NOTICE: As a security token, offerings of USPC must comply with US Federal securities laws.

How do security tokens work?

Want to know more about how security tokens actually work? In this article, we'll explain the basics of how security tokens function on a blockchain.

Security tokens have the potential to become a big thing in the blockchain space and traditional finance (tradfi). We defined security tokens in a recent article, and now you’re about to learn how they actually work.

To begin with, security tokens have two components:

  • The abstract component refers to the security token’s status as a fungible financial instrument with all the legal aspects that pertain to it. In other words, security tokens are securities in the first place from a legal perspective, which doesn’t allow us to put them in the same basket as cryptocurrencies like Bitcoin.
  • The objective component, which refers to the security token’s technical aspect, including the distinctive feature of being recorded on a blockchain.

The idea is to merge these components perfectly so that all the legal attributes are inserted into the token thanks to the programmability feature powered by smart contracts, which are self-executing programs running on a blockchain and enabling the automation of multiple functions. Therefore, while security tokens offer holders the same legal rights as traditional securities, they replace the paper or digital certificate, providing better technical features that relate to security, liquidity, and convenience.

Given that the technical aspect is what makes security tokens distinct, we’ll focus on that. Today, most tokenized securities represent company shares, helping businesses raise capital conveniently.

Companies can issue security tokens that provide holders with a claim of ownership in the business, with or without voting rights. Eventually, they can set a whitelist of wallet addresses of potential holders who are eligible to buy and own those securities. To reach the whitelist, investors have to go through KYC/AML verification and potentially comply with other rules, depending on the jurisdiction.

The 3 Layers in the Creation of Security Tokens

Businesses planning to issue security tokens should consider three main layers:

  • Blockchain – the blockchain protocol is the underlying infrastructure of a security token. It acts as the technical backbone of tokenized securities and dictates their level of security. Not all blockchains enable the issuance of such tokens. For example, Bitcoin doesn’t support smart contracts and thus cannot host other tokens on its network.
    Today, the most popular blockchain used by security token issuers is Ethereum, which supports the smart contract feature. Other protocols capable of hosting digital securities are Algorand, Solana, and Hyperledger Fabric, among others.
  • Smart contracts – smart contracts represent software built on decentralized protocols. They define the security tokens’ features. In fact, this is the most important layer that defines security tokens, as smart contracts embed all the parameters to allow or deny the transfer of a token depending on compliance with the law.
    A blockchain protocol (what we call Layer-1) can host several smart contract standards, some of which are focused specifically on security tokenization needs. The most popular token standard relevant to security tokens on Ethereum is ERC-20, but it doesn’t allow the enforcement of transfer rules to a full level. Ethereum also hosts the ERC-1400 and ERC-1404 standards, which have been created specifically to meet the needs for security tokens, enabling full compliance with securities laws.
  • Tokenization platforms – tokenization or issuance platforms represent the third layer in the security token creation process. These platforms develop a compliant smart contract for the issuance of the security token on behalf of companies. They can also act as a fundraising platform to hold Security Token Offerings (STOs), and provide additional support for companies looking to issue such tokens and might have no experience with blockchain whatsoever. Some examples of tokenization platforms are Securitize, tZERO, Polymath, Tokensoft, and ConsenSys Codefi.

Eventually, security tokens reach specialized or traditional exchanges not before going through the primary fundraising event, which is the STO.

Security Token Offerings

The STO is the main fundraising mechanism during which the tokenized securities issued by companies or other entities are transferred to investors and eventually reach secondary markets, mainly specialized exchanges. The crypto industry and the traditional stock market have their standard fundraising mechanisms, which are the initial coin offering (ICO) and the initial public offering (IPO), respectively. The STO merges many features of the two, borrowing the technical aspects of an ICO and the legal aspects of an IPO. Eventually, STOs are more cost-effective than IPOs and way more secure for investors than ICOs, which are an unregulated market that may fail to filter out scammers.

The STO is the most important step for a business looking to offer security tokens to raise capital. During the preparation phase, companies have to arm with legal advice and research the market in order to be ready to come up with an efficient token structure, informative whitepaper, and find exchange partners.

Many tokenization platforms, such as Securitize and Polymath, offer full support to successfully conduct an STO.

Given their novelty, security tokens might seem to involve complex mechanisms, but delegating the main tasks to specialized platforms after due diligence can help companies reap the benefits and efficiently raise capital from a broader range of investors.  

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