The Growing Power of Security Tokens

Last week, Switzerland made headlines passing a new legislation in favor of a wide range of decentralized activity: the Blockchain Act. Impressively, this unanimous approval covers a broad scope of activity from DeFi to trading digital securities and standardizing crypto exchanges to addressing money laundering, making it the first financial hub to do so. But the Swiss aren’t the only ones on this route. Neighboring Liechtenstein has done it, as has Malta, Wyoming, U.S and earlier this year, South Korea.

Needless to say, we are pretty excited about the regulatory landscape starting to lean in (finally) so naturally, our takeaway from this comes with a shiny bright affirmation on what we wholeheartedly believe in: the growing potential of tokenized business. Not only do these legal frameworks bring more legitimacy to the space but also fuels blockchain-based innovation and better real-world application. Small step for mankind, giant leap for the decentralized community. 

But why should you, as our reader, care about this in the first place? What’s in it for our existing or future founders? How will this affect the way we build, manage and develop our businesses? 

This is an article about asset-based tokenization. While we have previously written about tokenization from a rather internal, corporate governance-heavy perspective, now it’s time to turn a broader view on security tokens themselves. What do they actually mean? And as the regulatory landscape is shifting, what are the opportunities and limitations in this space today? 

Let’s start from the basics. 

What is a security token?

Security tokens, also known as asset-backed tokens or equity tokens, are cryptographic representations of tangible real-world assets. An easier way to understand this is to think of tokenization as digitizing assets through blockchain technology. Technically speaking, it’s a file registered on a distributed ledger. Legally speaking, these files are investment contracts that represent Securities. Why Securities? Because most types of investment contracts are considered Securities in the main financial jurisdictions in the world and therefore, as an asset class, extensively regulated. 

In the U.S., for example, the Security Exchange Commission (SEC) regulates and oversees all varieties of investment contracts. Therefore, security tokens are by default compliant in their respective jurisdictions. They can represent nearly any kind of assets: commercial buildings, bonds, heavy metals, whiskey collections, arts. As long as there’s money involved and you can expect to gain a future financial profit from it, these tokens are security tokens.

 

What security token is NOT

Security token ≠ utility token 

Remember the ICO waves from 2017? Utility tokens. Typically used to raise money for a startup or project; investors can use utility tokens later to purchase goods and services offered by the issuer. Utility tokens are not pegged to any real-world value and not regulated. 

Security token ≠ tokenized security

Easily confused nuance but not the same thing. Tokenized security is just traditional security (e.g. equity, debt) that has been tokenized (digitized) to trade over blockchain. This isn’t very life-changing itself. But as the blockchain ecosystem matures, migrating traditional securities into the ecosystem allows it to enjoy the efficiencies and cost-benefits associated with such platforms. 

Security tokens, or securitized tokens, on the other hand, are a brand new asset class. The key is to understand that they are blockchain-native. This is the kind we’re talking about in this post. Although they are legally recognized as securities, they also wear another hat: utility. A single security token can be a representation of real-world value (e.g. office building) and a utility (a right for something, access, discount, a rule). I will explain more of its advantages later on. 

 

Why is this relevant to our community? 

Because Smart Company shares = security tokens. 

Yes, automatically. 

When a founder incorporates a new company or migrates their existing company through us, we deploy this legal entity structure into a Smart Company, a company type that runs entirely on Ethereum blockchain. The shares of this company convert into security tokens as programmed, without you having to do anything.

In the Smart Company model, each share is represented by one security token. So, if you as the founder decide to issue 1,000,000 shares for your new company, your Smart Company will have the same amount of security tokens. Now, everything in this article is about security tokens, therefore relevant because this is essentially all about Smart Company shares. 

If you’re new to our site and have no clue what a Smart Company is, you can learn more here. 

 

How are security tokens different from traditional company shares?

To put it simply, a company share is a portion of ownership that gives you, as the equity owner, certain rights over the company’s distributed profits. Proof of your ownership is recorded in the Shareholder’s Register that used to be a pile of physical papers (contracts), now made electronic. To trade shares, you either need to have a broker license or work with a brokerage. In other words, everything happens through a middleman. Stock trading today is generally well established and extensively regulated. 

