Security tokens can help democratise access to otherwise elite securities, enable peer-to-peer transactions, and offer greater programmability and transparency than conventional securities.
In financial terms, a ‘security’ is any financial instrument that holds value and can be traded. It is heavily scrutinised and regulated and subject to laws that vary from jurisdiction to jurisdiction.
But what are security tokens?
Security tokens are digital representations of these very financial securities on a blockchain as tokens. Security tokens are considered one of the major reasons cryptocurrencies are gaining acceptance worldwide.
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In crypto, security tokens are much more varied than mere digital securities representations. Security tokens can mean any physical asset-backed token or even digital assets represented on a blockchain.
But then, what are security tokens in crypto, and what’s their importance in blockchain and Web3? Let’s find out.
In simple terms, a security token is the representation of a digital or physical asset as a token over a blockchain. This representation can denote ownership or other rights to the asset. Digital securities can be issued by governments, companies, or businesses.
Security tokens serve the same purpose as the assets they represent. When digitally represented as tokens, stocks, bonds, options, etc., can be considered blockchain-based securities or tokenised assets.
Japan is one of the most active jurisdictions dealing with digital securities issuance, i.e., representing securities as tokens on-chain. Daiwa Securities, Japan’s second-largest broker, has issued $153 billion worth of asset-backed security tokens on consortium-based blockchains to date and is moving towards public blockchains.
Read more on consortium blockchains in this NFT.EU article on permissioned blockchains.
Societe Generale, Santander, the European Investment Bank, Siemens, and ABN Amro have all issued security tokens on public blockchains like Ethereum.
Are tokenised assets security tokens, too?
Sometimes, the security token definition can be broad enough to include tokenised assets over a blockchain. These tokenised assets can be real-world assets, such as real estate, art, and other rare collectibles, etc.
But to be more precise, security tokens are part of the broad spectrum of assets that can benefit from asset tokenisation. In this case, securities are assets that are getting tokenised, aka issued as tokens over a blockchain. Tokenisation has been one of the biggest crypto narratives in 2024 and BlackRock CEO Larry Fink’s favourite.
Coming back to security tokens in the strictest sense: Security tokens can help democratise access to otherwise elite securities, enable peer-to-peer transactions, and bring greater programmability, efficiency, and transparency compared to conventional securities. Security tokens can also find many use cases in decentralised finance or DeFi.
The event of issuing securities as tokens over a blockchain is called a security token offering or STO. We will discuss this in detail in another section.
Cryptocurrencies aren’t just one kind. While security tokens have been behind the adoption wave, utility tokens are the most popular. Governance tokens also form part of the token classification.
Utility tokens are specifically designed to serve the economy of a particular blockchain ecosystem. Let’s understand this with the help of an example.
Ether (ETH) is the utility token of the Ethereum ecosystem based on the ERC-20 token standard.
Learn more about the ERC-20 token standard and wallet in this article by NFT.EU.
If users want to transact using the Ethereum network, they need to pay gas fees (transaction fees) in Ethereum. Similarly, if someone wants to become a validator on the Ethereum network, they need to stake 32 Ethereum to become eligible for the block validation process.
Reciprocally, the validators receive validator rewards in ether for contributing to the network's security. Ether cannot be used on the Bitcoin network to pay gas fees or any other fees. In other words, it is not compatible with any other blockchain technology.
On the other hand, security tokens aren’t native to a blockchain platform. Instead, they are digital representations of securities or other physical assets. They cannot be used to pay transaction fees or platform fees. Security token holders can earn yields on their holdings, but utility tokens have no yields.
Security tokens represent a stake in a company or ownership of an asset, but there’s no stake available for utility tokens.
Security tokens are bound by regulatory compliance, while utility tokens are not. Utility tokens are also used to raise funds through Initial Coin Offerings (ICOs), while security tokens are used to raise capital via security token offerings (STOs). However, STOs are a safer means of crypto fundraising.
Some examples of utility tokens include Bitcoin (BTC), Tron (TRX), Binance (BNB), and Toncoin (TON). Some examples of security tokens are Polymath, tZero, Harbor, and Securitize.
Let’s understand how security tokens work with the help of an example.
Suppose a company wants to tokenise its equity capital. First, it needs to choose a blockchain platform for its security offerings.
Shares can then be minted as tokens over a blockchain. Each equity token has an underlying smart contract that stores all the necessary information related to the token, including the identification number, company name, rate of yield, terms and conditions, owner’s name, if any, value of the share, etc.
This information is cryptographically stored on the blockchain. The token can now be easily purchased and sold in the open market securely, as no sensitive information is available for public viewing.
The token’s unique identification number is enough to verify its authenticity and trace its ownership, the number of times it changed hands, and the yields derived from that one token.
Due to the presence of smart contracts, yield disbursal happens automatically as soon as the holders become eligible for the gains. There are no brokers or intermediaries involved, which not only quickens the process but also removes any leakages from the supply chain.
Freshly issued tokens from a token issuance event are mostly sold in STOs and ICOs, depending on their characteristics. There’s a vesting period involved in STOs, where the holders need to hold the tokens for a minimum period before selling them in the market. This precaution is necessary for investor protection. STOs are heavily regulated by the governing laws of the underlying asset, in this case, securities.
