What are Security Tokens?

- September 4th, 2019

While they are a lesser-known digital asset, security tokens are projected to become a trillion-dollar market in the years ahead.

In 2017, five security token offerings (STOs) raised just over US$65.5 million according to a report from BlockState. Within less than two years, that number has towered to nearly US$1 billion worldwide. 

Like its crypto counterparts, STOs have joined the digital asset phenomenon. Since 2017, initial coin offerings have raised over US$22 billion. The total market size of cryptocurrencies tops US$269 billion, according to Coinmarketcap.

As new digital avenues for investing and raising money unfold in the capital markets, it is important to pay close attention to their different definitions and classifications. Each digital instrument has a variety of attributes concerning their foundation, technology and governing regulations. Even though the space is relatively new, properly differentiating between the various digital assets can have major implications on whether or not they are even able to trade.

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What are security tokens? The Howey Test

When it comes to security tokens, the definition still remains gray.

To start off, security tokens can be categorized as security tokens or utility tokens. This classification depends on whether it passes the Howey Test, which defines how a given instrument is to be regulated as a security under US federal securities laws.

While the Howey Test dates back to 1946, it has only very recently been linked to crypto regulation. A paper was published by the Securities and Exchange Commission (SEC) in April 2019 explicitly stating that it is classifying security tokens according to the Howey Test criteria.

In the SEC paper, it states that tokens whose value is based off of an asset, such as a currency, real estate or assets in a company’s balance sheet, are securities, and therefore a security token. Additionally, if the token represents an investment in a shared or common enterprise that is anticipated to generate profits in the future, it would meet the criteria for being qualified as a security under federal securities law.

If a token does not pass the Howey Test, it would be considered a utility token.

Some utility tokens on the market have offered a gateway to a given network, or offer utility token holders the right to vote in a network. In essence, a utility token helps build an economy within the system. Civic, Filecoin and Siacoin are some examples of utility tokens.

Ultimately, one of the primary goals of the SEC’s legal framework is to protect each individual investor. Newfound secondary market liquidity for these financial instruments has resulted in a number of fraudulent activities, thefts and scandals since they originated.

What are security tokens? Security token offerings

So how do security tokens list on a market in the first place?

Despite the accelerated growth of the security token market over the last few years, there are only two exchanges — tZero and OpenFinance — that are regulated for security token offerings.

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TZero, a subsidiary of Overstock.com (NASDAQ:OSTK), launched its security token exchange in January 2019. The exchange provides a secondary market for investors to trade its tZERO security tokens. At that time, it was exclusively regulated for accredited investors or institutional investors. It has since launched a preferred token, TZROP, that is available for retail trading.

Despite the broadened move in accessibility for the security tokens, The Block reported that daily trading volume remained under 15,000 as retail investors remarked on high fees, narrow trading windows and the limited kinds of deposits available.

OpenFinance, on the other hand, launched the first regulated security token exchange in late 2018. The exchange was developed in partnership with Sageworks Capital, a registered broker-dealer. Blockchain Capital (BCAP) security tokens are among the four security tokens that are tradable on the exchange; one BCAP equals one US dollar. As a formative venture capital firm in the technology and blockchain space, Blockchain Capital has invested in financial services companies, including Bitwise, a blockchain startup. The BCAP token offering raised an equity pool of US$10 million. Forbes estimates that daily transaction volume is less than US$1 million on the OpenFinance exchange.

Although not driven to become wholly security token exchanges, several cryptocurrency exchanges such as Binance, Coinbase, the Canadian Securities Exchange and the Malta Exchange have expressed interest in security token trading pairs.

Security token trading pairs are when two security tokens can be exchanged or traded for one another. For example, you could sell BCAP to buy TZROP. This means that BCAP or TZTROP could, in a sense, be replacements for cash.

As the limited number of exchanges illustrates, the process of opening a security token exchange is rare and burdensome. Firms must register as either an exchange or an alternative trading system with the SEC in accordance with its regulatory requirements. Due to the nascent nature of the STO industry, the regulation process is quite slow and costly.

What are security tokens? Security token outlook

Even as the security token market faces a number of regulatory roadblocks, the number of STOs continues to increase on a global scale. The opportunities of security tokens could also be unprecedented. Deloitte forecasts that trillions of dollars could be eventually tokenized, and previously illiquid assets such as real estate or art could be accessible through a secondary market.

Where tokenized assets stand to benefit is the potential for technological innovation in the digital asset ecosystem, including automated transactions, improved authentication, greater accessibility to a wider range of investors and increased transparency through immutable records. While the current infrastructure remains clunky, the potential for removing a middleman could both reduce fees and heighten the liquidity of a wide variety of tokens.

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Securities Disclosure: I, Dorothy Neufeld, hold no direct investment interest in any company mentioned in this article.

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