Security Token: What is it and is it worth investing in it?

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Securities are a popular instrument of exchange trading. They are well known to many investors, but the current realities require changes. The matters of ownership and increasing the liquidity of securities in the age of cryptocurrencies are developing within new legal and technical contexts.

A Security Token is one of the latest exchange instruments. It is a digital analog of physical securities (stocks, bonds), running on blockchain and representing a smart contract (as a non-fungible token). According to Jay Fraser, Director of Strategy atBSTX, investing in Security Tokens is an investment in the future that everyone should think about.

In this article, Traders Union experts will describe how promising Security Tokens are, where they can be bought, and how to make money on them. We will also talk about the Security Token Offering and explain how Security Tokens compare favorably with Utility Tokens.

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What is a Security Token

A Security Token is a digital analog of a security that, without additional documents and guarantees, certifies ownership and allows the owner to realize their investment interests (the right to sell shares, earn a percentage of the company's profits, and dividends). Legally, a Security Token is a stake in the ownership of a business or financial instrument. Digital counterparts differ from physical securities only in form while fully preserving the main characteristics.

The main feature of a Security Token is that digital securities are created using the blockchain technology, like ordinary cryptocurrency assets, and therefore also have the properties of cryptocurrencies. But these are not the properties of conventional cryptocurrencies like Bitcoin or Ethereum, but non-fungible tokens (NFTs). A Security Token and NFT have in common the fact that both types of assets are smart contracts. A smart contract is a code in a blockchain environment that is a self-executing contract between two parties without involving third parties (banks, or government agencies).

The smart contract itself acts as a guarantor of anonymity and security because it is supported by the decentralized blockchain technology, the operation of which is ensured by the community and does not have supervisory authority. All transactions on the blockchain are anonymous but transparent. A smart contract cannot be forged, altered, or stolen (unless an attacker gains full access to your digital wallet).

Thus, a Security Token exists at the junction of such concepts as "security", "cryptocurrency", and "smart contract". It takes the best of all three assets. Having the key advantages of real shares, the Security Token is a much more reliable, secure, and flexible financial instrument, because it exists on the blockchain network. These tokens are traded in the same way as regular cryptocurrency.

Security Token regulatory aspects

Unlike cryptocurrencies, Security Tokens are legally recognized as securities, so they are regulated by the relevant local and regional financial laws. Examples of such bodies are the U.S. Securities and Exchange Commission (SEC) and the Swiss Financial Market Supervisory Authority (FINMA).

The official generally accepted definition of a Security Token was given by Tony Pompliano of Morgan Creek Capital. In his guide, he states that security tokens are “digital assets subject to federal security regulations. In layman terms, they are the intersection of digital assets (tokens) with traditional financial products — a new technology improving old things.” Speaking about Security Tokens as a right of ownership, Pompliano clarifies that it is not only about shares, bonds, and futures. It is also real estate, private capital, and any monetary obligations.

Why do I need Security Tokens?

Security Tokens, unlike Utility Tokens, which will be discussed below, are linked to real security and are a full-fledged financial instrument, or investment medium. Private and public companies issuing these tokens must comply with additional regulatory requirements, including reporting. Here we need to say a few words about the Initial Coin Offering (ICO) because Security Tokens were created to solve the main problem of this process.

A startup launches an ICO, selling digital tokens for cryptocurrency or fiat money to interested investors. This is how the company receives funding for development, and investors can sell tokens at a better price in the future. This phenomenon is also called “crowdsale”. ICO tokens are used as the internal currency of the project and are actively traded on exchanges.

So, Security Tokens, like ICO tokens, are built on blockchain technology and solve the problem that arises in the event of a project failure. For an ICO, there can be no guarantees of compensation of invested funds: if the startup fails, no one will reimburse investors for their invested funds. Security Tokens have such guarantees because they are about digitalization of real assets. Roughly speaking, by owning a Security Token, you own a stake in the company.

