Security Token Academy Frequently Asked Questions
What is a security token?
A security token is a type of tokenized asset (e.g. stock), classed as a security under the laws of a governing jurisdiction (e.g. United States), issued, tracked, and traded using a blockchain (e.g. Ethereum).
Security tokens are also referred to as digital securities, tokenized securities, and blockchain-based securities.
Are security tokens treated the same as “regular” securities by securities regulators?
Today, most jurisdictions aim to treat security tokens using the exact same laws and regulations as “regular” securities. The difference between “security tokens” and “securities” is one of form -- not substance.
Security tokens are unique in that they are created and issued inside of a digital wrapper (i.e. a digital token), allowing the security to be owned, tracked, and traded in a blockchain-based environment. This digital wrapper, in conjunction with a trustless blockchain database, aims to empower our global pool of assets in new and innovative ways.
What are some of the benefits of security tokens?
There are a number of potential benefits that security tokens and blockchain-based transfers of assets could bring to our private and public securities markets:
- 24/7 Markets. Today, major U.S. stock market exchanges have limited daily trading hours, and are closed on weekends. Blockchain ecosystems empower a technology stack that operates non-stop, which could one day extend to our private and public securities markets -- creating additional forms of value.
- Fractional Ownership. For many retail investors, it’s non-trivial to come up with the resources to buy single high value assets, like commercial real estate or fine art. Today, an investor can either forego exposure of that expensive asset category entirely, or obtain exposure through an intermediary (REIT). Due to the unique divisibility of blockchain-based securities, fractionalization can provide non-intermediated access to previously inaccessible categories of expensive assets.
- Rapid Settlement. Today, public market exchanges like NASDAQ and NYSE can execute trades quickly, but settling ownership of those trades is typically two days (Trade + 2 Days). Alternatively, private market securities can often take weeks or months to trade or transfer. With security tokens, ownership claims will have the ability to trade and settle in seconds or minutes.
- Cost Reduction. One of the most attractive benefits for security tokens are the proposed reduction in back-office and administrative costs associated with today’s issuance and management of securities. For example, when startups are acquired, reconciling capitalization tables to the underlying purchasing agreements and option grants can be costly -- when ownership claims are tokenized, cap tables are reconciled in real time by code.
- Increased Liquidity and Market Depth. Many private securities today, like Limited Partner (LP) interests in a fund, are relatively illiquid -- which means the ownership interests are costly to trade and will affect the asset’s price. Tokenized funds could allow fund managers to invest in illiquid assets without fear of redemptions, while fund investors are able to access liquidity in secondary markets. As a result of these deeper markets and improved investor liquidity, one might also expect an increase in an asset’s value.
- Automated Compliance. Today, regulatory compliance for securities is typically documented through a series of separate ledgers -- each constructed by entities that facilitate issuance and/or secondary trade. Only through reconciliation of these segregated ledgers is ownership and compliance legally validated. With security tokens, which are built on a model leveraging transparent and immutable blockchain ledgers, regulators will have a far easier time keeping track of compliance issues, system manipulation, or fraud.
- Asset Interoperability. Today’s centralized solutions for electronic value transfer of securities lack compatibility -- they don’t talk to each other. With standardized digital formatting, security tokens will be able to reference each other contractually and automatically.
- Design Space Expansion. Security tokens will allow us to build in contractual features to securities that have previously been impossible to execute. For example, features can be built within the digital wrapper of a security token to help shape corporate governance -- the longer you hold the stock, the more votes you may be able to get. Or, new forms of access rights -- a minority owner of a restaurant could gain access to priority seating or off-menu items. With security tokens, new forms of value could be un-bundled and re-bundled to blockchain-based securities.
You can learn more about these security token benefits in Security Token Stories Episode #2 between STA’s Derek Edward Schloss and Stephen McKeon, Professor of Finance at University of Oregon.
What is a blockchain?
A blockchain is a type of database. Like other databases, a blockchain can store information about transactions and events that have occurred in the past. However, a blockchain is a special type of database because multiple copies of its contents are shared across many computers simultaneously -- a kind of “distributed” database.
It’s important to note that blockchains are distinct from other types of distributed databases due to the unique method by which all participants are able to simultaneously agree—or, form consensus—as to the contents of a blockchain's stored information. As a result, participants can be sure that they’re looking at the same historical data as all other participants, and that no actor was able to improperly manipulate the ledger’s historical data.
Before blockchains, recording, storing, and managing information on a database required a centralized party. With blockchain, however, a central party is no longer required—opening up new opportunities for peer-to-peer value creation.
