In this Security tokens basic guide, I have pointed out the very basics of these cryptographic tokens that pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders. It performs the same function as conventional security, except that it confirms ownership through blockchain transactions and also makes fractional ownership possible. Security tokens are subject to federal laws that govern securities, protecting investors on some levels. They are programmable too. Since these securities are tokenized on a blockchain, “smart contracts” can make them act in a certain way, without the use of a third party. For example, a loan “tokenized” on a blockchain could automatically make payments without the use of a traditional middleman like a bank.
According to Wikipedia,
“The first blue sky law was enacted in Kansas in 1911 at the urging of its banking commissioner, Joseph Norman Dolley, and served as a model for similar statutes in other states. Between 1911 and 1933, 47 states adopted blue-sky statutes (Nevada was the lone holdout). Today, the blue sky laws of 40 of the 50 states are patterned after the Uniform Securities Act of 1956. Historically, the federal securities laws and the state blue sky laws complemented and often duplicated one another.”
Moreover, there is sufficient demand for such types of security tokens because security regulations in the respective jurisdictions govern them.
Security is found to exist when all four of these elements exist:
Investment of money
In a common enterprise
With an expectation of profits
From the efforts of others
However, security tokens will need:
STOs (Security Token Offerings)
Example of some of the SEC-regulated ‘security tokens’ that are developing the base infrastructure for the securitization of real-world assets and their liquidity are:
Open Finance Network
The Howey Test
In the US, any instrument defined as a ‘security’ is regulated by the Securities and Exchange Commission (SEC), including security tokens. This sounds straightforward enough, but the legal definition of a security is actually quite complex, and many coins sit uncomfortably between the categories of ‘utility’ and ‘security’.
To understand what the SEC counts as a security, it is necessary to go all the way back to 1946, and all the way to a citrus grove in sunny Florida. At that time, a company called the Howey Company was leasing out part of their orange groves to investors. Investors in this scheme would buy a plot of land, but there was also an explicit promise from the Howey Company that they would work the land and payout part of the profit to investors.
The SEC moved to block the sale. From their perspective, the planned scheme was an investment contract, and as such the investors were entitled to protection. The Howey Company disagreed and argued that the transaction would be no more than a land sale. The case would eventually be appealed all the way to the US Supreme Court, who contentiously found in favor of the SEC, and thereby created the current definition of what counts as a ‘security’. This is defined by what has become known as the ‘Howey Test’.
A transaction will be classified as security if all four of the following requirements are met:
There is an investment of money.
There is an expectation of profits.
The investment of money is in a common enterprise.
Any profit comes from the efforts of a promoter or third party.
Why Are Security Tokens Important?
Since the assets which are represented by the security tokens already exist in the “real world”, they act as a bridge between legacy finance and the blockchain world. So, let’s see what are the exact changes that security tokens are bringing along with them:
Bringing credibility back: As of right now, the ICO space is a little dicey, to say the least. There is a real deficit of accountability in the space because of a lack of regulation for utility tokens. In order for the ICO space to regain some credibility, it should make sense to somehow amalgamate the crypto space and the legacy finance space together.
Improving traditional finance: Traditional financial transactions can be a little expensive because of all the fees associated with the middlemen like bankers. Security tokens remove the need for middlemen which reduces fees. In the future, smart contracts may reduce the complexity, costs, and paper works.
Speeding up execution: Traditional financial institutions have a lot of middlemen involved which simply increases the execution time. By removing these middlemen, securities allow for faster execution time for the successful issuance of security tokens. Because of this increased speed, the security tokens are bound to become attractive investments.
Exposure to free-market: Investment transactions today are extremely localized. What do we mean by that? Chinese investors find it extremely hard to invest in private US companies and vice-versa. So, how are security tokens going to help here? Well, by using security tokens, creators can market their deals to anyone on the internet. This exposure to the free market helps in increasing asset valuation.
A huge number of investors: Since creators can now present their deals to anyone on the internet, the investor base increases exponentially. This is another huge incentive for creators.
Reducing lawyer service: In the future, security token projects will use smart contracts that will automate service provider functions through software. These functions are currently provided by players such as lawyers which add on to the potential middlemen involved in the project.
Lack of institution manipulation: Because the number of middlemen decreases drastically, the chances of corruption and manipulation by financial institutions decrease drastically and may even be removed from the investment process.
Easier liquidation: Secondary trading on security tokens will be made simple through licensed security token trading platforms and it will be extremely easy for investors to liquidate security tokens.
