by Noah Newfield
Cryptocurrency, Stable Coin, Utility Token, Security Token.
These are the four major digital assets that are available right now. Previous articles have touched upon these topics, but here’s a quick review: Cryptocurrencies are digital assets that function as a store of value for transacting, Stable coins are cryptocurrencies that use algorithms or backing from real-world assets to always stay the same value, Utility Tokens are used to complete certain network activities, and now I’ll break down the features of security tokens.
A security token is an ownership contract that is enforced by the blockchain for a percentage of a real-world asset. This is similar to the way a share of stock represents a portion of a company, with the ownership of a share being enforced by the presiding legal system.
Shares of stock used to be paper certificates backed by the legal system of the country where they were issued. The rise of online brokers in traditional financial markets increased the number of third parties involved but opened up the markets to capital from online investors. Now, proving the ownership of a stock you purchased relies on the security and honesty of third parties such as brokers, clearing houses, financial custodians, the involved countries legal systems, and many others.
With a security token, there is only one party whose honesty and security you must trust, the blockchain. The legal system of the of the blockchain is written in smart contracts. These contracts dictate the rules regarding the transfer and ownership of the asset. These include what rewards you receive, how you receive them, who you are able to transfer the asset to, and all the other aspects of the assets internal guidelines.
Instead of needing brokers, a clearing houses etc. to prove ownership, ownership will be defined by the possession of the token in your wallet.
The token is a digital representation of a binding contract in the physical world. In the current state of the financial system, we pay third parties to keep these contracts safe for us, but a shift in the technologic paradigm will now allow us to manage the safety of our own assets.
As the name states, these tokens are considered securities.
As defined by Georgetown Law, A security is an investment in a business. It can take the form of shares of stock, bonds, a package of loans or mortgages offered for sale by a financial institution or a financial instrument representing an investment in a company or an international project.
Assets that fall under the umbrella of securities are subject to comply with securities law in the countries where these assets are traded. Issuing any security, including a security token, requires approval from the governing body. In the case of the United States, the SEC, Securities Exchange Commission. Although the regulatory landscape for security tokens is still being shaped, these governing bodies heavily scrutinize traditional securities like company IPOs, and they are likely to use a similar level of caution with a new asset class.
Opening up Liquidity
The capitalist model thrives on the freedom of liquidity. The world economic experiment of the last few hundred years has shown us that as we loosen regulations and take down barriers for investors the economy thrives. Security tokens have the opportunity to accelerate the freedom of capital investment at an incredible rate.
Let’s look at a comparison between crowdfunding and the Initial Public Offering process. The two extremes at either side of raising capital.
Crowdfunding on websites like Kickstarter or GoFundMe allows people to make small contributions to projects or causes. There is far less regulation on crowdfunding than issuing shares of stock because the individual donations are typically small and are not in return for something that will speculatively rise in value. The lack of regulations limits the return “investors” can receive but opens them up to a far larger pool potential capital. That’s why we’re all so amazed when we see the power of crowdfunding raise enormous sums of money for individual causes. Because there’s no regulation to ensure your crowdfunded money is being spent responsibly, larger donations are naturally discouraged.
On the complete opposite side of the regulation spectrum, we have the institutional purchase of shares of stock. Here investors must have the proper paperwork, be registered with an online broker, reveal a large amount of personal information for identity verification, and pay multiple third party brokers for their services and fees. These fees seem small, but they accumulate over time and now account for billions of dollars every year of investor money that could’ve gone to the company the investment was intended for. Investors can invest much more capital here, and it can be in return for an appreciating asset. The increased regulation encourages larger investments but greatly restricts the pool of investors.
Security tokens fall at a good middle ground. They are issued by institutions that need to comply with a strict regulatory environment, which will encourage larger investments. Because of the absence of third parties associated with online brokers, a large percentage of capital will return to the pool of actual investment. Because the blockchain will allow individuals to secure their own investments, anyone with a connection to the internet and spare capital will be able to invest.
Now there will absolutely be tighter regulations with STOs Security Token Offerings than crowdfunding websites. And, It is possible that regulators will hold security tokens to the exact same third party compliance as typical IPOs, but it is my hope that legislators and regulators are able to find some sort of middle ground to enable what could be a great capital resource.
Security tokens are an interesting application of distributed ledger technology. They are in the infancy of their development, but their future holds a lot of promise. Like every industry, the financial industry will be disrupted by technology that is more efficient and secure. Security tokens have the potential to be that disruptor but it will be an arduous road through the gauntlet of securities law before that can become a reality.