Why Security Tokens: Will the Age of Security Tokens Come?

by | Dec 4, 2018

1. Will the Age of Security Tokens Come?

Talks of security tokens have become more robust in the second half of 2018. .In the trading perspective, crypto exchanges such as Bithumb have rolled up their sleeves in developing security token trading platforms and conventional stock exchanges like the NASDAQ have also entered into security token trading. In terms of token issuance, many blockchain projects are shifting from ICOs that use utility tokens to STOs (Security Token Offering) for fundraising. Even non-blockchain start-ups are opting for STOs as a means for drawing in new investment.

If you take a closer look, the security token ecosystem is multi-layered and complex. First, there are issuance and compliance platforms that help with the issuance of token issuance. These platforms assist with legal regulation and token issuance according to token standards or develop and distribute token issuing protocols.

Next are the exchanges. As mentioned above, many exchanges are developing platforms for trading security tokens. There are also liquidity companies that help exchanges to acquire liquidity in low liquidity markets. Lastly, there are STO projects that issue security tokens in this ecosystem. These projects range from blockchain projects to start-ups, real estates, and collective investment bodies.

Then, what exactly are security tokens and why are they receiving so much spotlight?

2. What are Security Tokens?

Definitions of Security Token and Utility Token

To understand what a security token is, you must first know what a utility token is. Most tokens issued by blockchain projects so far are utility tokens. A utility token is ‘a token that grants user rights of the services or goods provided by a certain network’ (the detailed definition of a utility token can vary from perspective). The usage value of a utility token is determined by the ‘rights’ bestowed by the protocol.

A golf club membership is much alike a utility token. Even though a golf course has not yet been physically constructed, you could still buy the right to play golf there. This membership is actually traded on a membership market outside of the golf club. It is not just about ‘consumption’ rights. It could also be ‘sales’ rights at a newly opened department store. You could say a utility token grants certain rights on the blockchain and can be used like coupons or credit points.

A security token is a security. A security token does not bestow the right to utilize a service but represents legal ownership of a network that includes the right to withdraw profit and participate in decision-making. Some tokens could replace stocks and some could replace bonds. Moreover, security tokens could represent shares of spot assets such as real estate or art pieces.

Tokenized securities inevitably will have stronger intervention by policy and regulation than utility tokens. It is the same as how airlines have the freedom to internally decide their mileage policy but their stocks have to comply with the securities act and financial regulation. Then how do we know whether an issued token is a utility token or a regulated security token?

Differentiating Utility Tokens and Security Tokens

In July 2017, the U.S. Securities and Exchange Commission (SEC) deemed DAO as a security token and set forth the categorization standard. A token that passes the Howey Test, which verifies whether an asset is a security, will be defined as a security token. In order to pass the Howey Test, a token has to satisfy the following four conditions:

  1. Investment of money
  2. Expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

If all four conditions are satisfied, the SEC categorizes a token as a security token. A security token has to be issued in accordance with the guidelines set by the SEC and will be subject to constant surveillance and regulation. Also, trading of that token can only take place on SEC approved platforms.

Does this mean that a token could evade the SEC’s surveillance if it intentionally does not satisfy one of the four conditions? Unfortunately, there is no guarantee because the SEC applies the ‘substance over form’ rule. This means that even if a company issues a nominally utility token by evading the SEC’s conditions, the SEC will still deem the token as a security token if, in reality, the token’s users use it as an investment means. In other words, all utility tokens could be categorized as security tokens and become subject to regulation.

3. Why All the Attention on Security Tokens?

At a glance, it may be incomprehensible why security tokens are receiving so much attention. As explained above, once security token is issued, there would be more regulation and surveillance by financial authorities. Compared to how easily ICOs could autonomously set a token’s value and easily attract investment while ducking regulation by the government, STOs make companies appear to be strapping on shackles voluntarily.

However, as previously mentioned, the blockchain industry and financial industry are actively accepting STOs. For what reason are they jumping in on security tokens? First, we will find out what advantages security tokens have over conventional securities in the traditional financial standpoint. Next, we will stand in the shoes of blockchain projects and look into how fundraising via security tokens is better than utility tokens.

From Traditional Investor’s view: How Security Tokens are Better than Conventional

Securities

First, let’s learn about the advantages that security tokens have over securities like stock and bonds. STOs are not solely tied to blockchain projects as did ICOs. Start-ups that have business models irrelevant from blockchain are implementing STOs to issue their shares in tokens. Furthermore, there are companies that have synchronized ownership of expensive assets such as real estate and artwork with tokens. The key reasons why these companies utilize STOs are 1) high liquidity, and 2) programmability.

1. High Liquidity

If company shares are issued as security tokens, you would be able to secure higher liquidity than the existing shares investment.

