Security tokens have garnered a lot of hype lately. And, why not? It is now a trend in the cryptocurrency market just like how cryptocurrencies, smart contracts, and utility tokens made news in the past.
So, why it is getting so much attention? The main reason behind the hype is its ability to enable startups to raise funds for their project by decreasing complexity and need for resources.
In this guide, we will be covering the different facets of security tokens. We will also be covering the difference between utility and security tokens to get a better understanding.
But, before we move on and learn about security token, let’s try to get the basics right…
What Are Tokens?
Tokens can be used to represent different aspects of a particular ecosystem. It can be used as a value or a stake or better used to perform actions such as voting, purchasing and so on. However, don’t confuse it with cryptocurrency as they are not bound to a particular ecosystem. Bitcoin, for example, can be used independently and hence is not a token.
Tokens, on the other hand, are bound to a particular system. One famous example would be OmiseGo.
We can define a token as a utility or asset used by startups to manage their platform. It is also useful in raising money through ICO(Initial Coin Offering).
What are Securities?
To learn more about security tokens, we first need to learn about securities as well. Securities stand for the tradable financial assets which are useful in owning a part of the company. There are many types of financial assets including stocks, options, notes, bonds, shares and so on.
Securities are used by companies and government to raise money for their projects. Both institutional investors and common people can buy securities and become part of a company’s growth. They are paid through a return back programme.
What is a Security Token?
Security tokens are tokens that are offered by startups, companies or organization as securities through STO(Security Token Offering). Security tokens are cryptographic and hence can be implemented without any security threats. The security tokens are purchased by investors to make future profits.
When it comes to security tokens, everything is done electronically with no paperwork involved. This is done and achieved thanks to the capabilities of the blockchain. Security tokens are also closely related with smart contracts. They are coded by programmers which act as a legal document in electronic form. It dictates how the tokens are managed. As you can see, there is a lot of automation. This is done to ensure that everything works smoothly without the need for human interference.
How does Security Tokens Work?
Security tokens are distributed through the STO process (security token offering). To get a better understanding, we need to go learn how ICOs takes place. At first, a startup needs to create a digital token for their platform. They can use a blockchain such as Ethereum or NEO to create ERC20 or NEP-5 standardized token. Once done, the startup will do a private ICO where they give early access to investors.
After the private sale, they do a public ICO where anyone can take part including the general public. The startups release a fixed amount of tokens in the market to make sure that the token’s value stays healthy.
During the ICO process, the buyer needs to send an amount in cryptocurrency or fiat to the smart contract address specified by the company. Once done, the smart contract executes itself and allocates tokens to the buyer. The tokens are then transferred back to the buyer’s wallet.
How to classify a security token?
Right now, there are two types of tokens defined by SEC and FINMA. They are utility token and security token.
So how do you determine if a token is termed as security or utility? For that, we have the famous, “Howey Test.”
It came into existence during the SEC vs. Howey case. The Supreme court created the test for determining transactions as investment contracts. This laid the foundation, and the conditions and requirement are set to decide whether it falls under security or not.
The three criteria for the securities include the following:
- Investment of money
- The investment is done in a common enterprise
- Expectation of profit
If these three criteria meet, then the token is a security token. As an investor, you should understand that security tokens are based mostly on speculation and rarely on real products. So, it is wise to invest in a startup with proper research.
Utility Token vs. Security Token
Great, we learned about security tokens. But, you might be wondering, how it differs from utility token? Let’s find out.
Utility tokens are tokens that are used to access a service or a product. It is deeply integrated into the service/product where almost every activity can be done using those tokens. The major difference between a security token and a utility token is that utility token is not designed for investment purposes. Also, utility tokens are regulated and are only used to perform tasks in an ecosystem. An excellent example of a utility token is Filecoin which is used in decentralized storage platform.
Why are Security Tokens becoming so popular?
Security tokens have enabled the cryptocurrency market to evolve in new ways. After all, it has so many uses cases. Its prospects are bright, and even institutional investors and bankers are taking notice.
There are many reasons behind the popularity of security tokens. Let’s list them below.
- Security tokens, on the other hand, bring regulation to the market. Also, the projects using security tokens get good support from investors.
- They can be liquidated faster.
- Security tokens also enable startups to get their funding faster without any huge initial investment.
- The security tokens can also be released in the market for traders. Lastly, it is completely automated.
Security tokens are here to stay. They offer new ways to leverage blockchain and enable companies to use it to bring funds. The only drawback is that not all security tokens are SEC regulated. Some security tokens try to disguise as utility token and remain unregulated.
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