Benefits Of Security Tokens
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 the 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 of day also makes them highly desirable to other traditional models that are a time constraint.
Security Tokens Disadvantages
Too many regulations, as well as limitations on who can invest in security tokens, is one of the factors that could stifle the mass adoption of security tokens. Regulations affecting people who can take part in Security Token Offerings STOs also go a long way in affecting such securities liquidity.
“Secondary trading of private securities often requires various middlemen (such as brokers and exchanges). In addition, the process for tracking trade activity is manual and costly, and there is a significant burden on issuers to safeguard against potential regulatory risk. These inefficiencies can often lead to issuers imposing trade restrictions, making private securities illiquid. To account for the lack of liquidity, the value of private securities is discounted (i.e. the “illiquidity discount”), preventing issuers from capturing the full value of the underlying asset.”
Ways Security Tokens Can Change The Market
Unlocking liquidity: Traditional securities take a long time to settle. Sure, the settling process has sped up over the years. It’s gone from T+5 (trade date plus 5 business days) to T+3, and eventually what it is now: T+2. So, as it stands now, if you sell a security on a Thursday afternoon, the transaction may not be settled until the following Monday (that’s a total of 4 days). With thousands of securities transactions happening constantly, this inefficiency compounds. But when you remove these inefficiencies, trades can settle faster (minutes instead of days!), and the illiquidity discount is eliminated.
Opening up capital to global markets: Depending on how the token is set up, it may be eligible for trading in global markets. For example, an investor in Germany could easily buy equity in a cafe in Florida with a few clicks of the mouse.
24/7 trading: With traditional stocks and securities, the markets are strictly open for 6-7 hours, and on weekdays only (9:30 am-4 pm EDT from Monday-Friday in the US, excluding holidays). This hinders liquidity because investors can’t trade on news or market developments over the weekend. This could lead to sketchy behavior from companies. For example, they will often release information after 4 pm on Fridays in order to capitalize on this. However, security tokens allow for 24/7 markets, which eliminates the huge inefficiencies of daily market closures.
Asset interoperability: In a future where just about anything can be tokenized, this opens the door to asset interoperability – the ability of computer systems or software to exchange and make use of information.
Stephen McKeon explains what this could mean in his Security Token Thesis:
“If the ecosystem for global assets becomes interoperable, it means we can hold ownership claims to a commercial building, early stage equity, corporate bonds, a T-bill, a single family residence, and a decentralized network on the same platform. Further, we could self-custody these types of ownership claims in a single hardware wallet, if so desired. It means these assets to be able to reference each other contractually and interact in an automated way. It could mean global pooled liquidity for all asset classes through a single interface.”
This would create endless opportunities and new markets from the likes that we have never seen before.
Automated compliance: One of the most difficult aspects of trading securities is adhering to regulations. This is because of two reasons: First, regulations can vary by asset type, investor type, and buyer/seller/issuer jurisdictions; and second, you typically need to document regulatory compliance through a series of separate ledgers. But because security tokens are programmable, compliance can be baked right into the token. The hassles of being compliant are greatly reduced, as legally compliant protocols like Polymath and Harbor work together with exchanges like tZERO, 0x, and more. This allows compliance to become exponentially easier, and just about automatic once the systems are in place.
Fractional ownership and increased market depth: Consider high-priced assets like real estate and artwork. These assets can have huge costs, ranging in the millions to even hundreds of millions of dollars – and have minimal market depth. (Market depth is a property of the orders that are contained in the limit order book at any given time. It lets you know the supply and demand of a particular cryptocurrency or security at different prices. Securities with strong market depth allow traders to place larger orders without significantly affecting the price). With security tokens, you can get the benefits of fractionalized ownership. Instead of spending millions of dollars for an entire property (or even a piece of artwork), you can spend far less and buy a fraction of that property. Then, if you want to hedge your bet, you can buy a fraction of another property in a different part of town or even in a different part of the world. This also increases market depth, because there will now be more buyers out there who are interested and capable of owning a tokenized version of the asset.
Carlos Domingo, the founder of SPICE Venture Capital, summarized his thoughts on the potential size of the security token market:
“It’s inevitable that security tokens will transform equity just as bitcoin has transformed currency, because they afford the owner a direct, liquid economic interest and the expedited delivery of proceeds. Every type of ownership can be tokenized, which is a massive multi-trillion dollar addressable market.”
Security tokens have a far less share of the market as compared to utility tokens. It is believed that tons of capital is going to flow from Wall Street to security tokens instead of utility tokens.