What are Security Tokens?

Security tokens are crypto tokens issued to investors in a token sale or ICO for the exchange of their money. Crypto tokens that pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders are deemed as "security tokens".

Such tokens have to abide by certain regulations and should be compliant with SEC (and similar organizations) prior to their ICO or token sale to be able to conduct in such affairs.

But lately, due to the euphoria of blockchain and ICOs, many start-ups and founders have become ignorant of this fact and have launched "security tokens" without the knowledge of the regulators. That is what has led the governments to crack down on such unregulated ICOs or token sales in order to protect the investors. If you are a "security token", you need to abide by the rules of the regulatory organization.

Here’s the definition right from the Securities Act of 1933

Benefits of Security Tokens

  • Digital tokens can be traded 24 hours a day, 7 days a week and 365 days in a year. The market is also truly global and you can trade your tokenized share of ownership with anyone around the world.
  • Ownership records are changed immediately on the blockchain. 
  • Because the market is so large and expansive, it opens up many funding opportunities for those companies that are raising financing. They merely need to tokenize their shares and then make their pitch to the global community.
  • There is no need for various middlemen and lawyers that invariably inflate the costs.
  • Security tokens will allow the average individual to partake even if it is only with small levels of investment. 
  • Security tokens have the benefit of being regulated. Given that they are by definition securities, It means that the SEC (or other accountable institutions) will have jurisdiction over them. This means that they are much more reliable than all of the current ICO offerings that are selling unregistered securities.

How do we actually distinguish security and utility tokens?

A security token is an asset that has been securitized and then tokenized. In other words, security tokens are immutable digital records of ownership to some underlying asset. They are different from their utility token counterparts in that they are not developed to be used in an ecosystem. They are developed for investment purposes so that the holder can partake in the future fortunes of an underlying asset.

With a specific end goal to decide if a digital token is a security, we can apply the Howey Test. This is used to confirm regardless of whether or not a transaction qualifies as an "investment contract". If it meets the criteria, at that point it will be considered as a security and will be subject to additional disclosure and regulation requirements.

To be named an investment contract under the Howey Test, a token must meet the following prerequisites:

  • There is an investment of money.
  • The user expects to profit from the investment.
  • The investment of money is in a common enterprise.
  • Any profit comes from the efforts of a third party or a promoter.