Securities, on the other hand, is an umbrella term that covers a variety of investment instruments. By default, they are tradable and regulated. Company stock is one type of security. Security tokens, then, can be understood as a company equity that has been tokenized. In our Smart Company model this is exactly what happens. 

But what’s the point of tokenizing an established asset class in the first place? 

The world of financial transactions, corporate governance and trading is highly complex. It’s an engine currently managed by massive amounts of manual work from institutions, agents and middlemen. It’s inefficient and expensive in terms of resources. The cost of managing paper contracts is exponentially higher than managing digital versions. And the cost of managing digital versions is still higher than having smart contracts execute tasks automatically with built-in compliance. Use of blockchain provides greater efficiency, liquidity, transparency and accountability. And most importantly, it does all of this without compromising regulatory aspects with its built-in compliance.

 

How are security tokens improving the status quo?

If ‘Security Tokens’ was a book, this is probably what its first page of praise would look like:

“Security Tokens and Blockchain Will Revolutionize ‘Inefficient Capital Markets’”
– Tim Fries, The Tokenist

“Within five years I expect the average individual investor will have access to assets currently reserved just for the ultra-wealthy or connected, such as private limited partnerships, hedge funds, pre-IPO securities and many others.”
– Brooke Navarro, tZERO

“Ultimately, Blockchain and Security Tokens will be a dream of a generation come true”
– Ziv Kienan, Digital Assets Lawyers 

“Security Tokens can represent many different types of investment contracts, and that’s one of the reasons why it is going to revolutionize businesses forever as businesses will adopt STOs [Security Token Offering] as a key financial tool representing different forms of investment opportunities”
– Alex Nascimento, Author of ‘The STO – Financial Revolution’ & Co-founder of Blockchain at UCLA 

Some real potential for becoming a bestseller, right?

While I myself certainly don’t need any further convincing in believing in the power of digital assets, I do believe it’s important to keep our feet on the ground while we’re gazing at the stars.

The potential of securitized tokens is undeniably immense, but the ecosystem is still learning to walk.

Over the past years, I’ve witnessed how the blockchain space has become more mature (or more boring, as some say). It’s less hype-driven and increasingly more tangible. This is great news for those genuinely interested in the fundamentals of this technology and its ability to make a dent in the universe. 

The big picture

One of the reasons why security tokens have been said to revolutionize our financial markets is the argument that it will give accessibility to those who otherwise would not be able to participate in the global market. Think of an average individual who now can, thanks to blockchain-based solutions, tokenize any assets they own and create financial products related to them. From intellectual property to sharing agreements, the tokenized world would enable a larger pool of possibility through greater accessibility, liquidity, efficiency and security. These are all very high flying values – the promise of the token economy. 

The reality, however, isn’t quite as rosy just yet. Like any new technology, many enabling factors (infrastructure, supportive legislation, protocol performance) are still very much under development. That said, the direction seems to be increasingly more clear: a decentralized ecosystem of finance and governance is on the agenda for countless private and public decision makers. 

Because blockchain in this context is largely seen as a democratizer of different types of investments, traditionally only available to a privileged few, this raises some interesting discussions from the role of national fiscal policies to inclusive financing. Combined with automated management and possibility of fractional interest, we have a technology at hand that allows all kinds of assets now to be sold at a radically low entry cost. 

What would be the possibilities in such a world? 

 

Opportunity #1: Liquidity, efficiency and transparency 

Security tokens will enable:

• Greater liquidity for transfers 
• Greater liquidity for illiquid, intangible, soft assets
• Better efficiency and cost-effectiveness
• Increased transparency 

These are perhaps the most recognized benefits of security tokens today. When assets can be traded in a frictionless way without intermediaries, this will naturally increase their liquidity. Because security tokens are blockchain-native, many parts of trading can be executed automatically with predetermined conditions. Such intelligence (smart contracts) minimizes the need for the middlemen we currently need; it decreases admin processes and leads to faster deal execution with lower transaction fees. 

The ability to increase transparency is also becoming increasingly more important in today’s world. The ability to embed token owner’s information, rights, legal agreements directly into the digital asset in an immutable way adds security and therefore trust.