For this reason, Security Tokens are often considered a risk-hedging instrument for Simple Agreement on Future Tokens (SAFT). This is one of the most popular investment strategies today. The SAFT model is just related to investing in developing projects using blockchain technology. However, the SAFT assumes investing in future tokens, not current ones (that is, you will receive them later). Of course, some risk always remains, since it cannot be completely excluded under any type of investment.

How does a Security Token work?

Let’s assume that a company issues shares and tokenizes them, basically turning them into an analog of cryptocurrency. The owner of the company's token receives not just a token, but the right to vote and the right to dividends. At the same time, there is no red tape, because the smart contract is stored in your wallet and already includes everything you need to identify you as the owner. All the advantages of Security Tokens follow from the above feature – there is no downtime, asset fragmentation is available, all transactions are executed at maximum speed, and they are strictly transparent.

Downtime is the determination of the state of a certain system during which its features are unavailable. This may be, for example, planned maintenance work or a sudden software failure. For blockchain technology, downtime is impossible.

The advantages of Security Tokens

The key advantage of the Security Token is the absence of a third-party intermediary in the execution of the transaction. In the case of physical assets, there is always an intermediary, for example, a bank or a regulatory government body. As you can see, we get a fundamentally different environment for investing, one that is faster and more convenient. There are usually other advantages to using Security Tokens:

Transparency and anonymity. All movements of funds under a smart contract are easily tracked, but the identities of the transaction participants cannot be disclosed under any circumstances.

The highest speed of execution. If we consider traditional assets, the clearing and confirmation of a transaction take a lot of time (sometimes days and even weeks). Blockchain technology fully automates the process, so transactions are made within a few seconds, and at most – within a few minutes.

Permanent uptime. In the field of financial markets, uptime is the period of activity of a particular system. Unlike traditional financial institutions, blockchain networks work around the clock without breaks and weekends.

Divisibility. A picture worth 100 thousand dollars can be split into one hundred tokens of 1 thousand dollars each. The divisibility of the Security Token (this property is also called granularity) makes investing more accessible for ordinary market participants with small capital.

Stephen McKeon, professor at the University of Oregon, among the advantages of using Security Tokens, also highlights the reduction of transaction costs to a minimum, increased liquidity and market depth, automated compliance, and the possibility of forming a full-fledged service ecosystem around the token. Given these features, it is easy to understand why businesses today seek to tokenize securities, turning them into Security Tokens.

Security Token and Utility Token: What’s the difference?

At first glance, there is no difference. Both tokens are built on the blockchain; they are smart contracts that can be bought and sold on exchanges and through peer-to-peer networks (P2P). The difference, however, is huge, but it lies not in the technical aspect, but the economic and regulatory field.

So, Utility Token and Security Token are usually launched during the initial offering. However, Utility Tokens will be used as working tokens on the platform in the future, because they are not tokenized securities. Accordingly, they do not give the right to own part of the business and receive dividends. It's like loyalty points, which you can use at a store to pay for part of the purchase, but they have no actual value.

Utility Tokens can only generate income through speculation. They are bought at the start in the hope of selling them at a higher price later if the project is successful and is highly appreciated in the domestic market. This will lead to an increase in the cost of native tokens, so they will be profitable to sell. If something goes wrong with the project, the holder of the Utility Token simply loses their investment, because there are no protection mechanisms or guarantees.

As for Security Tokens, we have already noted that they are the full digital equivalent of real security. That's the difference, and as you can see, it is fundamental. By purchasing a Security Token, you get not only all the advantages of a smart contract but also all the advantages of stocks, bonds, or derivatives regulated by the company in order to protect investors. Owning a Security Token, which can be treated as an investment contract, means you own an off-chain (external) asset. A Utility Token, once again, does not give you ownership or other rights.

Security Tokens and programmable financial instruments

A Security Token acts as a standard of a programmable financial instrument. This concept has no generally accepted definition. Usually, it means not only tokenized assets but also independent instruments like Utility Token with specific factors of market value formation. In one way or another, the digital approach brings companies much more profit, including in the aspect of investment.

