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A security is a financial instrument that has value and can be traded. According to this concept, many of the instruments we see today, such as stocks, bonds, and options, can be regarded as securities.
From a legal perspective, securities encompass a smaller scope and vary across jurisdictions. According to the standards of some countries, security-type instruments are subject to strict supervisory review.
In this article, we explore how blockchain technology can simplify long-standing financial markets with security tokens.
A security token is a token issued on the blockchain that represents shares in some external companies or assets. It can be issued by entities such as enterprises or governments, and has the same function as stocks, bonds and other similar products.
Let’s look at an example of a company looking to tokenize shares for investors. These tokens are designed to bring the same benefits as shares, especially voting rights and dividends.
This approach has many advantages. Like cryptocurrencies and other forms of tokens, security tokens benefit from the characteristics of the blockchain on which they reside. These features include transparency, fast settlement, 24-hour trading, and divisible trading units.
The public ledger does not provide the specific identity of the participants, but everything is open to review. Smart contracts are visible to everyone and are used to manage tokens or track token issuance and holding status.
When it comes to asset transfer, clearing and settlement have always been a difficult problem. While transactions can be executed almost immediately, redistributing ownership takes time. On the blockchain, this process can be completed automatically in an instant.
The current financial market has restrictions on operating hours. Open during fixed times on weekdays and closed on weekends. On the other hand, the digital asset market has opened up a new model of round-the-clock trading.
Art, real estate, and other high-value assets, once tokenized, will be open to investors who would otherwise be unable to invest. For example, we have a painting worth $5 million that can be tokenized into 5,000 copies, each worth $1,000. This will significantly increase the success rate and also improve the granularity of investment.
However, it is worth noting that some security tokens may have restrictions on the division of tokens. In some cases, if voting rights or dividend rights are treated as ordinary shares, the division of tokens may be restricted for the sake of enforcement convenience.
Security tokens and utility tokens have many similarities. Strictly speaking, both tokens are issued in exactly the same way. All are managed by smart contracts and can be sent to blockchain addresses and traded on trading platforms or through peer-to-peer transactions.
They differ mainly in the economic and management pillars. They can be issued in an Initial Coin Offering (ICO) or in an Initial Exchange Offering (IEO), allowing startups or startup projects to crowdfund the development of their ecosystem.
Users obtain these digital tokens by providing funds to participate in the project network (either immediately or later). These tokens give holders the right to vote, or serve as protocol-specific currency to purchase products or services.
Utility tokens are inherently valueless. If a project develops successfully, investors do not receive a portion of the profits as in traditional securities. Tokens work somewhat similarly to loyalty points. They can be used to purchase products (or sell them), but do not provide an interest in the company offering the token during the transaction.
As a result, its price is often subject to speculation. Many investors will buy tokens in the hope that their value will increase as the ecosystem grows. There is a lack of protection for holders if the project fails.
Although the distribution of security tokens is based on the Security Token Offering (STO), its issuance method is similar to that of utility tokens. But from an investment perspective, the two types of tokens represent completely different financial instruments.
Even if security tokens are issued on the blockchain, they are still securities. It is therefore strictly regulated to protect investors and prevent fraud. In this regard, a security token offering (STO) is closer to an initial public offering (IPO) than an initial coin offering (ICO).
Generally, when investors purchase security tokens, they buy stocks, bonds or derivative financial products. Their tokens function as investment contracts and ensure ownership of off-chain assets.
In fact, the blockchain industry lacks some legal aspects Much needed clarification. Regulators around the world are still catching up with new fintech trends. There are still issuers who believe they can issue utility tokens that will eventually become securities approved by the Securities and Exchange Commission (SEC).
Perhaps the best-known standard for trying to determine whether a transaction qualifies as an "investment contract" is the Howey test. In short, it seeks to determine whether an individual investing in an ordinary business can expect to receive the same returns as an advocate (or third party).
Long before the emergence of blockchain technology, this test originated from the US courts. Therefore, it is difficult to apply it to a large number of new tokens. Still, the test is a popular tool for regulators trying to classify digital assets.
Of course, each jurisdiction will adopt a different framework, but many areas follow a similar logic.
Given the current market size, tokenization can Revolutionize the traditional financial sector. Investors and institutions in this space benefit greatly from sophisticated digital approaches to financial instruments.
Over the past few years, the centralized database ecosystem has created a lot of friction. Organizations need to find ways to optimize business processes and manage external data that is incompatible with their own systems. The lack of industry-wide standards increases the cost of enterprises and greatly delays settlement time.
Blockchain is a shared database that any user or business can easily interact with. Functions that used to be handled by institutional servers are now outsourced to ledgers used by other peers. By tokenizing securities, we are able to embed them into interoperable networks that enable rapid settlement and global compatibility.
Since then, automation can handle what would otherwise be a time-consuming process. For example, identity verification (KYC)/anti-money laundering (AML) compliance, locking investments for set fixed periods, and many other functions are handled by code running on the blockchain.
To learn more about this topic, please read the article How Blockchain Technology Impacts the Banking Industry.
Security tokens seem to have become an inevitable development trend in the financial industry. Although they use blockchain technology, they are closer to traditional securities than cryptocurrencies or even other tokens.
However, regulatory authorities still have a lot of work to do. For such assets that can be easily transferred around the world, authoritative institutions must find ways to effectively supervise their issuance and circulation. Some have speculated that security tokens could also be automatically paired with smart contracts, encoding certain deterministic rules. Projects such as Ravencoin, Liquid and Polymath are already promoting the issuance of security tokens.
If the promise of security tokens is truly realized, the operations of financial institutions will be greatly simplified. Finally, the use of blockchain-issued tokens instead of traditional instruments can well facilitate the integration of asset and cryptocurrency markets.