What is a tokenized asset?
An asset is any item of value. Assets can refer to things like cash, a home, a share in a company -- even precious metals and artwork.
Generally, assets can be categorized into the following three categories:
- Tangible Assets. Assets that have a physical presence (property, equipment, art).
- Intangible Assets. Assets that have no physical presence (patents, copyrights, trademarks).
- Financial Assets. Assets that have value based on a contract (stocks, bonds, derivatives).
Using these three categories, a tokenized asset is simply a digital entry (“token”), representing any item of value (“asset”), on a distributed database (“blockchain”).
Examples of tokenized assets include things like tokenized currencies (e.g. US Dollars), tokenized commodities (e.g. Oil), tokenized real property (e.g. Empire State Building), tokenized goods (e.g. Gift Card) or even tokenized securities (e.g. Apple Stock).
What is the legal definition of a security?
Generally, “securities” refer to assets like notes, stocks, bonds, futures, options, and investment contracts.
From a legal perspective, the U.S. Securities Act of 1933 defines a security as any “note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. (15 U.S. Code §77b(a)(1)).
Importantly, “investment contracts” are a category of security defined in the Securities Act of 1933. The U.S. Supreme Court’s Howey Test is used to determine whether certain transactions (offers, sales, distributions) qualify as “investment contracts” -- if so, then the transaction is a security subject to the regulatory oversight of the SEC.
Under the U.S. Supreme Court’s Howey Test, a financial instrument qualifies as an “investment contract” for the purposes of the Securities Act of 1933, if a person:
- (1) Invests money;
- (2) In a common enterprise;
- (3) Expecting a profit;
- (4) Predominantly from the effort of others.
What are some examples of how issuers, investors, and regulators can benefit from security tokens?
- Issuers. With security tokens, securities issuers might enjoy a larger investment pool, a wider geographic base of potential investors, and a reduction in the “cost of capital” typically associated with securities issuance -- in addition to cost reductions as a result of streamlined compliance and reporting.
- Investors. With security tokens, investors might enjoy improved settlement speeds, a wider range of trading times, more sovereign ownership of their assets, and efficiency improvements -- all of which may create significant cost savings for investors over time. In addition, fractionalizing assets using blockchain ledgers could deepen the investor base for certain categories of assets. By deepening the pool of potential investors and reducing existing frictions to trade (e.g. compliance, trading times, intermediaries), it’s possible that certain assets might enjoy improved liquidity over time.
- Regulators. With security tokens, regulators might benefit from improved visibility into assets, entities, and markets -- along with enjoying new forms of automated legal enforceability.
What are the major categories of entities helping build the security token industry?
- Issuance Platforms. Issuance platforms help provide asset owners the necessary tools to create, issue, and launch security tokens. Often integrated with issuance platforms, security token compliance providers will help issuers on these platforms engage in key services like KYC (“Know Your Customer”) and AML (“Anti Money Laundering”) identity verification.
Example: Harbor, KoreConX, Securitize, Securrency, StartEngine, TokenSoft, Tokeny
- Trading Platforms. These platforms facilitate the secondary trading of security tokens.
- Custodians. Custodians are third-party service providers that custody security tokens on behalf of their legal owners. Custodians safekeep digital assets and minimize the risk of their theft or loss.
Example: Prime Trust, TokenSoft
- Cap Table Management. Cap Table Management platforms enable Broker-Dealers, Issuers, and Investors to visually manage portfolio data on a single platform -- including accurate capitalization tables, communications, and compliance.
- Transfer Agent. Transfer Agents are service providers tasked with tracking and managing securities transfer and ownership. This includes the ability to issue and cancel changes in ownership, act as an intermediary between an issuer and asset holder, and handle certificate theft, destruction, or loss.
- Regulators. In the United States, the SEC regulates securities law at the federal level. FINRA, a self-regulatory organization (SRO), declares the rules that govern broker-dealers (BD) and other professionals within the securities industry.
Example: SEC, FINRA
- Broker-Dealers. Broker-Dealers are organizations which engage in the business of trading securities. When executing trades on behalf of a customer, the organization is called a broker. When executing for own account, they are called dealers.
- Law Firms. Law firms and legal practitioners help provide the legal structure and regulatory compliance required for both security token issuance and lifecycle compliance.
Example: Clifford Chance
Many of these early security token infrastructure companies and professional service providers are part of Security Token Academy’s growing list of Corporate Members and Professional Members. You can learn more on securitytokenacademy.com.