What Is A Security Token?

Want to learn more about security tokens? You've come to the right place! This article aims to educate you about what a security token is, why they exist, and how they work.

Security tokens represent a great example of how the mainstream financial system can integrate blockchain solutions to improve security, streamline the transfer of value, and achieve better scalability.

To put it in simple terms, security tokens are blockchain-based digital units representing traditional securities, such as equities and bonds. In other words, a security token is a digital representation of ownership of an underlying asset, be it a company share or real estate. For example, the most common type of security tokens includes company shares or stakes in private firms. Think about holding Apple or Tesla shares in the form of digital tokens.

Security tokens, also known as digital securities, bear similarities to cryptocurrencies like Bitcoin and Ethereum in the sense that they use the same underlying technology, which is blockchain. However, their distinctive aspect has to do with their quality of acting as traditional securities. Therefore, digital securities are in the purview of traditional securities laws.

In the US, security tokens have to be registered with the Securities and Exchange Commission (SEC) in order to have legal ground. During the last decade, the SEC has initiated dozens of enforcement actions against businesses or individuals for providing unregistered securities in the form of digital tokens.

It’s worth noting that, as per the SEC, most cryptocurrencies are in a gray zone and could potentially act as securities. The financial watchdog’s head, Gary Gensler, said in a recent speech that the “vast majority” of the 10,000 tokens in the crypto industry were securities and thus might operate illegally on US soil, although Bitcoin is regarded as an exception.

Whether the SEC ponders intensifying the regulation of cryptocurrencies or not by relying on the so-called Howey test, security tokens are in a league of their own as they already have all the attributes of securities, which represent tradable financial assets, including stocks, bonds, as well as security-based futures, swaps, and other derivatives.

Why Do We Need Security Tokens?

With well-established stock, bond, and real estate markets, why even bother converting securities into digital representations? It’s because security tokens leverage the features and benefits of blockchain in terms of security, transparency, and ease of transactions.

Here are the main benefits of security tokens compared to traditional securities:

  • Liquidity – security tokens can boost the liquidity of any asset by making it easier for holders to trade it on primary and secondary markets. They also can provide fractional ownership, which makes the asset more affordable for retail investors, who can get exposure to divided slices of the asset, especially when it comes to real estate. When it comes to company shares, while some traditional stock trading apps enable users to buy fractional shares, security tokens’ fractional ownership feature enable companies to directly raise capital from a broader range of investors.
  • Global reach – securities tokens that reside on public blockchains are borderless. Companies can raise money from around the world, although they have to make sure that the tokens are considered securities in each jurisdiction.  
  • Programmability – the good news is that complying with the rules in each jurisdiction is easy thanks to security tokens’ programmability. The tokens can embed all the rules, automating the management of the rights of holders. Anything related to voting rights, KYC/AML requirements, and any thresholds can be programmed into the tokens to comply within each jurisdiction.
  • Security – thanks to blockchain’s immutability of data and decentralization feature, the security risks are reduced to a minimum. The ownership of the security is recorded on blockchain, and that means it cannot be changed or deleted.
  • Convenience – Security Token Offerings (STOs) – a fundraising mechanism similar to Initial Public Offerings (IPOs) – enable companies to raise funds without necessarily becoming public, which comes with loads of obligations.

How Do Security Tokens Work?

Security tokens are financial assets that legally act as securities but technically represent digital tokens on a decentralized network, aka blockchain. It’s worth noting that only blockchains supporting the smart contract feature can host security tokens, with Ethereum being the most prominent example. For those unfamiliar, smart contracts are self-executing programs that run automatically when predetermined conditions are met. They enable the programmability of tokens.

Blockchain, whether permission-less or permissioned (public or closed for private networks), is a technology that has no single point of failure, meaning that the ownership of the security is recorded securely and cannot be tampered with. Public blockchains, such as Ethereum, enable users to conduct transactions directly in a decentralized manner, i.e. without the involvement of centralized entities. Nevertheless, thanks to the programmability of security tokens, regulators can monitor transactions and the entities issuing security tokens.

Thanks to security tokens, companies and funds can raise capital from institutional and retail investors by conducting an STO, in which the tokens are sold on specialized exchanges. Some traditional stock exchanges, such as the Luxembourg Stock Exchange, also support security tokens.

Security tokens might be the future of equity and real estate trading. Many blockchain startups and traditional companies choose to issue digital securities thanks to the benefits of blockchain and the potential higher liquidity.

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