The fact is that any company has external databases that are incompatible with their internal systems due to differences in standards. This leads to delays in the execution of transactions and additional costs, which multiply when unification is attempted (which is not always possible). But today, server tasks are easy to outsource, whereas digital assets do not require conventional support (simplification of accounting) and provide absolute compatibility.

The result of the integration of programmable financial instruments into the activities of any company is the automation of transactions and the shortest time of their execution. This is not only the investment itself, as in the case of a Security Token. We are talking about all transactions in general. For example, KYC verification can also be automated and accelerated in this way. This applies to any operation that is processed at the code level. For the same reason, online banking is so advanced today.

What is a Security Token Offering?

We have already mentioned the Initial Coin Offering (ICO). This is when a startup introduces its native token to the market, allowing everyone to invest in the development of the company by purchasing it. However, this concept is mainly used for the issue of Utility Tokens. When Security Tokens enter the market, the process is called the Security Token Offering (STO).

In terms of the mechanism of implementation, there is no difference between STO and ICO. In both cases, the company introduces its token to the market, and investors actively buy it in the hope of future profits. However, in the case of ICO, profit is not guaranteed, and the token itself has no real value. With Security Token Offering, investors are investing not in a token, but a share of profits, dividends, and voting rights. That is, they invest in real stocks or bonds. It is important to understand that ICO tokens are supported only by the interest of the community, and tokens issued as part of the Security Token Offering increase their value as a result of real cash flows (including company profits).

In simple terms, the value of Initial Coin Offering tokens is theoretical, while the value of Security Token Offering tokens is tangible.

The only special aspect is that Initial Coin Offering requires a minimum of documents and there is no need for international regulation at all. Any company can issue such a token without complying with any legislation. Of course, it's very simple. As for Security Token Offering, everything is much more complicated, because these tokens are equated to securities and are necessarily regulated by competent authorities, as well as legal regulations.

What is the future of the Security Token?

At a recent webinar "What it will take to tokenize the securities markets", the speakers outlined an obvious trend – the tokenization of securities markets will only accelerate due to the obvious benefits of this approach. At the same time, many startups (for example, the Swiss STOverse) are already building a bridge between Security Tokens and DeFi.

INX Limited confirmed that the issue of Security tokens led to a steady increase in the value of securities and helped to attract more than $85 million. Dominic Hobson, one of the leading European experts in the field of cryptocurrencies, predicted that in the future there would be only securities issued in the form of tokens. Their number has been constantly growing since 2018, and at the moment, it is no longer even about attracting investors. Security Token markets need traders.

Hundreds more facts and dozens of opinions can be cited. They all confirm one thing – Security Token Offering will soon replace the conventional ICO, and Security Tokens will be issued by all companies wishing to compete in their segment. This is great news for investors because investing in Security Tokens will always be profitable.

Is it worth investing in Security Tokens now?

Definitely. This is not a new market: the tokens have existed in their current form for 4 years. Such a period is more than enough for experts who share one view on the prospects of investing in Security Tokens. Another proof could be the feedback from the investors themselves. You can read them on the Traders Union portal and on large exchanges like Binance that work with Security Tokens.

What are the alternatives to Security Tokens?

The answer to this question is short but important. Security Tokens have no alternative and cannot have one. A Utility Token, which we discussed above, is often compared to a Security Token, but this comparison is incorrect. As you have seen for yourself, there is a fundamental difference between them: Utility Tokens have no inherent value, whereas Security Tokens are valuable because they are real assets. For the same reason, they increase the value of physical stocks and stimulate the securities market.

Where to buy Security Tokens and other digital assets?

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Without considering the economic and legal aspects, these tokens are no different from any other. Consequently, a Security Token of a certain company is traded on the same platforms where other tokens are traded along with Bitcoin, Dogecoin, Ethereum, and other cryptocurrencies. At the same time, even top-level exchanges do not provide access to all types of markets. Therefore, before registering on the platform, you need to see if Security Tokens are present on it.

