Crypto Basics Crypto Knowledge

What Is a Security Token?

Overview

Many aspects of Bitcoin, blockchain technology and the cryptocurrency ecosystem were born from the field of data science. As a result, the two areas share a lot of common terminologies. One of which is the term ‘token’.

In data science, a token represents a value assigned to sensitive data. For example, this value could be a randomly generated number, which would serve the purpose of masking the original information. When a token is created and assigned to data stored on a blockchain, this is known as ’tokenization’.

What Is a Security Token?

A security token is not too dissimilar to that of a traditional security. They represent rights of ownership, transfer of value, or a promise of returns. All of which are tokenized on a blockchain. They are intended to be viewed and treated as investment assets.

Understanding Security Tokens

Anything can be tokenized, so understanding tokenisation is critical to understanding security tokens. A token can signify ownership of an item, a car, for example, or even a company share.

However, the idea of tokenized ownership isn’t a new one. In the past, paper stock certificates were issued to investors with an ownership stake in a company. This again was to represent ownership alongside any other perks given to the investor. 

The difference with digital securities is the blockchain technology it lives on. Having an asset on the Blockchain means there can be multiple use cases for the token.

How Are Security Tokens Used?

Security tokens can be utilized as smart contracts to signify the ownership of an asset or part of an asset.

This leads to many potential use cases. Real estate investment trusts could become issuers of shares on a blockchain in the form of security tokens. And those security tokens would represent full or fractional ownership of a piece of real estate. This type of security token is often referred to as an equity token.

Companies and start-ups could also utilize security token offering (STO) platforms to become accessible to retail investors who wouldn‘t be able to invest until their initial public offering (IPO) through a stock exchange. This is not to be confused with an initial coin offering (ICO). Even though they may play out in a similar manner, it may be easier to think of an STO as a tokenized IPO. 

What Are The Benefits?

The benefits of security tokens are directly tied to those that come with blockchain technology. They bring the same use case as those that exist in real-world markets but without the fees, friction and delays.

Blockchain also offers investors peace of mind, knowing their stake is preserved on a public and distributed ledger. This leaves no room for any misunderstandings or corporate manipulation.

Multiple cryptocurrencies sit in an area of uncertainty around if they are, in fact, a currency or security. This is problematic for the intentions of both investors and token holders as different laws apply to each asset. However, regulators clearly define and recognise security tokens, eliminating any doubt as to which laws apply.

What‘s The Difference Between Security Tokens and Cryptocurrencies?

Security tokens and cryptocurrencies may appear incredibly similar. They are both digital assets. They are both stored on a blockchain, so what separates the two? 

The primary difference lies in the actual use of the token, or at least their intended use. Crypto is designed to be used as a monetary asset, a currency used as a medium of exchange or a store of value. They can be utility tokens for development purposes. The intended use case of a security token is that of a stock or bond you would find in a more traditional financial market.

They are viewed more in the light of an investment asset than a currency. For more information on the difference between tokens and coins, head to our article, which gives a more comprehensive breakdown.

How Do I Know If a Token Is Considered a Security Token?

To understand why some cryptos are considered securities, we first must understand the process of defining one. The Securities and Exchange Commission controls this; some cryptocurrencies may also fall under their regulatory definition alongside securities in traditional markets.

The Howey Test

To determine if an asset qualifies as a ’security’, the SEC runs it through “The Howey Test”. The four parameters of the test are as follows:

  1. Investment of money – Someone has invested money in goods or services.
  2. In a ‘common enterprise’ – This could mean there is a direct correlation between the promotion of the investment and its performance (vertical commonality). Or that the investor‘s funds are interwoven (horizontal commonality).
  3. With an ’expectation of profit’ – there is an expectation of profit from returns or capital appreciation.
  4. ‘Solely on the efforts of others’ – this is fulfilled if profits directly result from the efforts of those promoting the investment.

In short, and in the words of the SEC, these steps determine if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”

As you can imagine, this leaves a lot of digital assets in a gray area, leading to bitter disputes between the SEC and some crypto companies. The most famous involved the company Ripple Labs and their token XRP, which had a lawsuit filed against them by the SEC at the end of 2020.

Is Bitcoin a Security token?

The ’coin’ of Bitcoin is the telling part here, as it was designed to be used as a currency. However, investors and traders from more traditional markets often treat BTC as a security token. 

Everyone knows that BTC has produced significant returns in the past, and traders continue to invest, viewing it as a security if they’re only looking to benefit from price movements.

However, it‘s important to note, The Securities and Exchange Commission (SEC) does not consider Bitcoin to be a security.

Is Ethereum a Security Token?

Ethereum’s native token, ETH, is not classed as a security token. The intended use case of ETH is to pay transaction fees on the network. The SEC also acknowledges ETH as a cryptocurrency and not a security.

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