Security Tokens 101: Definitions, Examples, and How to Invest

Man holding a golden bitcoin coin.

A lot of what you’ve read about security tokens is wrong.

As an emerging market, investors should expect blockchain to more or less redefine itself every year. In 2017, this led to the dominance of the ICO and ecosystem business model. In 2018, the spotlight moved on to security tokens. They have largely replaced the utility token as the core business model for emerging blockchain firms, so much so that many investors question if the utility token even exists anymore (or ever did).

To understand blockchain in 2019 will mean understanding the security token – what it is, how it works and where it will take the industry.

Here are some answers.

What Is A Security Token?

To understand security tokens, you first have to understand that there are two main ways that people use a blockchain project.

  • Cryptocurrency – Completely platform-independent. The blockchain is used as a neutral store of value that people trade among themselves.
  • Tokens – Platform-dependent. People use the blockchain asset to use the native ecosystem, and the token takes its value from that access.

A few projects like Ethereum blur the lines, but most fall squarely in the category of either crypocurrency or token.

When companies launched the ICO as a business model, they were taking advantage of the value that a token gets from its native ecosystem. The goal of an ICO is to release a defined number of tokens and then, hopefully, watch their value rise based on the strength and popularity of the underlying platform. That rising value allows trading and investment, which both enriches the firm at its initial offering and allows it to steadily sell off future assets for operational cash.

It’s this investment mechanism, an almost carbon-copy of the IPO model, that caught the attention of regulators.

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Security Tokens Are A Legal Class, Not A Technical One

Over 2018, the Securities and Exchange Commission intervened in the blockchain market and made clear that it will begin regulating tokens as securities. This has led to many people discussing security tokens and tokenized securities as a distinct, technical class of assets.

Yet security tokens are a legal concept, not a technical one. A security token is any blockchain asset that meets the SEC’s standards for a securitized asset. The underlying intent or technology doesn’t matter.

In fact, this is what the SEC spent all of 2018 trying to make clear to the market.

Most Tokens In Circulation Already Are Security Tokens

As the SEC Chairman Jay Clayton explained during his testimony to Congress, virtually every token released as part of an ICO is a security token. That the companies called them “utility tokens” doesn’t matter. They meet the SEC’s test for a regulated securities product, so they are no different (legally) than flooding the market with shares of stock.

In Other Words, Every ICO Token On The Market Is Already A Security Token

At least, every token the SEC has seen, is aware of, or anticipates seeing.

The SEC has always had a loose, evolving definition of securitization, in a sense borrowing the Supreme Court’s attitude toward pornography. (“I shall not attempt to further define [it]… but I know it when I see it.”) There are cases where an asset is clearly securitized, such as a share of stock. There are cases where an asset is clearly not securitized such as a loaf of bread. These are called commodities.

Then there’s the great big grey area in between. The Securities Exchange Act of 1934 lists several examples of securities in action, but the clearest definition comes from the case SEC vs. Howey.  An asset counts as a security if it involves:

  • Consumer investment,
  • In a common enterprise,
  • With the expectation of profit derived primarily from the work of others.

To put it in layman’s terms, a security is an investment in someone else’s effort. This is why a share of stock is a security, because you put money in and make a profit off the company’s hard work. As a result, many writers have covered security tokens as specifically and only the equivalent to digital stock certificates.

This is not true.

The SEC has made it clear that tokens don’t have to confer ownership in anything to meet the Howey Test. All that matters is that investors buy the tokens expecting to then profit off of the performance of the underlying company. Ownership is optional.

Every Investment Token With An Underlying Company Is Probably A Security Token

This is why the SEC views most, if not all, tokens as securities products. They meet all three elements of this test.

  • First, it is a product open for consumer investment. The company will take your money in exchange for the tokens.
  • Second, it is a “common enterprise.” This means that your success as an investor depends on the “efforts and success” of the company which sold you the token.
  • Finally, your profits will come entirely from the work of the company selling you this token. The token won’t gain value through pure market action (like a brick of gold) or through your efforts (like improving a house). Its resale value will depend on the success of the company.