Fractional Ownership

The first reason why STOs ensure high liquidity is that security tokens enable fractional ownership. Generally, tokens are divisible up to 18 decimal points, which allows the average person, within legal boundaries, to own a fraction of high priced assets like real estates. Investors can enjoy a wider variety of investment portfolio and at the same time tokens will have greater liquidity.

Secondary Market

The second reason why security tokens have high liquidity is that a secondary market can be formed. Typically, LPs launch a venture capital fund and invest in a start-up, it would take three to ten years before they would ever see returns. However, if a security token trading platform is created, one can secure liquidity by selling his shares (security tokens) on that platform. For private investors, they now have an opportunity to directly invest in start-ups and simultaneously token liquidity increases.

The KRX Start-up Market have an inconvenient format of negotiating trades via direct messaging.

3) Korea already has a start-up shares trading platform called the KRX Start-up Market (KSM). However, the KSM 1) only trades Korean start-ups, 2) trades by one-on-one negotiations in compliance with the Financial Investment Services and Capital Markets Act, and 3) allows investment only with a security account. However, a security token trading platform is expected to overcome these limitations because it would be borderless, easy to trade, and enables anybody who completes ID verification to invest.

2. Programmability

The second reason why security tokens are better than conventional securities is that all the complicated procedures can be programmed into a token.

First off, governance among token holders can be automated. Since security tokens act as shares, token holders are no different from shareholders of a company. By programming into a token the decision-making authority of shareholders in the form of a smart contract, shareholder meetings can be held quickly and easily on the network.

Also, the settlement process can be efficiently shortened. Transferring shares on the existing financial system requires going through a complicated process of paperwork. However, if people transfer security tokens to verified users via KYC/AML on an approved trading platform, this process can be simplified to the extent legally allowed.

Additionally, security tokens are attractive because they are permanent record of property rights of a certain asset. Indeed, because there is no specific standard of security token’s structure, and there are only few actual implementation cases, it is hard to say that these advantages can be realized. However, since key financial authorities like the SEC are quickly working towards establishing guidelines and key financial institutions are building platforms, we expect that a more refined form of security token will come soon.

From Blockchain Project‘s view: How STOs are Better than ICO

Fundraising through security tokens has more benefits compared to ICOs utilizing utility tokens because ICOs rendered significant side effects for being rampant without regulation. The key benefits of STOs are that they 1) secure safety for investors and have 2) possible influx of institutional investors.

1. Securing Safety for Investors

The ICO boom in 2017 adversely created many ICO scams. Including extreme cases like OneCoin which gathered 350 billion KRW but turned out to be a ponzi scheme, most ICO projects that collected funds failed to deliver the products they promised on whitepapers. While companies easily obtained billions in investment, the investors were exposed to all investment risks because regulations protecting investors were not in place.

Meanwhile, the SEC has announced that it will take charge of securing soundness of security tokens from the issuing phase and protecting investors. https://www.sec.gov/news/press-release/2017-176. Now investors can trade security tokens issued by companies that comply with SEC rules with more safety. We have become safer from unstable variables from scams where companies run away with ICO investments and market manipulation such as pump & dump.

2. Influx of Institutional Investors

The 2017 ICO boom lured many people to become interested in cryptocurrency in general, but institutional investors kept distanced and just observed. For institutional investors, stable management of investment funds is crucial. Because tokens issued by ICOs could not be legally accounted or acknowledged as an asset, institutional investors could not make a move easily, which limited the amount of investment in ICOs even for companies with honest intentions.

However, if STOs become the norm for blockchain fundraising, we can expect many institutional investors to join in. Because security tokens are same as securities like shares and bonds, they are subject to regulatory protection. In reality most security token issuance follow one of the rules set by the SEC among Regulation D, Regulation S, Regulation A+, and Regulation Crowdfunding.

The SEC has jurisdiction over companies based in the U.S. or has investment by Americans. In other words, trying to avoid SEC regulation means giving up on institutional investment from the world’s financial investment hub. Yet, complying with SEC regulations reduces the possibility of being at the receiving end of unexpected sanctions and increases the possibility of receiving investment by U.S. financial institutions.

From Cryptoeconomist’s view: How STOs Changes Utility Token Economy for the Good

The benefits of introducing security tokens in blockchain projects are not confined to fundraising. In the case of ICOs, utility tokens that will actually be used on the network are used for fundraising.

Meanwhile, STOs differentiate the means for fundraising and means for service usage. Therefore, substantial changes in the network’s token economy can be easily anticipated. We will look into the difference between ICO and STO’s impact on the network’s utility token economy by using a fictitious blockchain company.

For instance, let’s say ‘Deacon Solar’ is a blockchain-based solar power trading platform. Using Deacon Solar, you are able to trade energy produced from small-scale solar panels at real-time market prices. To buy solar energy on Deacon Solar, users have to use a utility token named ‘Solar’. You need 1 Solar token to purchase 1kW power.

