What is a Security Token?

Tokens 101

What is a Security Token?

Security tokens are tokens that offer complete or fractional ownership of an asset or company to investors. They represent an external tradeable asset and ownership of the tokens confers certain rights, similar to shareholder rights, to investors. This is unlike utility tokens, which are solely used for conducting transactions in a platform. Investors in utility tokens do not have any rights with regard to management and practices of the platform, nor do they hold any stake in the company.

Why Do We Need Security Tokens?

The regulatory status of tokens on Ethereum’s blockchain has been the cause of considerable discussion and confusion.

The genesis of security tokens owes much to the regulatory problems of utility tokens. Part of the reason for the popularity of initial coin offerings (ICOs) as a fundraising method was due to their relatively simple regulatory structure. Entrepreneurs were able to offer tokens to investors without incurring significant disclosures and fees. Taking advantage of this structure, most startups declared their tokens as utility tokens.

While utility tokens offer an affordable mechanism for entrepreneurs to tap into an investor universe that spans multiple borders, their future seems uncertain in light of recent statements and actions by the SEC.

The federal agency’s main objection relates to the classification of tokens. The SEC has argued that most investors in such tokens did so with expectations of profiting from an increase in the token’s price, when it was listed on an exchange. The SEC cracked down on ICOs that window-dressed security tokens as utility tokens and issued warnings to investors. Those moves were enough to dissuade entrepreneurs and investors and the market for such offerings tanked.

The security token offers a way out of the regulatory gridlock. This form of token enables investors to fund or own a wide variety of assets, from real estate to line items on a company’s balance sheet.

A security token adheres to disclosure standards, such as anti-money laundering (AML) and Know Your Customer (KYC), which are applicable to securities. A smart contract format, that incorporates programmatic compliance within security tokens, is essential for successful implementation of security tokens. This is where the ERC-1400 format comes in.

ERC-1400 Tokens  

A majority of utility tokens are based on the ERC-20 smart contract format, which has a simple structure to enable distribution of standard tokens, but that format is not sufficient for the relatively complex functions of a security token.

To understand the need for an ERC-1400 token, it is important to understand the problems associated with ERC-20 tokens. ERC-20 tokens do not have a standard interface to enable easy transfers between two parties. Transfers made using the ERC-20 format are therefore either unreported or not recognized in the recipient’s account. This makes it difficult to know the status of a transaction, and, as such, traceability of smart contracts is not possible through ERC-20.

It is also not possible with ERC-20 to authorize a third-party to transfer coins from an account. Essentially, this means that tokens belonging to an address are locked up forever unless that address spends them. Given that most blockchains follow a schedule of controlled supply to limit price inflation for their tokens, this does not bode well for its price because it creates artificial scarcity. It is also problematic for investors because it means they will not be redeemed if a blockchain is hacked or goes down for any other reason.

There is already precedence for such an occurrence. In 2016, Ethereum’s blockchain forked after investor pressure due to a hack. (The new blockchain backed by investors – called Ethereum – has appreciated significantly in price since the fork, while the original blockchain – now called Ethereum Classic – recently suffered an attack.)

A series of interim standards were fashioned by the Ethereum community in order to enhance functionality for security tokens and make them suitable for investors. The ERC-777 smart contract standard represented a major step forward. This specification solved some of the most pressing issues associated with smart contracts.

For example, it enabled third-party spending from smart contract addresses through the use of operators. The development of a whitelist of trusted contracts is further enhancement of the feature because it restricts token access to parties trusted by the address.

ERC-1400 was released as a draft in September 2018 and is the culmination of coordination and partnership between a network of programmers, lawyers and investors to develop an ecosystem for a security token. It is compliant with both ERC-20 and ERC-777 standards.

Among other features, it has a standard interface to query and justify the success or failure of a transaction. It also enables forced transfers for legal and fund-recovery procedures. ERC-1400 also makes it possible to attach metadata in the form of “identity information” to a token holder’s balance to ensure compliance with AML and KYC laws.  

One of the main characteristics of security tokens is that they are non-fungible, meaning two identical assets may have different values. One of the best known examples of a non-fungible token is CryptoKitties, which emerged as the most popular application on Ethereum’s blockchain last year. CryptoKitties are unique digital assets which are imbued with value because of their scarcity and desirability. Even though they are, for all intents and purposes, the same, no two CryptoKitties had the same value. The price for Dragon, the most expensive CryptoKitty ever sold, was $170,000. Before Dragon, the most expensive CryptoKitty was Founder Cat #18, which sold for $110,000 in December.

For the most part, utility tokens are fungible, meaning there is an equivalency in their values. To account for the non-fungible nature of security tokens, ERC-1400 makes it possible to modify metadata and transaction parameters on and off the main blockchain.

Are Security Tokens Approved by the SEC?

While they comply with most regulations pertaining to securities, the status of security tokens is still unclear. Some say that such tokens should be treated as securities and must be subject to the same requirements.

Others differ. The details of an offering that incorporates security are still to be worked out. For example, the holding period for tokens differs based on the regulation applied to the offering. Depending on the rule being applied under Reg. D, investors will have to hold onto their tokens for a minimum period of six months to a year before they are allowed to resell the tokens in open markets. There are no such restrictions for investors in Regulation A offerings. It is also still not clear whether accreditation status of investors would need to be checked each time an offering takes place.

“Just because entrepreneurs say that [their token] is a security does not mean that they are compliant with existing regulation,” said Dan Jones from Genesis Blockchain, a firm that develops technology solutions for security token offerings. According to Jones, there is still a possibility that entrepreneurs might run afoul of the SEC, if they do not comply with the applicable regulations. For example, there might be legal ramifications, if they do not perform due diligence on investors before their offerings. Jones noted issuers of tokens should understand their offerings before discussions with regulators about their status. Commodity regulations can be applied to instances of trading for stablecoins (coins which trade at parity with a basket of collateral, such as fiat currency or other cryptocurrencies), according to Jones.  

That said, some of the contours of security tokens listing are beginning to take shape. It is highly likely that security tokens will only be listed on authorized platforms, such as SEC-registered broker-dealers or Alternate Trading Systems (ATS). Such platforms will need to implement checks, such as AML and KYC, in order to be compliant with securities laws.

Will Security Tokens Become the Standard?

Security tokens take steps toward solving the most important problem facing tokens in their current form: regulatory uncertainty. The ICO market crashed in 2018 in response to the SEC’s actions. The introduction of security tokens is expected to allay some regulator concerns about the pervasive scams and scandals that marked growth of ICO markets. Given the advantages of security tokens, it might be tempting to cast them as a future standard for tokens. Such predictions, however, underestimate the usefulness of utility tokens.

In the emerging blockchain-centric universe, utility tokens serve an important function. They enable transactions within platforms and create self-sustaining economies. Reinventing utility tokens as securities would cause problems for the survival of such economies. For example, decentralized storage startup Filecoin’s utility token enables exchange of value between different stakeholders in the system. Categorizing it as a security token would create artificial incentives for stakeholders to introduce volatility into its pricing.

But the popularity and global reach of ICOs means that a greater number of blockchain startups will use security tokens to tap into a bigger investor base. Development of new token standards, such as ERC-1400, will make it easier to issue these tokens in the future.

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