For example, let's take Binance as one of the industry leaders: the exchange has 350 cryptocurrencies available for trading. Binance also allows you to trade NFTs and Security Tokens. Most of these tokens are developed according to the BEP20 standard. Currently, the Ravencoin, Liquid, and Polymath blockchains are actively used to issue Security Tokens.

Traders Union experts recommend trading Security Tokens on Binance. It is a reliable and trustworthy platform with low trading fees, a variety of instruments, a built-in multicurrency wallet, and a developed blockchain ecosystem that offers many services, including a P2P exchange, a staking platform, and an NFT marketplace.

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Summary

A Security Token is the latest programmable financial instrument that has a stable market. In fact, we are talking about the digitalization of securities, but without replacing the latter. A Security Token acts as the digital equivalent of a real stock, bond, or futures. This is its main advantage – it has all the advantages of cryptocurrencies and all the benefits of securities. For example, it provides the investor with the right to a part of the company's profits, dividends, participation in voting, and other opportunities provided for by the contract.

At the same time, like any token, a Security Token can be bought and sold on cryptocurrency exchanges, while earning on the difference in its value relative to other assets. Since the Security token exists due to blockchain technology in the form of a smart contract, it cannot be changed or stolen (the exception is if a fraudster gets access to a Personal Account on the exchange where you hold these tokens). Smart contracts are transparent but anonymous. They are characterized by the highest speed of execution and the absence of delays and side costs.

No financial expert in the world doubts that Security Tokens are a serious thing that are here for the long haul. So the best time to invest in them is right now. It is quite easy to buy these tokens, for example, on the Binance crypto exchange.

FAQs

What is a Security Token?

It is a tokenized security, for example, a stock or a bond. A Security Token simultaneously has the properties of securities and cryptocurrency tokens. It guarantees the holder the ownership of the original security (not necessarily the entire one, because these tokens have a granularity (divisibility) parameter to engage investors with small capital).

What are the advantages of Security Tokens?

The advantage is that these tokens have tangible value, unlike Utility Tokens. Yes, you can also earn speculatively on them – by buying and then selling at a higher price. But also, tokenized securities provide the owner with the right to vote, a share of profits, dividends, and other opportunities that are specified in the contract.

What is Security Token Offering?

It is a process of introducing Security Tokens to the international market. During an STO, the company offers the opportunity for investors to purchase tokens at face value. If the startup is successful, the cost will only grow further. Unlike an ICO, tokens distributed through an STO are mandatorily regulated as they are securities.

Where can I buy Security Tokens?

There are two options: you can track STO on aggregators or buy already issued Security Tokens on a cryptocurrency exchange. Traders Union experts recommend working with the Binance exchange, as it is a trustworthy platform with low trading fees and many services integrated into its blockchain ecosystem.

Team that worked on the article

Ivan Andriyenko
Author at Traders Union

Ivan Andriyenko is a financial expert and analyst. He specializes in trading in the Forex, stock and cryptocurrency markets. His preferred trading style is conservative strategies with low or medium risk, medium and long-term investments. He has 7 years of experience in the financial markets. Ivan is involved in preparation of articles for novice traders, and also of the reviews and evaluation of brokers, analyzing their reliability, trading conditions and peculiarities.

Ivan continuously tests new strategies for various assets, choosing the most effective options. In addition, he believes that helping novice traders is an important aspect of work. He shares information that beginners require – educational materials, strategies.

Ivan’s motto: continuous studying and experimentation lead to success.

Dr. BJ Johnson
Dr. BJ Johnson
Developmental English Editor

Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.

The topics he covers include trading signals, cryptocurrencies, Forex brokers, stock brokers, expert advisors, binary options. He has also worked on the ratings of brokers and many other materials.

Dr. BJ Johnson’s motto: It always seems impossible until it’s done. You can do it.