Security tokens will NOT (yet):

• Increase the pool of capital 

Greater liquidity in this context does not necessarily mean more capital. Note that I’m talking about a regulated setting. This is because to trade securities today, you still need to be an accredited investor. Trading security tokens does not change the securities law. While it’s not illegal to trade private securities with non-accredited individuals (secondary markets), it is not very efficient yet. The security token ecosystem as well as its regulatory landscape is developing fast however, so definitely something to keep our eyes on.

 

Opportunity #2: Cross-border transfers and accessibility 

Security tokens will enable

• More efficient cross-border transfers

The ultimate test of decentralized technology happens at cross-border transactions. After all, the tech was designed to be frictionless, trustless and borderless by default. Cross-border financial movement, something that is traditionally heavily regulated by different jurisdictions, has always been rather pricey and inefficient. While securitizing tokens might not change securities law just yet, smart contracts can be programmed to be self-compliant in respect of relevant jurisdictions. Financial actions would then be executed only when certain conditions and requirements are met. 

We can apply this to receipts of payments, automatic issuance of contracts, restricted ownership rights and so on. You can see how this spreads the cost of execution, something that would traditionally require legal agents and counsels, across the market as compliance layers would already be included in the smart contract. 

Opportunity #3: Fractional interest and payment of distributions

Security tokens will enable

• Greater ease and transferability of fractional ownership 
• More efficient and accountable payment of distributions 

It’s not that we don’t have fractional ownership today. It’s just that security tokens enable greater and more efficient division and transferability of assets. As we’ve written in our earlier post, tokenized assets could literally be sliced down into tens of millions of fractions which would not be limited by fiat currency decimals such as US$0.01. This is still a rather unexplored territory and has the potential to open doors for entirely new business models, new services, even new industries. 

Because profit sharing is at the core of security tokens, automatic and real-time updates on transactions are in high demand. Our current process of sending checks to shareholders is inefficient to say the least. And certainly ripe for greater efficiency, accuracy and scalability. 

 

Opportunity #4: Ability to include utility or purpose-driven goals

Security tokens will enable

• The ability to embody utility elements 
• The ability to embody collective, purpose-driven goals 

Although utility isn’t the main purpose of a security token, combining both profit-sharing and incentive elements are another area full of possibilities.

What would your business model look like if you could link your desired call-to-action directly to your offering? Can you tokenize your value proposition?

Utility typically allows their owners (users) a certain access, right or exclusivity to a product or service. An example of this could be Filecoin, clearly classified as a security token but their utility element is what gives their owners access to store data on their blockchain. 

Purpose-driven elements is another area that can be embodied with security tokens. Think of a collective goal for public good: a P2P lending platform for the unbanked or reduction of CO2 emissions. The idea could be incentivizing security token owners for a certain behavior to reach that collective goal. More philosophically, this would provide an alternative to our traditional economic value system; one that incentivizes individual value creation to focus on private gain. 

 

Opportunity #5: Built-in compliance and corporate governance 

Security tokens will enable

• Greater compliance with regulations 
• Better traceability, security and accountability 
• Better overall corporate governance 

Okay, now we are in our core territory. First of all, blockchain-native security tokens embed a lot of information in them that we can use to compliant-proof its actions. Different corporate law applies in different jurisdictions, making corporate governance conventionally a complex environment to navigate as an individual. Events such as fundraising, due diligence, shares transfers and board resolutions are still highly reliant on middlemen and agencies in terms of consultation and actual execution.

Security tokens address this inefficiency with pre-coded criteria in smart contracts.

In our Smart Company model, for instance, we’ve embedded a smart escrow, automated service that makes sure all parties have fulfilled their contractual requirements before releasing funds. Traditionally, this part of the process would be facilitated manually by an escrow or settlement agent, adding friction and inefficiency. 

Secondly, because security tokens leave an immutable trace on everything that happens in its log, it naturally provides better traceability, transparency and accountability for both the board and any external stakeholders you’d choose to show your books to. It makes fraudulent intentions harder. Also simple things such as a company’s shareholder’s register, for instance. I’ve heard asset managers complain how difficult it is to genuinely know how many shareholders a given company has due to limited ownership disclosure requirements and lack of technology that would provide real-time data and clarity. 

