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How Do Security Tokens Work?

11/24/2021
STO OFFERING Security Tokens

How Do Security Tokens Work?

Nov 24, 2021

You’ve probably heard the term security tokens. They either pop up in the conversion or on an online video. If you are not sure what this is, or how do security tokens work, stick around to find out.

Back when the whole blockchain and crypto frenzy started, a lot of companies started to offer the so-called utility tokens. Almost all of these really looked good and promising on paper, but due to the lack of regulatory oversight, they were considered as a high-risk investment. At that time, companies took advantage of this and performed pump and dump schemes, or simply took all the money and left. These instances led to the creation of the so-called security token

A security token is very similar to a utility token, and it can also function within a certain ecosystem, but it is also regulated. Not all of the utility tokens actually fall under the security token category, but there is a good way to determine if they do. That way is The Howey Test.

The Howey Test 🧪

In spite of what many companies are claiming, only a small portion of the utility tokens are indeed utility tokens. Using the Howey test regulators can easily figure out whether a token falls into a utility or security category. The questions used in the Howey test are the following:

  1. Is there an investment of funds?
  2. If so, is this investment into a company or enterprise?
  3. Do investors expect to make money out of this investment?
  4. Is this expectation of profit based on the involvement or work of other people?

When you closely examine these questions you see how easily most of the utility tokens fall into the security token category. People are investing money in tokens, and that money is going to a specific enterprise. The investors are hoping to buy low and sell high, which indicates they expect to make a profit. Moreover, the value of the token will increase if more people buy it at a higher price. On top of that, it is also based on the performance of the company that is working on creating an ecosystem where that token is more versatile.

Since this gives a broad description of security tokens, it would be useful to go over different types of security tokens and explain how they work.

Types of Security Tokens

Companies that were desperate to present their product as the utility tokens, and ended up in the security token category. They weren’t too happy about this arrangement, as now they are subject to regulations. However, companies that were upfront about being security tokens managed to create a unique way for investors to get more value out of their investment. Here are the main types of security tokens and how they work.

  • Equity Tokens – It’s very similar to how the stock exchange works, but the ownership transfers are recorded using blockchain. Users basically become stakeholders in the company, they are entitled to a portion of the profits and have voting rights
  • Debt Tokens – Using debt tokens users can buy a portion of an interest rate from a certain loan. The price is usually affected by that loan’s risk rating.
  • Asset-backed Tokens – these tokens represent the ownership in a certain asset like art, land, real estate, or commodities like gold, or silver. This is great for those who wish or can only afford a certain percentage of an asset rather than a whole thing.

The way all of this is done is by purchasing the tokens that either represent equity, debt, or asset ownership, and this is called digital security offering. Also, you can’t simply buy this anywhere you like you need to use a digital securities exchange platform.

As you can see, this technology is mainly aiding the existing infrastructure of financial systems. But at the same time, it might seem like they are not bringing anything new to the table. So you might wonder what is the use, or advantages of using security tokens over other existing systems?

What Are the Uses for a Security Token?

By using security tokens you shift to using blockchain to do your business and to invest money. Meaning, you get all of the benefits from doing business on the blockchain. These include:

  • Transparency – Everything is auditable and at the same time people get to stay anonymous, at least in some cases. The point being is that you get to perform reliable and secure transactions.
  • Instant Settlement – Trading publicly and settling ownership issues can take days, whereas using blockchain ledgers you can instantly trade and transfer ownership to someone else.
  • Availability – The system or digital security exchange is available 24/7 whereas current markets tend to operate on an everyday work schedule and are available only during business days.
  • Divisibility – With the ability to segment the ownership opportunities into smaller chunks you allow more people to participate. Before, only wealthy investors had the financial capability to trade, whereas now you can own 1% or 0.5% of something. Much like the stock exchange.

How Security Tokens Can Change The Market

The Crypto community has significantly grown. Those who genuinely believe in this technology are working diligently to create an environment where more people can recognize its potential. Regulations created a situation where initial coin offering or ICO is no longer a wild west and was replaced with digital security offering.

 

Based on how digital security tokens work it’s clear that they are not an outright game-changer, but they are definitely an improvement to the existing systems. In other words, digital transactions, buying assets, or stocks, or even debts were possible way before security tokens. However, some of the aspects of this trade were only made possible by disruptive tech like this one.

Unlocking Liquidity

Given how fast you can exchange the ownership of the tokens, the liquidity of your digital assets is significantly higher. So, should anyone choose to sell out they will have access to their money immediately.

Opening Up Capital to Global Markets

A large portion of the world is underbanked and doesn’t have access to digital payment. With blockchain and e-wallets, they can also participate and trade on a global scale, allowing them to create meaningful capital.

24/7 Trading

If you wake up in the middle of the night and decide to sell your digital securities you can do so right then and there.

Asset Interoperability

The whole system is interconnected, and the possibility of fraud is significantly reduced.

Automated Compliance

The reason why transactions are so fast and available 24/7 is because the whole compliance process is automated. It’s easy to follow the trail of previous owners, and blockchain is in essence a self-monitoring system.

Programmable Assets and Securities

Tokenization of assets or voting rights is an extremely flexible way to adapt the environment, to accommodate a growing user base. Giving someone a 10% of the painting is useless, but making him a 10% owner ensures that a person can get value for his or her ownership.

Fractional Ownership and Increased Market Depth

Before tokenization, someone had to have a substantial amount of money in order to fully own expensive assets or commodities. Now being an owner of only a fraction of something is possible. Also, the more people want to participate in that ownership the higher the value of that asset. If someone wants to be a sole proprietor they have to buy out all of the other owners, and people end up profiting off of something they wouldn’t be able to fully afford on their own.

These are all incredibly positive changes and they help even up the playing field between average working citizens and wealthy investors. Therefore, users have more options on how they want to manage their funds and allow their money to work for them.

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