2019 will be the year of the Security Token Offering (STO), learn about how it emerged, the token model, and more.

A Brief Overview

In 2017, the hype around token economics and ICO skyrocketed and was followed by numerous scams and controversies, which have made a big concern in the cryptocurrency industry.

Since the industry was in the grey area of law during this time, efforts were made to ensure the prospective projects comply with the regulation which was soon to take place.

During October 2017, The SAFT (Simple Agreement for Future Token Proposal) was introduced. The SAFT was created to provide a method for new cryptocurrency ventures to raise money without breaking financial regulations.

SAFT is a security, specifically an investment contract to fund a cryptocurrency project for receiving utility token in the future when the network is functional.

Ventures issue the SAFT to investors. The SAFT is bought to fund developers. Once the network launches, utility tokens will be distributed to the SAFT investors. (ex. Basecoin and Orchid Labs)

Coming into 2018, many countries began to regulate ICOs or even ban to protect their investors. During the regulatory process, ICO tokens were defined into two subcategories by SEC and FINMA:

Utility Token

A utility token is used as a mean to access services or assets. The purchase of a utility token is like purchasing the rights to use a software or a product. Utility tokens are not created to be an investment. (ex. Filecoin, Basic Attention Token)

Security Token

A security token is a token which derives their value from an external, tradable asset such as equity, debt, financial derivatives, etc. A security token must pass the Howdy Test:

In order for transactions to be qualified as “security”,

1. There must be an investment of money.

2. The investment of money is in a common enterprise.

3. There is an expectation of profits from the investment

4. Any profit comes from the efforts of others (a third-party or promoter).

Security token holders own the shared ownership of derived assets in form of a digitalized token and this typically entitles them to that fraction of the token issuer’s earnings, proceeds from the liquidation of assets, or even voting power. This means that investors must go through KYC/AML process and satisfy the regulatory requirement in their country of origin.

Security Token Models

Security token = Security + Benefits of Blockchain

Security tokens provide a way to liquidize a wide range of traditional assets in the market. The models include:

Derivative Tokens — Forward-Futures, mutual funds, ETFs, non-equity investments, etc.

Debt Tokens — Represent outstanding debts and liabilities; Bonds, mortgages, etc.

Equity Tokens — Represent an equity position in a backed asset; Stocks, futures, and options contracts

Convertible Tokens — Convert between debt and equity based on their behavior

Security Token: Pros

Reduced cost and time to raise funds

Using current IPO(Initial Public Offering) system to publicly raise fund not only requires regulatory approvals but also cost large sums of money for corporates. With STO, some of these time-consuming and costly processes can be eliminated with the power of smart contract and blockchain.

Merkle Tree: Proof of Process — Polymath Whitepaper

For example, Polymath uses Proof of Process (shown below) for auditing documents on a blockchain. The authenticity of legal documents are verified with a tree of SHA256 hashed documents.

Regulatory Requirement

Unlike traditional cryptocurrency markets, both investors and issuers must follow KYC and regulatory requirements. Both parties will be well-regulated and protected by the law.

Token Ownership — Global & Fractional

Security tokens can completely liquidize assets, allowing fractional ownership. This would lower the barrier for investment as compared to the traditional stock market. Assets which had only been accessible by a few large investors can now be divided and be traded in form of security tokens.

While regulations differ by country, security tokens attract global investors with numerous opportunities and greater liquidity. This allows an early stage business to raise the required capital for substantial growth and to have an international presence.

Security token: Cons

Investor Limitation

The biggest downside for security tokens is the regulation limitation. In the US, only accredited investors with 1 million dollars in the bank or an income of $200,000 per year could participate in STOs. Countries are looking into regulating security token in their own terms. Additionally, investors must comply with requirements regarding foreign investment laws.

Exchange Regulatory Barrier

Furthermore, due to secondary trading market restrictions, security tokens can only be transferred via licensed platforms. These platforms are expected to go through multiple regulatory steps to be licensed in the country they operate in.

Despite the convenience in setting up an STO, the regulatory barriers for both trading platforms and investors are detrimental for the market growth.

Conclusion

Overall, security tokens power the conventional markets with blockchain, providing opportunities for everyone to invest in a wider range of assets.

Implementation of security token will democratically revolutionize the traditional security market and is now gaining momentum. You should be expected to see the unimaginable growth within a couple of years as the blockchain technology rapidly emerges all around the globe.

Enjoy and please don’t hesitate to reach out with questions, corrections or feedback (email, twitter).