A security token is a token that represents a contract for expected profits in someone else’s company
How does a securities token differ from other types of token?
Securities tokens differ from other tokens, such as digital currencies, because they stand for something uncertain. Digital currencies don’t stand for anything — they are something, all by themselves — while other tokens stand for fractional ownership of assets.
How do you know a token is a security token?
This is a fraught question. To understand the answer we have to look past the digital assets space to securities law, because it’s this which will ultimately determine whether something is a security or not.
The crucial test here is known as the Howey Test, after the test case that established its precedence: Securities and Exchange Commission v. W. J. Howey Co., May 1946, in the US Supreme Court.
That case established that a security is a security, regardless of its form. A verbal agreement with no written verification of any kind can be a security, as can an informal handwritten contract; so long as a contract (defined very loosely in common law jurisdictions, and essentially consisting of agreement plus ‘consideration,’ which more or less means ‘payment’) exists, it can be a security.
What’s the definition of a security?
Here’s how you figure out whether something is a security. Does it involve:
- Investment of money: You can’t give securities away for free. A security involves investment of money, or money’s worth of some other asset. Without initial value exchange it isn’t a security.
- Common enterprise: Securities offer investment in a common enterprise, which is usually seen as being an enterprise in common between a promoter and several parallel investors.
- Reasonable expectation of profits derived from the efforts of others: Securities contracts are contracts to pay some money now and get more back later, from the operations of a business owned by someone else.
They are not stocks, because what’s being offered isn’t shares in ownership of the company but in profits generated by it. These need not be ‘profit’ to the company in question; the money can come direct from revenue or even from asset sale. The profit in this case is profit to the security purchaser.
The purchaser expects to gain not by participating in distribution, appreciation on an asset, or by selling at a gain in a secondary market. When a promoter or other ‘Active Participant’ provides essential managerial efforts — even if they don’t technically own the enterprise — that affect its success, and if investors reasonably expect to gain profit from those efforts, the contract is a security.
If all three of these conditions are met, it’s likely that something is a security.
So is this token a security?
If it’s being distributed for sale in return for profits which the promoter will be responsible for acquiring, then yes, it is. It’s important to note that even if the project is a decentralized network owned by its participants, without central authority, the promoter is still the Active Participant and thus it is still a security.
Securities tokens and regulations
Securities law doesn’t apply differently to tokens than to other types of security. The SEC has announced its intention to pursue unauthorized securities traders, even if their projects have been successful and token purchasers have realized profits. (In cases where project descriptions were misleading or in cases of exit fraud and similar activities, the SEC may go after those promoters for securities fraud as well as for unauthorized dealing.)
Securities Token Offerings
Unlike ICOs (Initial Coin Offerings), which offer access to a network but nothing further, STOs offer profits or revenue from the company and frequently voting and revenue distribution rights as well.
Most reputable STOs are now clearly aware that they are offering a security in digital form. While STOs offer security tokens — entries on an encrypted open ledger, rather than pieces of paper — the function of the security remains the same and they are subject to regulation by the relevant financial authority.
What obviously does not remain the same is the nature of the enterprise; the enterprise for which an STO is offered need not be based on the blockchain, but may be widely geographically distributed, technologically or commercially innovative, or otherwise differ from more traditional enterprises.
Advantages of securities tokens
Compared with a paper contract, security tokens have these advantages:
- Fast: The process of selling and buying security tokens is faster than the traditional approach, since KYC, AML and other due-diligence procedures can be accelerated and automated using the same blockchain technologies that underlie the tokens.
- Secure: The specifics of blockchain encryption differ, but almost all are based on AES-256, which is effectively unbreakable by ‘brute force’ (computerised guessing) and vastly more secure than any safe.
- Nonlocal and 24/7: Digital securities tokens can be exchanged rapidly with peers around the globe, sold and resold near-instantly regardless of the location of buyer and seller, and can be bought and sold at any time.