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What are security tokens?

What are security tokens?

Explainers Essentials

14 Jan 2020

2017 was clearly the year of Initial Coin Offerings (ICOs). Investors were flowing to the cryptocurrency market, while startups raised a record amount of funds for their projects.

However, while ICOs allowed crypto projects to raise funds by offering their tokens for sale directly to investors, the flaws of the crowdfunding method eventually led to its downfall.

At the time, many in the cryptocurrency space took advantage of the lax regulatory environment to launch ICOs for immature and fraudulent projects. In fact, a study revealed that scammers ran 80 % of 2017's ICO projects.

But everything changed during the 2018's bear market. The cryptocurrency industry matured with governments increasing their regulatory scrutiny over the digital assets market.

As a result, security tokens appeared on the crypto market, allowing organizations within the industry to raise capital in the form of the regulation-compliant Security Token Offerings (STOs).

So today, we'll take a look at security tokens as well as how they differ from utility tokens.

What Are Security Tokens?

Before deep-diving into the world of security tokens, we first have to explore what a security is.

In traditional finance, a security represents a fungible and negotiable financial instrument that holds some type of monetary value. Fungible here refers to the interchangeability of an asset; 1 dollar is equal to 1 dollar, everywhere).

Securities have two main categories: equities and debts.

While an equity (e.g., Apple stocks) provides the investor with an ownership position in a publicly-traded company, a debt security (e.g., U.S. Treasury or corporate bonds ) represents a creditor relationship with a government or enterprise where the borrower pays interest to holders.

Simply put, a security token is the digital version of a security. If the issuer complies with regulations, the main benefit of security tokens is the ease with which they can be traded, as they act as a bridge between the blockchain industry and the traditional financial market.

This feature comes in handy when organizations tokenize illiquid assets like small Real Estate Investment Trusts (REITs). While the investors of these REITs may own a building in your street, they have to lock up their capital for a long time until they can sell their shares (they have to wait until the building is sold).

However, when the same REITs are tokenized, investors can still purchase a share of the building, but without the need to lock their funds up. It's a win-win scenario as token holders can exchange their assets with each other on a secondary market, while businesses can still use the capital they collected from investors.

Furthermore – in contrast to traditional securities – security tokens allow investors to trade their digital assets on a global scale.

Security Tokens vs. Utility Tokens: What Is the Difference?

Regulators like the U.S. Securities and Exchange Commission (SEC) use a method called the Howey Test to tell whether a digital asset is a security or utility token.

According to the SEC, an asset is considered as a security token if it fulfills the following criteria:

  • It's an investment of money
  • Contributors invest in a common enterprise
  • There is an expectation of profit from the work of a third party or promoters

The table below summarizes the main difference between utility and security tokens:

Security Tokens: the Future of the Crypto Market?

Security tokens have not yet reached mainstream adoption. To date, STOs have raised $953 million in 124 token sales. By comparison, Initial Exchange Offerings (IEOs) – token sales conducted on crypto exchange platforms – collected $1.672 billion just in the first half of 2019.

However, IEOs – that stole the game from STOs last year – may have had success in the short-term but not necessarily in the long-run - at least not for all projects. The industry is still young and while IEOs represent progress compared to ICOs because of better screening processes, the regulatory framework is still very fragile - security tokens are already heavily regulated.

While security tokens are only gradually picking up, many consider them as the viable future of the cryptocurrency industry as they offer a regulation-friendly way to connect traditional sectors with the blockchain industry.

Therefore, we will see an increased number of assets being tokenized in the form of security tokens. To reach mainstream adoption, the cryptocurrency industry needs strong exchange platforms that support STOs and cater to the growing community of investors.

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