makes them highly desirable to other traditional models that are time constraint.

Disadvantages of Security Tokens

Too many regulations, as well as limitations on who can invest in security tokens, is one of the factors that could stifle mass adoption of security tokens.

Regulations affecting people who can take part in security token ICOs also go a long way in affecting such securities liquidity.

What is a Utility Token?

The evolution of blockchain technology continues to give rise to new products all designed to simplify people’s lives as well as providing companies with other ways of raising much-needed financing. Utility token vs. security token is a battle taking shape given that both are products of tokenization but with a different use case.

Utility tokens and security tokens are million dollar concepts shaping the world of cryptocurrencies as well as how people invest. Just like security tokens utility tokens is another type of token.

A utility token is simply a type of digital token issued to fund the development of a blockchain project or cryptocurrency. It is often used to purchase a good or service offered by the cryptocurrency issuer. Unlike security tokens, utility tokens are simply coins used to enable access to products and services offered by a company.

Utility Tokens Purpose

Most tokens in the cryptocurrencies space are securities that provide investment opportunities. However, tokens developed not to provide investment opportunities fall under the Utility token categorization. That said, utility tokens are simply a way that project developers use to raise much-needed financing for funding product or service under development.

Filecoin is a perfect example of a utility token as it raised $257 million in an initial Coin offering. The firm intends to use the funds to support the development of a decentralized could storage service that is to take advantage of unused computer hard drive space. Participants in the ICO received tokens that they are to use to purchase cloud storage space once the service is available.

The value of utility tokens tends to appreciate with time especially on the demand of the underlying products or service increasing.

Security Tokens vs. Utility Tokens: Differences

Security tokens vs. Utility Tokens tussle comes down to intended use as well as the purpose of the two.

While both of them are issued’ in a token sale or ICO, security token offerings act like investments that people invest with the sole purpose of enjoying a piece of profits and dividends on offer. However, that is not the case with Utility Tokens, which are issued’ with the sole aim of gaining access to a product or service on offer.

Security Tokens do provide investors participating in security token ICO with ownership rights to the underlying company. In most cases, a blockchain platform is created’ resulting in a voting system whereby participants in the token sale can exert control over a company’s decision-making process.

Utility tokens don’t provide participants in a token sale with ownership rights that they can use to influence the direction of a company. A tech company offering utility tokens is only mandated’ to provide participants with a framework in which they can spend their utility tokens.

That said a security token entitles holders to ownership rights of the underlying project seeking financing while Utility tokens are simply coupons that grant access to products and services on offer.

Howey Test settles the security tokens vs. utility tokens debate in two simple questions.

Question one: Does a token in question offer holder’s rights to contribute to a startups capital as well as a share of profits?

Question two: Does ICO fundraising involve investment in a project whereby profits are generated’ from efforts of individuals or entities other than a project founder or creator?

If the answer to the two questions is yes, then the token is categorized’ as a security token, subject to regulation like any other security offered for investment purposes.

Security Tokens vs. Utility Tokens: The Future

Initial Coin Offering sector experienced one of its best years in 2017 as startups raised over $ 5 billion on the issuance of both security and utility tokens. 902 ICOs took place in 2018, with 2018 expected to be much bigger as more entities continue to embrace cryptocurrencies.

The unregulated nature of the cryptocurrency space, especially on Initial Coin Offerings, is one of the reasons why most startups are opting for this route to raise funds instead of going the IPO way. While a good thing for startups, the same has brought about a string of challenges with the emergence of more fraudulent projects in the sector.

 ICO Frauds & Scams

Initial indication is that more than 50% of ICO projects launched last year might have closed shop and in the process went down with people’s money. Unscrupulous companies have sought to benefit from the growing popularity of security and utility tokens by running illegal pyramid schemes. In some cases, the companies promise new members payments or other services, in case they enrolled new members.

A lack of product or services in some ICO projects has come to be associated with fraudulent projects all in the run to dupe unsuspecting investors. While pyramid schemes are illegal in most countries companies, appear to have found a way of using ICOs to evade regulators scrutiny.

It is for this reasons that regulators around the world are increasing their scrutiny of the space as they seek to protect unknowing investors from scandalous projects. In the U.S for instance, the country’s top investment watchdog, the Securities and Exchange Commission has already set an official cryptocurrency desk tasked with ensuring security tokens abide by laws that govern securities.

Utility Tokens vs. Security Tokens Regulation Calls

Strict regulations are needed’ if blockchain innovations and cryptocurrencies are to grow and hit their full potential. The lack of regulations is one of the reasons why institutional investors have shied away from investing in security tokens as well as utility tokens.

With clear-cut regulations, such investors should be able to invest their hard earned money on the assurance of protection from fraudulent practices as well as misrepresentations about investment opportunities.

Regulations should put to an end the practice of selling security tokens disguised as utility tokens thereby ensuring that investors end up with what they actually pay for. While regulation will also come with its fair share of inconveniences such as lengthy processes of conducting reports, disclosure as well as abiding by KYC and AML policies, it seems to be a cheap price to pay, all in the effort of strengthening investor confidence in the industry.

Bottom Line

Security Tokens and Utility Tokens are by-products of blockchain technology that are destined to stand the test of time. Demand for security tokens should continue to increase with the increased adoption of cryptocurrencies as well as blockchain innovations.

The fact that such tokens offer a way for investors to own rights to companies in addition to profits and dividends on offer, explains why they continue to grow in popularity.

Companies, on the other hand, should continue to leverage the capabilities of utility tokens as a way of raising additional financing to facilitate the development of additional products and services.

*Disclaimer:  The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. Do your own research!


About Author

Swati Goyal has an extensive work experience of more than 6 years, in the field of Finance in diverse roles ranging from accounts, financial research to and Cryptocurreny. She follows the Finance market and enjoys writing on it, Swati's hobby is reading, watching movies and television shows.

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