A token represents an asset, such as a stake, voting right or some other form of subjective value. Real estate and commodities, for instance, can be traded as security tokens. Token issuers can create a token by leveraging functions on certain blockchains, such as Ethereum and its native smart contract technology. Issuers often sells these tokens, which represent an asset or utility, during a public token sale known as an initial coin offering, an initial exchange offering or a security token offering.
Security tokens are asset-backed and compliant with securities regulation. Security tokens follow strict guidelines about who can purchase, own, and trade these instruments. A token can start as a security token, but might evolve into a utility token as its native platform is built out.
As the representation of a share of interest in value-producing assets, securities tokens can provide holders with dividends. In this sense, security tokens act like investment contracts. Purchasers speculate on the future profits from dividends, revenue share or appreciation.
How Are Tokens Regulated?
Regulators took notice as ICOs raised more than $21 billion in 2018. The U.S. Securities and Exchange Commission went after a number of token issuers, who ultimately settled and registered as a security issuer and offered refunds to investors. Most ICO promoters said their coins were not securities tokens, but utility tokens, which buyers would use for services provided by the business and not for speculative purposes.
The SEC found that nearly all of the coins they examined, however, didn’t necessarily work as promoters framed. Furthermore, the agency found that investors had bought them hoping to earn money. The cryptocurrency industry’s dialogue quickly turned away from utility tokens towards security tokens, whose issuers at least acknowledged their asset as subject to securities laws. The concept of security token took hold and an entirely new crypto niche had been born.
In order to tokenise a real asset, you have both technology and business regulations to which you must adhere. Security token issuers seek to comply with national and even global regulations, such as Anti-Money Laundering (AML), Know Your Customer (KYC), and securities law. Startups conducting security token offerings must provide investors with legally required information, including location, financial statements, business purposes, and management details. As a security token issuer, for instance, DXone must not only adhere to the rules, but also ensure that its security token holders do, too.
In the U.S., the Securities Act of 1933 and Section 3 of the Securities Exchange Act of 1924 regulates security tokens. The Howie Test helps determine whether a token is a security or not:
- Are you investing money?
- Do you expect profits in return for your investment?
- Are you investing in a common enterprise?
- Will your profits come from the efforts of a promoter or third-party?
The Howey Test stems from the Supreme Court case SEC v. W.J. Howey Co. in which the SEC alleged that Florida’s Howey Company ran afoul of securities law by failing to register a land investment agreement with the SEC. Investors purchased half of the company’s unused land so that they could develop the rest of their land into more citrus fields.
The Supreme Court ruled that the investors had no “knowledge, skill, and equipment necessary for the care and cultivation of citrus trees” and were therefore acting as speculators. In other words, they invested in the land with the hopes of making a profit from the efforts of someone else. They had not invested in the land to themselves develop it. The SEC concluded that the investors were seeking future profits in the citrus fruit enterprise and that they had purchased a security.
The SEC requires a full accounting from companies looking to conduct security token offerings, including complete financial statements, and more. The organisation only approves companies that meet these stringent requirements. While the security token market suffers from reduced liquidity — holders cannot easily trade these securities as they must adhere to regulatory requirements — security tokens provide the added transparency needed to increase investment into the space.
In the European Union, token issuers have to write a Prospectus, and you must get approved by financial market authorities, whether that is FMA Liechtenstein, FMA Austria, Bafin or any other European Union regulator.
The regulations are designed for many purposes. If a token is lost or stolen, for example, a security token issuer must ensure the original owner gets their funds back. The issuer must store data in an appropriate manner and comply with know your customer data, such as who purchased the asset.
In order to be compliant, DXone and most security token issuers employ a centralized database in order to record data and secure our assets. In the traditional world of finance, clearinghouses, traditional exchanges and brokerages collect the appropriate data. In the case of DXone, and many security token issuers, we worked with a third party company on our security token to ensure all regulations and guidelines have been followed.
Although regulations in the EU are rather homogenous across national borders, there is some diversity. The types of assets you can tokenise, for instance, vary country by country. Setting up a structured bond in Germany, for instance, entails a distinct process that differs from that of Lichtenstein.
Each country in the European Union has taken a different approach to cryptocurrency regulations. The crypto industry remains unsure how the market will evolve. To be sure, security token offerings are a popular fundraising mechanism in Europe, especially in Liechtenstein, Germany, Switzerland, and France.
Security tokens can for now only be traded on the Gibraltar Stock Exchange. The market is virtually non-existent, however, because there’s no market for brokerages to set up products for direct market access to tokenised assets.
What Is A Security Token Offering?
New security tokens can be issued and sold to investors, similar to new digital tokens are sold through an initial coin offering (ICO), through a process known as a security token offering (STO). An STO provides a modern solution to fundraising. A security token offering differs from an ICO insofar as a regulated asset is being sold instead of a non-regulated asset.
Before a robust security tokens market can be established, token issuers, investors, brokerages, and MTFs must cooperate in pursuit of developing tokenised assets attractive for professional traders. The market needs brokerages, liquidity providers, and products like options, futures, and derivatives.