Shortfalls of ICOs: Increases Confusion Due to Increased Complexity of Token Economy

Let’s assume that Deacon Solar issues Solar tokens through an ICO. Before launching its service, investors who participate in the ICO will buy Solar tokens with the expectation that Solar’s price will rise once the service launches and solar power is traded on the network. As such, pre-launch demand is mostly investment demand.

What changes will happen after the service launches? Users who actually want to trade energy will buy Solar tokens to use the platform’s service, meaning that there will be increased usage. At the same time, investment demand from users who do not trade energy but just invest will still exist, creating an entanglement of use and investment demands on the same token.

The co-existence of these two different demands will cause significant price volatility depending on the size of the investment fund and greatly degrade user experience.

Let’s assume that 1 Solar is worth 10 KRW. If one day, investors evaluate Solar to have higher value and mass accumulate it, 1 Solar could rise to 12 KRW in a day. This means users who want to buy 1kW now has to pay 20% more than before.

The next day, investors believe that Solar has risen enough and starts selling. The price could drop from 12 KRW to 9 KRW in a day. In this case, energy sellers will be impacted since their profit from producing and selling energy has decreased 25%. Unless an energy vendor cashes in profit immediate, his revenue will inevitably be exposed to volatility. The presence of both investment and user demand will immensely aggravate user experience because of price volatility instigated by investors selling their tokens.

Even in the investor’s perspective, these two demands only add to confusion. For an investor to make a wise investment decision, he has to understand the token economy and overall mechanism of the network. ICO projects have to consider many factors in token economy design. Because the token’s price has to rise as the network grows, many mechanisms to include staking and burn & mint have to be accommodated and investors will have to use their tokens under these complicated mechanisms. An investor has to have complete understanding of these mechanisms to accurately know the impacts on token supply and demand. There are more factors that a investor has to consider in terms of investment decision and timing.

STO — Benefits to the Users : Improved Experience Due to Alleviated Price Volatility

However, the situation would be different if Deacon Solar carries out an STO. Aside from its utility token Solar, Deacon Solar would issue a security token ‘Solar Fund Token’ for fundraising purposes. Investors who see investment value in Deacon Solar would help the company’s fundraising by purchasing Solar Fund Tokens and acquire shares of the company. If they forecast a grim outlook for Deacon Solar, they would sell their Solar Fund Tokens.

All the while, the price of Solar would be more stable. Users who want to buy 1kW and small-scale energy producers who want to sell energy will always be able to buy and sell 1 Solar for 10 KRW like a stablecoin. Investors who do not really use the service will have no reason to buy Solar tokens which has flat volatility, and actual users of Deacon Solar will be able to trade energy in a stable environment. With investment demands nested in security tokens and user demand in utility tokens, user experience will greatly improve.

STO — Benefits to the Investors : Lesser Complexity in Investment Judgment Due to

Simplified Token Economy

If Deacon Solar proceeds its STO with SOlar Fund Token, investors will be able to make their investment decision easily because the token economy has become simplified thanks to the divided investment and use demands. No longer does Deacon Solar have to implement a complex token economy structure, most significantly because the utility okens are decoupled from the network’s value. Naturally, the network’s value will be coupled with Solar Fund Token, and the utility token will be designed focusing on its intrinsic purpose. There is no need to introduce staking or burn & mint mechanisms. Investors do not need to struggle trying to understand complex token economy structures and do not need to worry about price volatility due to use demand.

4. In Closing

As we have discussed, security tokens have a lot of advantages and are at the center of attention in various fields, but it is not a perfect alternative yet. There are no clear regulations on security tokens including taxation and KYC, and there is yet to be a complete technological standard for security tokens.

Although we believe in a future in which security tokens will bridge the blockchain industry and conventional finance industry, nobody can guarantee that security tokens will actually perform such role.

Decon strives to accurately identify the advantages and limitations of security tokens through continuous research and provide the best solution for our clients.

5. Summary

  • Unlike utility tokens that represent the usage right of a certain network, security tokens replace securities. Therefore, security tokens must be issued and traded under the regulation and surveillance of financial authorities.
  • The popularity that follows security tokens despite regulations stems from benefits over traditional securities, benefits in fundraising and token economy compared to ICOs.
  • Security tokens have an environment of higher liquidity than traditional securities and have enhanced efficiency thanks to their programmability.
  • In terms of fundraising, STOs have more stability and have a more hospitable environment for institutional investors compared to ICOs.
  • In the token economy aspect, the introduction of security tokens will simplify utility token structures which will greatly improve token user experience and make investment judgment easier.

Further Reading

How does tokenization work anyway
The official guide to tokenized securities
The security token thesis
Understanding the regulatory framework of security tokens
The argument for security tokens