The explosion of ICOs means that there are now thousands of cryptocurrencies, usually referred to as ‘tokens’. 2021 will likely signal the rise of one special kind of token, called a security token, which provides one of the most encouraging cases for blockchain technology yet.
Nowadays, security tokens are the talk of the town. Security tokens are poised to take over the blockchain, securities, and finance industries with their backing from financial institutions such as HSBC, the support of regulatory bodies, and mounting evidence proving their benefits. While investors, institutions, and regulatory bodies are embracing the concept, significant barriers remain such as identity and governance issues. By leveraging blockchain, digital securities are set to move past traditional capital markets and transform the blockchain landscape.
In this guide, we are going to learn what are security tokens, how do security tokens work, what is an STO, and if they are worth your time or not.
What Is an STO (Security Token Offering)?
For a deeper understanding of what is an STO and why they are needed, first, we need to understand how ICOs were perceived as a fault in the blockchain industry. Tokens are often associated with initial coin offerings, a new type of crowdfunding for cryptocurrencies that became popular in 2017.
Let’s begin there.
Bitcoin’s emergence transformed Blockchain into a mainstream technology. Despite the reputation that cryptos and other blockchain-based financial products are volatile and speculative, experts agree that blockchain technology, along with other forms of distributed ledger technology, is essential to financial markets.
Investors started pouring money into ICOs from 2016 to 2018 as they became increasingly popular. Over time, it was expected that these investments would increase in value. But in 2018, it all came crashing down as the total market value of all cryptos fell by more than $750 billion. Unfortunately, token offerings were not regulated by the United States Securities and Exchange Commission.
The government and regulators then started making announcements related to compliance – which eventually led to protests organized by the blockchain entrepreneurs. They claimed their projects offered utility tokens, not security tokens. Thus, ICOs have been dogged due to the regulatory uncertainty, over the past few years.
Securities regulations require token offerings to comply with current laws and rules. This is how the Security Token Offering evolved. ICO and STO are similar in many ways, but STO is governed by securities laws in each area where the token will be traded. Aside from complying with related laws, STOs impose additional legal requirements to issue shares in the company.
What Are Security Tokens?
So, the question here is: what is a security token and how do security tokens work? Security tokens represent stakes in external assets or companies that are based on permissioned or permissionless blockchains. Security tokens can be issued by government agencies as well as private companies. These digital securities held and traded on a blockchain function similarly to stock, bond, and equity issues.
According to the security token definition, they automate and provide a golden source of truth for several time-consuming and highly manual processes. Simplified, security tokens combine the speed of blockchain technology with the safety of traditional securities.
Utility Token vs Security Token: What’s The Difference?
The main purpose of ICOs is to provide investors with a way to participate in investing in the company. For that reason, most tokens are considered securities. When a token fails to pass the Howey Test, then it is categorized as a utility token. Tokens are merely products and services that users can use- just like gateway tokens.
A major difference between utility tokens and security tokens is that security tokens are designed for investment purposes. These products are therefore governed by the same regulations as other investments.
Security token offerings do not fall under ICOs, but rather security token offerings (STOs). A security token offering must be registered with the corresponding financial market authority. Adding regulatory oversight to STOs should make them safer and less vulnerable to abuse and fraud.
Pros Of Security Tokens:
Due to the fact that the assets represented by security tokens already exist in the “real world”, the tokens are used as a bridge between legacy finance and the blockchain. So what changes are being brought about by security tokens?
The company is able to provide investors with shares using a security token that provides identical benefits as traditional security like shares, rights to vote, and dividends. Due to the fact that blockchain technology supports security tokens, the method has numerous advantages.
Apart from offering a host of benefits over traditional securities, security tokens include:
The blockchain offers auditable transactions, including participant identities occasionally. The ledger can be viewed by anyone to track token holdings and distribution. Keeping an accurate record reduces disputes between parties and reconciliation is unnecessary.
Investors seeking to transfer assets are often concerned with clearance and settlement. The process of trading can be done very quickly, but reassigning ownership takes time. A public ledger automates and speeds up the process.
Financial institutions with a lot of middlemen simply slow down the process. As a result of removing these middlemen, securities are able to issue security tokens at a faster rate. With this speed increase, security tokens are bound to become more valuable investments.
Currently, financial markets only operate during business hours, since manual effort is required. Alternatively, a blockchain marketplace is always active, 24/7.
In the form of security tokens, fractional ownership of real assets can be represented more clearly and investors can expect that their ownership stake will be preserved on the blockchain. With asset tokenization, everyone can invest in a wide range of assets.
In the case of Damien Hirst’s artwork, a token for $10 million could be broken down into 10,000 pieces each of which would be worth $1,000. With tokenization, assets will be more accessible, granular, and democratized.
