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Security Tokens can be the next big “talk-of-the-town” of the blockchain revolution. Articles about this have started to spread, but for those who are new to the crypto universe (and to the financial world in general), understanding it might be tricky.
Before we explore what security tokens are, it is crucial to understand securities first.
What are Securities in the financial world?
A security, in a financial context, is a certificate or other financial instrument that has monetary value. It can be traded through a medium between exchanges or peer-to-peer. Securities are classified as either equity (e.g. stocks) or debt securities (e.g. bonds and debentures). And if we take the example of stocks, you might understand that it’s owning a part in a company without taking actual possession of it.
Companies and governments use this method to raise money from capital markets from various investors. And then these investors are promised a return back program in the form of dividends or interest rates or share of company’s profit in some form or other.
What are Utility Tokens? How they differ?
Before we explain how they differ, let’s discuss what utility token is and its purpose.
The SEC and FINMA have broken down tokens into two broad categories:
- Utility Tokens
- Security Tokens
Utility Tokens
Since most ICOs are investment opportunities in the company itself, some of these tokens qualify as securities. However, if it doesn’t qualify according to the Howey test, then it classifies as utility tokens. These tokens simply provide users with a product as well as service. Think of them as a gateway or App tokens.
As Jeremy Epstein, the CEO of Never Stop Marketing, explains, Utility tokens can:
- Give holders a right to use the network
- Give holders a right to exploit the network by voting
- Since there is an upper cap on the maximum token availability, the token value may go up because of the supply-demand equation.
Security Tokens
In simpler terms, security tokens are cryptographic tokens that pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders. This takes care of the liquidity issues.
A crypto token that passes the Howey Test is deemed as a security token. These usually derive their value from an external, tradable asset. Because the tokens are deemed a security, they are subject to federal securities and regulations. If the ICO doesn’t follow the regulations, then penalties will apply.
However, if all the regulations were properly met, then these tokens have immensely powerful use-cases. If partnered by agencies like Crowdcreate that can help them in crowdfunding, marketing and contacting with some of the most influential people in the cryptosphere, STOs will surely be the topic of the day.
While for ICOs, the way it usually works is tokens or coins are offered by companies for purchase as a form of crowdfunding, however with Security Token Offerings (STOs) it’s an upgrade whereby tokens can be bought which then you can trade, sell, or hold. However, since security tokens are actual financial securities, your tokens are backed by something tangible like the assets, profits, or revenue of the company.
In the latter half of 2018 and in 2019 we are therefore going to see a huge rise in STOs, and they may eventually out-duel ICOs. The reason is that it offers more security for potential investors and thereby less chance of fraud.
What is a Security Token Offering?
In practice, selling security token is comparable to ICOs, though the process is instead termed a Security Token Offering (STO). Much like an initial coin offering, STOs issue coins to investors. However, similarities usually end there. In an ICO, investors are purchasing tokens to benefit from the possibility of token appreciation or to unlock the ecosystem’s utility. By comparison, STO investors are investing with the expectation of receiving future cash flows, dividends, or voting rights directly tied to the security.
Security tokens are backed by assets, profits, or cash flows, and thus have an intrinsic value from the moment they are issued unlike utility tokens, where the value is largely theoretical until an application is developed. Additionally, STOs are fully compliant with regulatory frameworks, allowing investors from all over the world to participate without violating respective securities laws. This is especially true in countries like the US, which exhibit stricter oversight of securities and investments.
Another key aspect of STOs is that they allow companies to create whitelists and blacklists, a factor that easier to comply with know-your-customer (KYC) and anti-money-laundering (AML) reporting requirements. By operating more transparently, STOs can effectively negate some of the bigger issues facing utility token offerings — a lack of corporate accountability, the possibility of fraud, and no recourse in the event of a company failure.
In a sense, many STOs will look more like IPOs than ICOs. Instead of a “wild west” approach to fundraising, whereby companies are simply aiming to raise as much capital without any concern for the source of funds, STOs are subjected to strict regulations. However, this clears the way for institutional participation, a factor that may represent a potential tidal wave of capital destined for blockchain-based services.
What’s the Difference between an STO and an ICO?
The most important question would be “What makes a token a security”. In the United States, the main focus would be the purpose of the investment. The centennial case that addressed this issue is Securities and Exchange Commission v. Howey Co., 328 U.S. 293 (1946). The test addresses four issues:
{a} whether the investment involves money or assets;
{b} whether the investment of money or assets are in a common enterprise;
{c} whether there is an expectation of profits from the investment, and
{d} whether any profit arises from the efforts of a promoter or third party.
Instances where the answer is yes to the above four questions, then the token sale is likely subject to the U.S. securities laws.
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What’s a Security Token Offering? And How Do You Market it? was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.
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