The truth is, every blockchain company already knows this. The ICO business model is based on attracting investors who pay good money in the hopes that they can sell this token for a profit.

They have invested money in the company and its platform. That’s a securities transaction.

Dedicated Security Token Releases Mean Either Technical Dedication or Legal Compliance

Over 2018, more and more firms announced their dedicated security tokens or dedicated platforms. In quarter three alone, according to ICO Rating, 6.54 percent of all blockchain projects at the fundraising stage were dedicated “security tokens.” Another 25.3 percent were utility tokens, and 12.47 were hybrid tokens.

In reality, this means that about a third of these startups were security tokens. The small percent that label themselves security tokens are projects that have some dedicated design that contemplates securities regulation. They have taken the legal and technical steps necessary to bring their project into compliance with the SEC.

Yet Security Tokens Can Also Represent Ownership

Yet when many in the blockchain marketplace discuss security tokens, they are referring to something else entirely.

This is because security token has a dual meaning. It can also refer to:

a digital contract that denotes a share of ownership in some asset of value. Holding the token would give you the right to some percent of a house, for example, or equity in a business. In many senses, a security token is the digital equivalent of a stock certificate, updated and secured for the 21st century.

In this regard the marketplace is currently confusing.

Many blockchain projects use the term “security token” interchangeably to mean a digital asset that “indicate[s] full or partial ownership of an [underlying] asset.” The development team has built their token specifically to store ownership data and often around a digital contract for its transaction; many of these projects use Ethereum for this purpose.

Through this form of security token, you can own something either in whole or in part, and the blockchain is built to record and preserve the value of that ownership. Several companies have developed competing formats for ownership-based security tokens such as Polymath’s ST-20, Harbor’s R-Token and even Bitcoin Market Journal’s own technical package.

The important thing to remember is that while this is the increasingly common use of the term “security token,” it is not the only one. When regulators call something a security token, they mean any securitized blockchain asset. Ownership of an underlying and/or tangible asset is not necessary for securitization.

If You Hold Tokens, You Probably Already Trade Securities

Make no mistake , if you have traded ICO-based tokens, you should comply with securities regulations. Whether they represent one dot in a Seurat or not, those tokens are probably investment products.

  • Trading Securities

As a consumer and investor you will notice few regulations around buying and selling security tokens. However your platforms for doing so will likely soon change.

Any exchange which allows securities trading must obey certain rules regarding registration and financial holding. As the SEC continues its review of the blockchain space, it will likely begin to enforce these rules on cryptocurrency exchanges.

  • Holding Securities

The chief difference between holding a security and a commodity is in taxation. Your profits and losses from trading security tokens will likely be taxed as investment income and you should approach them as such. Be certain to consult an accountant as to how you should reflect this on your tax returns.

Hourglass on a beach with the gold bitcoin coin.

Security Tokens vs. Utility Tokens – Are Utility Tokens Even Real?

The SEC has always questioned the legitimacy of utility tokens.

Consider utility tokens like buying those small coins at the arcade. They let you play the game, only work within that arcade, and don’t have any meaningful resale value in the outside world. They are platform-dedicated tokens, which is the utility token in a nutshell. It gives access to the services an ecosystem provides. The token’s value is (or should be) entirely based on the value of those services.

The trouble with this business model is that it is not entirely useful. A pure utility token, one that isn’t an investment product but which only gives access to the platform, is little more than a coupon. There’s rarely a reason why consumers couldn’t simply purchase access directly.

Instead the value of a utility token is external resale. By letting investors and platform participants sell the token on an open market, the platform can drive up its value, the profits of its users, and the profits of its investors. For utility token platforms, the ability to sell tokens at a profit is the entire point of the business model.

Unfortunately, that third-party market is also what transforms a utility token into a securitized asset.