Smart contracts will be used in the future, which will automate the function of service providers through software. The functions of these parties are currently performed by players such as lawyers, which adds to the potential number of middlemen involved.
Automating, speeding up, and enhancing transparency in blockchain technology allows for easier, faster, and cheaper creation, issuance, and transfer of securities. Security tokens streamline labor-intensive processes while keeping costs down and reducing the possibility of manual errors.
Licensed security token platforms will make secondary trading on security tokens simple, and investors will be able to liquidate securities very easily. The use of security tokens makes some assets like real estate and fine art more liquid thanks to fractional ownership and secondary markets. By fracturing ownership into tiny fractions, rather than owning it all, smaller investors can participate in wealth creation.
Exposure to Free Market
The world of investing is becoming increasingly localized. Investing in private US companies can be extremely difficult for Chinese investors, and vice versa. Basically, creators use security tokens to sell their products to any internet user. As a result of this exposure, assets are valued higher.
No Institutional Manipulation
By eliminating middlemen, the chances of financial institutions being corrupted and manipulated decrease dramatically, and in some cases, they may even be removed from the investment process altogether.
Cons of Security Tokens
By revolutionizing traditional asset ownership, security tokens have made a great start. But, apart from the advantages, there are also some drawbacks associated with security tokens. How can security token adoption be slowed down?
Right now, the obstacles to a successful security token space are too great to ignore. There are multiple reasons behind the poor adoption.
Firstly, smart contracts can be used in multiple jurisdictions at the same time. Before we can even think of investing globally, regulation must be considered thoroughly.
Secondly, security tokens are not yet widely accepted by exchanges. Since they know there will be legal problems, they can’t take the risk.
Third, issuers have a greater number of rights in security tokens, and this must be accounted for in a clear way. Thus, they can transfer tokens without any restrictions whatsoever.
Also, KYC needs to be in place on-chain to streamline that process, which has not yet been formalized.
Lack of Human Resources
The number and complexity of regulations governing security tokens are expected to rise in the near future. Some participants have implemented proprietary compliance systems that require manual intervention, but these don’t deliver the level of automation required for automated compliance.
The removal of middlemen is usually considered to be a huge advantage. However, it might not be that “good” of an advantage. By removing middlemen from the transaction, responsibility is shifted to the buyer or seller. As middlemen, financial institutions participate in all aspects of the ecosystem, such as deal underwriting, preparation of marketing materials, solicitation of investor interest, and security and compliance regulation.
Without traditional financial institutions, it is uncertain whether the creators will be able to perform these functions well.
Compatibility with Existing Structures
In spite of more and more digital asset intermediaries, market infrastructure providers, issuers, and promoters requiring regulation, there are still certain aspects of crypto that remain unregulated. These services provide decentralized exchanges, and P2P exchanges, for the buy-and-sell of tokens, as well as cloud mining services, to allow for the mining of crypto assets.
3 Types Of Security Tokens
There are three different types of security tokens: equity, debt, and asset-backed. We’ll go into greater detail about each one in a moment.
On a blockchain, stocks are represented as equity tokens. In contrast to a traditional stock, an equity token records ownership in a different way. The records of traditional stocks are logged into a database and then represented by paper certificates. Unlike traditional asset records, equity tokens are stored on an immutable blockchain, which digitizes the traditional process of storing assets.
By owning equity tokens, an investor will receive a portion of the profits and have a vote in the company. Although it is more common to find companies offering tokens during seed rounds, these tokens aren’t limited to just early-stage funding.
Debt-based security tokens act as risk instruments, such as real estate mortgages and corporate bonds. In determining the price of the tokens, two factors determine their value: Risk and Dividend. For a real estate mortgage, medium default risk cannot be compared to the price of a bond of a non-IPO company.
Modeling the price of a security token after dividends and risk is crucial. For example, a smart contract representing a debt security token should determine the dividend model while accounting for different risks associated with the underlying debt.
Traditional securities do the same thing as a security token except it confirms ownership via blockchain transactions and allows fractional ownership. Security tokens also fall under federal securities law, which provides some protection for investors. The use of smart contracts can, in theory, remove the need for a third party in the tokenization process. By tokenizing loans on blockchains, lenders could automate loan payments without relying on banks.
Bottom Line: Security Token Offerings Are Not Going Anywhere
Initial coin offerings are still in their infancy and may take some time for security tokens to incorporate their true beauty. In contrast, initial coin offerings democratize a process of raising capital that previously only existed for large institutions and accredited investors. In another world, a person from Chile is able to own shares in a Chinese company simply from their phone. Meanwhile, a Chilean resident must continue to make investments in security tokens and wait for the next solution.
But, as we seek to revolutionize the financial system, the STO market is one to watch in the coming years.