Since the underlying tech is blockchain technology, all the transactions concerning the tokens since their birth are recorded chronologically and immutably, leaving little to no room for manipulation.
As discussed earlier, a security token offering (STO) is the process of capital fundraising involving the sale of security tokens. An STO is bound by strict securities regulations and protective measures for the safekeeping of investor funds by financial authorities and governments.
In short, STOs provide the same security and investor protection as traditional securities like stocks and bonds.
STOs are more secure and safer than ICOs if you are seeking blockchain investment. There are two reasons STOs provide a more secure way of blockchain fundraising:
The token issuance or token sale platforms list STOs after thoroughly vetting the project.
Secondly, all security tokens have underlying smart contracts, making it hard to manipulate any terms after or at the time of token launch or conditions preset while being coded. Smart contract security makes tokens better protected over any utility tokens having an ICO.
ICOs have earned a bad reputation for being fraudulent and risky. During the 2017 ICO craze, thousands of projects launched tokens and private token sales without prior checks or vetting processes. As such, investors lost millions of dollars to useless scams and fraudulent projects.
STOs can serve many purposes, including the development of a new product or adding to the working capital for business expansion. STOs are based on blockchain technology. Therefore, unlike traditional public offerings, STOs are more transparent, faster, and accessible.
22x is a tokenised venture capital fund that raised $22 million in 2018 through an STO. Similarly, tZERO, another security token platform, gathered $134 million for an STO conducted in 2018.
The idea behind security tokens isn’t unique. Earlier, companies issued paper stock certificates, which were securitised tokens representing ownership. Today, security tokens carry that significance, but in a better and more advantageous fashion.
Security tokens also represent ownership of an asset, except that they are digital and live on a blockchain network. In financial terms, security tokens fall under the ambit of securities, as per the Howey Test. As such, security tokens remain one of the foremost tokens that must face regulatory scrutiny before they reach buyers.
Security tokens have been a major factor in driving institutional interest in crypto. By investing in security tokens, institutions and big firms can be exposed to blockchain technology without investing in unregulated tokens.
Reciprocally, crypto gained much validation owing to the interest of big firms like BlackRock and government bodies dealing in tokenised treasury bonds and other security interests. Experts predict the tokenised sector to be a $16 trillion opportunity by 2030.
Let’s discuss a few advantages that come with security tokens:
Security tokens benefit the owners by fusing native blockchain capabilities with the virtues of digital security tokens. Security tokens benefit from smart contract security, which makes them highly secure. The tokens can be exchanged, bought, and sold easily without the fear of disclosing sensitive information.
Blockchain-based tokens also benefit from secure blockchain transactions over a distributed ledger. There’s no central party or middleman interfering in the process, which helps bring operational, time, and cost efficiencies.
Unlike utility tokens, security tokens aren’t legal or compatible with a single platform or blockchain. They can be based on any blockchain but are heavily regulated and governed by laws governing the underlying security, i.e., the asset, share, or security that has been tokenised over a blockchain. These tokens help to make securities.
Security tokens can be traded 24/7 across borders without any sanctions from governments or other authorities. They can be traded in open markets. As retail investments start driving the security token market, the wave of adoption will make the markets more fluid and moving, making it easier for investors to cash in on profits.
FYI, security tokens are not available to retail investors in the US. However, recently, cryptocurrency investment firm Midas started offering security tokens to retail investors in Europe.
The fractionalisation of assets is a big advantage that comes with tokenised assets and security tokens. Usually, real estate, jewellery, art, collectibles, etc., are only available to accredited or a closed group of elite investors. The entry barriers come in the form of high investment.
Assets like real estate, art, etc., can be given a value (verified by a third-party auditor). This value can then be broken down into fractions of equal worth and tokenised over a blockchain. That way, small investors can also invest in the related sector without spending a fortune. Fractionalised assets, therefore, help to open up new avenues of investment or crowdfunding for businesses.
While security tokens have global acceptance, given their inherent law-abiding nature, they remain an investment option for a close-knit group of investors and institutions. As regulatory clarity trickles in the crypto sector, we will soon witness a mass adoption movement at the retail and small-scale levels.
Another hurdle that security tokens or tokenised assets face is moving the physical asset representation on-chain. Every asset change, ownership transfer, buying, and selling needs to be reflected in real-time on a blockchain. Custody and special purpose vehicles (SPV) are currently used to move assets on-chain, but we need a more direct method.
Nevertheless, government authorities recognise security tokens' clear advantage over their traditional counterparts and intend to move more assets on-chain. Larry Fink’s remark that every asset would be tokenised in the future comes from the same realisation.
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Security tokens are a form of cryptocurrency backed by real-world assets like securities and based on a blockchain. They combine the merits of traditional investments and cryptocurrencies, proving a safer route for investors to invest in crypto.
Therefore, STOs are more popular and safer than ICOs today as they are highly regulated and vetted events. Take time to understand how STOs work and inform yourselves about the brightest investment opportunities that await the retail sector today.
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