Regulators have kept open the possibility of a non-securitized utility token, with William Hinman, the head of Corporation Finance, saying that the agency “certainly can imagine a token where the holder is buying it for its utility and not as an investment.” Yet the SEC has not yet seen an ICO release that it considers a commodity. The utility token is hypothetical, and that’s about it for now.

Security Tokens vs. Equity Tokens – When Does A Security Become Equity?

Equity tokens are a class of security token. The defining characteristic of an equity token is that it confers a share of ownership in the underlying company.

As we discuss in more detail here, equity tokens are functionally the same as shares of stock. Each represents a percentage of ownership in the company that sold it. The underlying company will typically issue dividends to holders. This, along with the value of the company itself, drives the token’s price.

This ownership stake defines an equity token but, like we mentioned earlier, it is not necessary for a security token. These are simply a subset of a greater class.

Security Tokens vs. Cryptocurrency – Why Are Cryptos Not Securities?

Chairman of the SEC Jay Clayton has clearly said that bitcoin, Ethereum, and other cryptocurrencies are not securities. They are commodities, the same as ordinary currency trading.

There are two chief reasons for this.

The first is the asset’s purpose. Cryptocurrency is released as a medium of exchange and, even though many investors trade currencies like bitcoin for a profit, this is still the main purpose. Per Clayton, when a product functions “as a replacement for currency, that has been determined by most people not to be a security.”

The second, as Hinman has made clear, is the decentralized nature of cryptocurrency projects. These assets don’t represent the work of a coherent, for-profit project such as a company. Instead, their decentralization makes them far more like pure market-driven commodities.

Essentially, the SEC does not consider money to be a securitized asset, and it thinks that cryptocurrency is close enough to traditional money to avoid regulation.

Criticisms of Security Tokens

Investors and developers have two main criticisms of security tokens.

The first is that this will slow down the development of blockchain. One of the main reasons that the ICO business model proved so successful in 2017 was its agility. Developers could raise money within weeks, sometimes even days, of formally announcing their project. There was little or no friction between potential investors and new blockchain businesses.

Securities law will change that. Complying with the SEC’s multi-step regulatory process will make launching a new token both more expensive and relatively time-intensive. Putting hurdles in between entrepreneurs and their money will only stymie this burgeoning industry.

The second criticism is that blockchain is too international to effectively regulate.

Critics of security tokens argue that this will hurt Americans by forcing them to comply with lengthy processes. In response, companies and investors will simply move their development elsewhere. Businesses will flourish outside of the United States and this country will be all the poorer for it. The international nature of blockchain development means that this industry moves too quickly and easily to effectively regulate in just one jurisdiction.

Top Tokens and How To Invest

Security tokens are poised to dominate blockchain in 2019. Certainly, they will be a critical story for investors. If you’re looking to start exploring this space, here are three assets you might consider. In terms of sales, brand or both, these are all heavy-hitters:

Polymath

This token platform has released its own token, the POLY, and helps companies develop their own tokens. Polymath specializes in security tokens and has begun making a name for itself as a go-to shop for firms that want to enter this space.

Swarm 

At time of writing, Swarm’s token, the Swarm, does not have the strongest price, trading at only USD $0.15. However its market cap is still north of USD $10 million, and this infrastructure development firm has caught a lot of buzz. Check it out.

Blockchain Capital 

One of the first firms that issued a public offering for a formally securitized token, Blockchain Capital is a tokenized venture capital firm. Their token, the BCAP, has done quite well, with a market cap of almost USD $27 million at time of writing.

Investing in security tokens will be a moving target in 2019, however.

At the moment, you will find these assets, and many more just like them, listed on standard cryptocurrency exchanges. The trading floors of the crypto world have not yet shifted, but you should expect that to change.

As the SEC cracks down on unregulated securities in the blockchain space, it will eventually get to the exchanges. An exchange which handles securities must be regulated, which is why projects like t.Zero and Equitybase have launched, among others. They promise to specialize in legally compliant trading.

Soon, that’s going to be a very big deal.

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