Security tokens seem to be establishing themselves as a new and promising wave of funding in the blockchain technology industry, but what are they exactly? Is funding the only benefit they offer? How are they different from utility tokens? Such questions are relevant now more than ever as the emergence of tokenised securities could represent a paradigm shift in finance.

Security tokens have the potential to fundamentally change the way that equity, bonds, futures, stocks and more are traded.

The security token ecosystem is growing at an accelerating pace. Each week, new tokenised securities and security token exchanges debut. Traditional exchanges such as Gibraltar Stock Exchange, New York Stock Exchange and Switzerland Stock Exchange have all announced plans to integrate tech and compliance measures that facilitate the trade of security tokens. Countless startups, corporations, companies and funds are unveiling plans to tokenise securities and enable their exchange in secondary markets. As so much news saturates the space, the terms being coined for coins can become confusing. Puns aside, this article aims to debunk security tokens, distinguish them from utility tokens, and discuss the implications for financial markets.

Utility Tokens vs. Security Tokens

Utility tokens are distinct from security tokens, while the latter encompasses a variety of underlying assets, one such being equity tokens. Security tokens change the game because they provide companies an efficient way to raise capital while offering investor protections and ownership of the underlying asset which utility tokens do not. Here are some of the defining features of utility tokens and security tokens:

Utility Tokens

Utility tokens provide investors with utilitarian functions in a company. Also called app coins or user tokens, utility tokens are given to investors in exchange for the capital they contribute in an Initial Coin Offering (ICO). In return, investors have access to a future service or product promised by the respective company. Of course, there is also a big range of secondary markets to trade utility tokens, where investors hope to make speculative gains on price fluctuations. Since the tokens are not designed as investments, the tokens and agreement are exempt from securities regulations. Hence many “companies” launching utility tokens in “ICOs” have been caught mired in scams, often taking investors’ funds and disappearing without providing any return. The very nature of security tokens would make the same scenario impossible.

In summary, utility tokens:

… enable companies to fundraise capital in an ICO.

… are quasi-vouchers that provide access to a product or service.

… do not possess an inherent value outside of a company’s product or service.

… can be traded on secondary markets.

Security Tokens

Security tokens are digitised financial instruments attached to underlying assets of monetary value. They tokenise traditional financial instruments as well as tangible assets, and this latter point could make security tokens irresistible to the financial markets. The tokenisation of tangible assets has the power to make traditionally illiquid assets liquid, freeing trillions worth of assets formerly inaccessible in the secondary markets. Before tokenisation, a tangible asset could not be divided into multiple shares. Now, real estate and fine art can be split — allowing fractional ownership. The blockchain technology on which security tokens are built use smart contracts to self-regulate and ensure that they qualify securities laws as well as contractual arrangements between the provider and investor. This aspect makes security tokens precedentially safe: guaranteeing the provision of investor rights. It serves as an exceptional use case for an asset like equity.

In summary, security tokens:

… are digitised financial investments with an inherent underlying value.

… tokenise an underlying asset such as equity, bonds, stocks or real estate.

… guarantee ownership rights to their underlying asset.

… facilitate investments and fundraising, by easing the access to regulated funding.

… provide better liquidity of securities through fractional ownership and tradability in secondary markets.

Equity Tokens

The terms security tokens and equity tokens tend to be used interchangeably, though equity tokens are a subset of security tokens. As the name suggests, equity tokens tokenise equity and represent the ownership of shares in a company. They use smart contracts to embed and automate the execution of shareholder rights — whether dividend payouts, voting rights, liquidation preferences — anything the token is programmed to do, it will do. A company wishing to offer equity tokens would do so in an Equity Token Offering (ETO). ETOs are available to both retail and institutional investors and offer liquidity of the shares in secondary markets, making them more accessible than equity in the traditional financial markets. ETOs are fully regulated and abide by laws under the jurisdiction in which they are issued, ensuring investor rights.

Many speculate when Wall Street will incorporate blockchain technology and cryptocurrency and how it will alter the traditional finance market.

The Future of Finance

Security tokens have caused the financial markets to evaluate ‘business as usual’ since they have proven to be innovative and distinct from utility tokens. Furthermore, the advantages of security tokens have set them ahead of traditional securities, as businesses can use them to cut costly and lengthy processes of traditional fundraising. Tokenised securities are becoming the perfect use case for blockchain technology in traditional finance because they:

… reduce the need for intermediaries like notaries thereby reducing costs.

… automate the execution of contracts reducing lengthy processing times and making it secure,

… provide companies easier and broader access to investors and can provide investors with easier access to investments.

… lower the risk of manipulation making them more trustworthy.

… provide greater liquidity through easy access to secondary markets and fractional ownership.

The World Economic Forum projects that $8 trillion worth of securities will undergo tokenisation in the next 10 years and that 10% of the worlds GDP will be tokenised in the coming 20 years. Buyers and sellers around the world would be able to trade tokenised securities 24/7/365 with a nearly instant settlement and zero counterparty risk, something that only blockchain technology enables. Finally, fractional ownership opens investments to any affordability level — retail investors, who have historically been excluded, can now access assets traditionally reserved for accredited investors and venture capital firms. Will security tokens dismantle the notion that only the rich get richer?

Blockstate is launching its ETO in early November 2018 as one of the first companies worldwide. Access to the investor whitelist for the pre-sale is open. To save your seat on the whitelist, leave your email address at www.blockstate.com or reach out to eto@blockstate.com.