WhaleVest｜WhaleVest 100 Compass｜Security Token Getting Started Guide

What are security tokens?

Security tokens are tokens issued on the blockchain that represent an interest in some external business or asset. These bonds can be issued by entities such as businesses or governments for the same purpose as existing counterparties (e.g. stocks, bonds, etc.).

Why use security tokens?

For example, let’s say a company wants to distribute shares to investors in the form of tokens. These tokens can be designed to have all the same benefits one would expect from a stake, especially voting rights and dividends.

The advantages of this approach are many. Like cryptocurrencies and other forms of tokens, security tokens benefit from the properties of the blockchain on which they are issued. These attributes include transparency, fast settlement, no downtime, and divisibility.

Transparency

On the public ledger, participants' identities are abstract, but everything else is auditable. Anyone can freely inspect the smart contracts that govern the tokens, or track issuance and holdings.

Quick settlement

Clearing and settlement have long been regarded as bottlenecks in asset transfers. While transactions can be completed almost instantly, reassigning ownership often takes a while. On the blockchain, the process happens automatically and can be completed in minutes.

uptime

The uptime of existing financial markets is somewhat limited. There are fixed opening hours each week and are closed on weekends. On the other hand, the digital asset market is active from morning to night.

Divisibility

Art, real estate, and other high-value assets, once tokenized, can become available to investors who would otherwise not be able to invest. For example, we could tokenize a painting worth $5 million into 5,000 pieces, so that each piece is worth $1,000. This greatly improves accessibility while bringing a higher level of investment granularity.

However, it is worth noting that certain security tokens may have restrictions on divisibility. In some cases, where voting rights or dividends are granted entirely in the form of equity shares, there may be restrictions on the divisibility of tokens for enforcement purposes.

Security Tokens vs. Utility Tokens – What’s the Difference?

Security tokens have many similarities with utility tokens. Technically speaking, the release content of both sets of products is the same. They are managed by smart contracts and can be sent to a blockchain address and traded on an exchange or via peer-to-peer transactions.

They differ primarily in their economics and the regulations that support them. They can be issued through an Initial Coin Offering (ICO) or an Initial Exchange Offering (IEO), which allows new startups or established projects to crowdfund funds to grow their ecosystem.

By donating funds, users receive these digital tokens, enabling them to join the project's network (immediately or in the future). They can grant holders stock rights, or serve as an agreed-upon currency to acquire products or services.

Utility tokens have no value in themselves. If a project develops successfully, investors cannot obtain part of the profits like traditional securities. We can compare the role of tokens to membership points. They can be used to buy goods (or sell them), but they provide no interest in the distribution business.

Therefore, their value is often driven by speculation. Many investors will buy tokens in the hope that their prices will increase as the ecosystem develops. If the project fails, there is almost no protection for the holder.

Security tokens are issued in a manner similar to utility tokens, although their distribution event is called a security token offering (STO). However, from an investment perspective, the two tokens represent very different instruments.

Even though they are issued on the blockchain, security tokens are still securities. Therefore, they are strictly regulated to protect investors and avoid incidents of fraud. In this regard, STO is more similar to IPO than ICO.

Typically, when investors purchase security tokens, they are purchasing stocks, bonds, or derivatives. Their tokens effectively function as investment contracts, guaranteeing ownership of off-chain assets.

What makes a token a security?

Currently, the blockchain industry still lacks much-needed legal clarity. Regulators around the world continue to catch up with new financial technologies.In some cases, issuers believed they were issuing utility tokens, but those tokens were later deemed securities by the U.S. Securities and Exchange Commission (SEC).

Perhaps the most famous indicator for trying to determine whether a transaction amounts to an "investment contract" is the Howey test.

Security tokens and programmable finance

Given the size of today’s market, tokenization has the potential to fundamentally change the traditional financial sector. Investors and institutions in this area will benefit greatly from fully digital financial instruments.

Over the years, the centralized database ecosystem has generated a lot of friction. Agencies need to dedicate resources to administrative processes to manage external data that is incompatible with their own systems. The lack of industry standards increases costs for businesses and severely delays settlement.

Blockchain is a shared database that any user or business can easily interact with. Functions previously handled by an organization's servers can now be outsourced to ledgers used by other parts of the industry. By tokenizing securities, we can plug them into interoperable networks, allowing for fast settlement and global compatibility.

From there, automation can take care of other time-consuming processes. For example, KYC/AML compliance, investments locked for a fixed time, and many other functions can be handled through code executed on the blockchain.

Summarize

Security tokens seem to be a logical development for the financial industry. However, there is still room for improvement on the regulatory front. Because these assets can be easily moved around the world, authorities must find ways to effectively regulate their issuance and movement.

Some speculate that this could also be automated by coding smart contracts with certain rules. Projects such as Ravencoin, Liquid and Polymath have facilitated the issuance of security tokens.

If the promise of security tokens comes to fruition, the operations of financial institutions could be significantly streamlined. Replacing traditional tools with blockchain-based tokens can effectively catalyze the merger of traditional currency and cryptocurrency markets.