Cap table management is another example that is simple yet takes more time than anyone would probably like to spend on it. In the traditional world, this work is done by countless intermediaries, updating book entries for securities and so on. Manual, slow and prone to human errors and early out-of-offices. Equity trade today still takes 3 days to settle, matching shares multiple days as well as updating trader’s accounts and so on. You get the idea. Security tokens certainly do offer some disruptive value in this category. 

 

A word of caution: do you have real ownership?

Security tokens will enable

• Direct ownership over the asset 
• Direct custody over the asset in terms of rights (e.g voting)

This is one of the more subtle yet significant misconceptions in the space of security tokens today and therefore deserves a section of its own. 

When you, as an individual, trade traditional securities through a licensed broker, they have custody (your granted permission) to make decisions over the assets being managed. Because of this, the requirement is for most brokers to store their custody in financial institutions like JP Morgan Chase or Credit Suisse. This is to keep your funds safe and minimize the risk of theft or loss. 

When it comes to the blockchain ecosystem, however, custodian solutions are yet to become mature. As of today, very few mainstream banks offer custodian services for cryptocurrency companies; and regulatory frameworks around cryptocurrency storage are generally absent. So what does this mean to you as an individual investor?

When you buy tokenized security from a crypto exchange today, you don’t have direct custody over the asset: you hold the asset beneficially.

It takes time for the exchange to transfer this ownership to you and before the deal settles, there is a risk of falling into a regulatory grey area without much clarity today. 

“Available as tokenized securities”

Last year, companies such as Apple, Tesla and Facebook stock were announced to become available as tokenized securities through a cryptocurrency exchange. The concept was to offer digital stocks, in the form of tokenized securities, based on actual shares bought and held by a third party. The issuing companies themselves, Apple, Tesla and Facebook were reportedly not involved in this. The main operator was a European-regulated exchange. The headlines were big and bold. This was finally going to open the doors for the “bottom billion” population into the world of investment. 

Fast forward 6 months, and this operator files for bankruptcy and was never even regulated. To be caught in the middle, especially if you’re one of the “bottom billion” without access to much regulatory help, this isn’t the rodeo you want to be stuck in. 

Another downside to being an ‘indirect owner’ of tokenized security is your inability to directly exercise your rights. When companies vote for important things, your equity might give you a seat on the table. But the only way for you to participate would be either through your beneficiary holder or trust them to make the right decision for you. Again, inefficient and prone to misunderstandings.

How do security tokens solve this? 

Let’s use Smart Company as an example. Because Smart Company equity is born as security tokens, you as the solo owner of the company naturally own all of it. In other words, everything your company owns falls under its shares (tokens) and you are the owner of them. If your company owns a car, real estate, IP or licenses, these are your company assets and no one else but you has direct custody and control over them.

Now, if you want to raise capital, you could trade your equity (security tokens) with any potential investors and buyers. As this event takes place, they would gain direct ownership over those tokens immediately.

In the case of a Smart Company, this happens on a digital dashboard that literally shows the transaction to both parties in real time, with all relevant paperwork done and signed by itself at execution. 

What if you didn’t want to give equity away from your actual company but rather, just raise capital on the asset alone? You could open another legal entity under your main company. This new company (subsidiary) could be the owner of all your intellectual property for instance. These are security tokens too. If you trade them, buyers will gain immediate ownership in this case too with direct custody, voting rights or whatever you decide to grant to your new shareholders. 

I hope this example illustrates the subtle yet critical difference between real ownership and real custody over an asset vs. indirect, beneficial ownership.

Final thoughts 

Zooming out on our economies today, security tokens keep growing in their relevance, significance and impact. If the recent legislative movements give any hint, blockchain-based finance and corporate governance is gaining increasingly more support as well as maturity. The potential of securitized assets is certainly incredible. As the blockchain ecosystem keeps developing, forward-thinking innovators (shoutout to our founders and community members) will have plenty of possibilities of testing new ways of doing business: from profit sharing to elevated participation and new incentive models to collective purpose. 

We discussed some pretty tricky concepts in this post today – cheers for making it all the way here. If you have any questions or would like to understand security tokens better, don’t hesitate to reach out!