Innovations in Identity

Security Tokens

Security Tokens — A New Model for Ownership

Security Tokens

A new model for determining and exchanging value in regards to securities is emerging in the form of security tokens. Modernizing one of the oldest financial concepts, securities, with the transparency and effectiveness of Distributed Ledger Technology (DLT) such as blockchain, promises an easier, faster, and cheaper way to transfer asset ownership.

In general, a security is a tradable financial asset. Different jurisdictions will have specific definitions of what exactly is considered a security and can include: equities, debentures, alternative debentures, government and public securities, warrants, certificates representing certain securities, units, stakeholder pension schemes, personal pension schemes, rights to or interests in investments and various other assets. Traditionally, these assets trade on exchanges or over-the-counter (OTC).

Tokens, in the context of DLTs, refer to an internal currency to purchase products or services within that DLT application. For example, Ether is a token for operating the distributed application platform Ethereum to compensate people contributing resources. The numerous ICOs launched in the last 12 months were generally token offerings.

However, there has been a lot of confusion about categorizing various types of token offerings. As each project has a different use and financial structure, the determination if a token is a utility or a security is not clear-cut. The ramifications are significant, as security (or asset) tokens must comply with security laws, while utility tokens don’t.

While this has put a question mark over the legality of ICOs, as many position themselves as utility tokens, it also opens an opportunity for security tokens, as they are securities by definition. The regulations governing security tokens are clear and well established, so by following existing security laws, a tokenized security is a fully compliant offering.

Security Tokens

A security token represents ownership of the asset, similar to how a share (or other security) represents ownership of a company. So why issue security tokens instead of shares? The first critical factor is that they do inherit a wealth of legal precedents that provide legal clarity and protection, and thus less likely to suffer significant business interruptions from SEC enforcement actions and private litigations arising from unregistered securities offerings.

Cost

For a Company, going Public is an expensive endeavor. There are massive costs for lawyers and accountants to ensure the paperwork is in order. Then there are promotional and investor relations costs. On top of that, there are banking fees associated with getting an underwriter to support your offering.

While launching a legally compliant ICO for a security token faces many of the same requirements, a main advantage of DLT model is a reduction in the need for middlemen. Smart contracts can replace certain lawyer fees. Transparent transactions can replace certain auditing and accounting fees. As the scope and venue of the offering is different, banker fees are also cut.

As all the transactions are, by their nature, digital throughout the offering lifecycle, simplified transaction recording, tracking and management leads to more cost savings.

Speed

Quicker and smoother transactions make the process better for all parties. Trade settlement happens in minutes, not days. Offerings are less at the mercy of slow-moving banks or other middleman. Trades are possible 24/7, not limited to market hours.

Market access

As ICOs use the internet for distribution, it’s easier for them to reach a global market (within regulatory rules). A larger potential pool of investors is available, which can help the amount of funds raised and improve liquidity.

Programmable equities

As opposed to a static share, a security token is potentially enshrined with smart contract capabilities. The potential for automatic dividend payouts, or execution of some clause or benefit, being built into the token ownership opens the door for new value opportunities.

Security Regulations

While a security token has a path to full legal compliance, it still must follow the existing standards and have the proper exemptions, paperwork and filings in place. Restrictions of who can invest and secondary trading still exist and any offering needs to pay careful attention to ensure all the documentation, procedures and ongoing reporting is accurate and up-to-date.

While relying on existing regulations does offer clarity for security tokens, the full potential of these new types of offerings will require new rulings or regulations. After all, many security regulations came date back decades ago, so well before any idea of DLT and these new opportunities.

Tokenization

Already, with the advantages of security token mechanics, there’s significant interest from issuers and investors; according to Polymath Co-Founder and CEO over 20,000 issuers have signed with their security token service.

The big picture opportunity though, is tokenization. Any asset is potentially tokenized and the value tradable, from real estate to equities, artwork to commodities. As contributor John Koetsier states in a Forbes article, “a new way of recognizing, managing, and trading the massive value implicit in both public companies and private companies.” Or, as Vonage Founder Jeff Pulver states, a $4 quadrillion opportunity.

Leading crypto blogger Jeremy Epstein states, “the tokenization of assets may allow us to measure the creation, transfer, and destruction at previously unimaginable levels, which could unleash entire new ways to create value.” One house, or piece of art, could be sold to a syndicate of online investors, who could manage the investment on a distributed ledger. Investments could be atomized and bundled in a myriad of packages, all governed with smart contracts or new DLT governance systems.

Of course, that future is speculation at this point, as there have only been a few actual security tokens released. However, with promises of greater transparency, liquidity, tokenization and programmability, the future of security tokens looks promising indeed.

The information in this blog is intended for public discussion and educational purposes only. It does not constitute legal advice.

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