DeFi explained #2: Security Token
Although security tokens are traditional financial system, they are currently among the most underutilized products of blockchain technology . In this article, we will review the concept of security tokens and security token offerings.
Security Token is creating blockchain-powered fundraising instruments with a regulatory framework.
Examples of securities include stocks, bonds, ETFs, options and futures. Any of these assets can be tokenized to become a security token. In the near future, security tokens could serve as a very viable alternative and competitor to stocks and other traditional securities. That’s maybe the reason why major French banks stay away from crypto-currencies like Bitcoin or Ethereum, but are nevertheless active in the tokenization of financial assets, some example are at the end of this article.
First let introduce a Security, a Security Tokens, and a Security Token Offerings (STO) and it’s difference from Initial Coin Offering (ICO).
Tokenization allows people to be more involved in their personal financial decisions. -@KyleSonlin
Security & Security Tokens
- Security relates to a financial instrument or financial asset that can be traded in the open market, e.g., a stock, bond, options contract, or shares. The four types of security are debt, equity, derivative, and hybrid securities.
- Security tokens relate to digital assets registered on a blockchain and qualifying as financial instruments. What makes these assets ‘securities’ is that they’re regulated, with governing bodies across the world controlling how they can be issued, managed, and exchanged.
Security tokens, in addition to financial security, utilise the speed and efficiency of blockchain technology while benefiting from regulatory measures by governments. Due to the nature of the transaction, the regulation exists to guarantee user funds and investments and to hold founders responsible.
Accordingly, the Howey four-prong test to be used in determining if an asset is a security:
- Was there an investment of money?
- Was the money invested in a common enterprise?
- Was there an expectation of profit?
- Are the profits solely from the efforts of the promoter or a third party?
Security tokens are further divided into:
- Debt Token. These tokens are similar to bonds issued by companies when they want to raise funds through debt. It represents short-term loans with predefined interest rates.
- Equity tokens: These are similar to traditional stocks in form and operation except that ownership and transference happen digitally. Investors are entitled to dividends from managerial and issuer actions and decisions.
- Asset-backed tokens: These are backed by real-world real estate, art, carbon credits, or commodities as underlying value. They carry characteristics of gold, silver, oil, etc. They are tradable, etc.
People who own security tokens can benefit from the performance of the token and sometimes also earn profits through dividends in the form of additional tokens. They often get other benefits such as voting power. In this way, security token holders can enjoy the same benefits as stocks and other securities. One of the most well-known security tokens is Blockchain Capital (BCap).
They are issued through Security Token Offering (STOs)
Security Token Offering (STOs) and Initial Coins Offering (ICOs)
Security Token Offerings (STOs) is a fundraising operation in crypto currency. It combines the technology of blockchain with the requirements of regulated securities markets to support liquidity of assets and wider availability of finance.
Their applications include where investors need instant settlement, transparency in management, divisibility of assets, etc.
Thus, the main difference between ICOs and STOs comes down to the rights attached to the tokens issued: ICOs confer usage rights while STOs confer financial and/or political rights in the issuing company. STOs by issuing security tokens, attached tokens which give political and financial rights. And ICOs by issuing utility tokens are a way for startups related to blockchain to raise funds. Utility tokens represent a right to use the product or service to be developed.
ICOs are carried out directly through smart contracts, whereas STOs are carried out in practice on specialized platforms that are subject to regulation because the tokens issued are similar to financial securities.
STOs bring the best of both worlds — the ease of fund raising associated with the ICOs and the fool-proof mechanisms associated with the traditional markets.
Benefits of Security Tokens
But what exactly are the advantages of security tokens compared to classical securities?
Liquidity:
With Security Tokens enabling fractional ownership and thereby lowering minimum investments, more liquidity will come into the market. Meaning that trades can settle in minutes rather than days, removing the illiquidity discount. For example, if an owner of an expensive piece of property or a rare piece of art wants to turn it into cash, it will be much more likely to find investors who want to lay claim to just a fraction of it, rather than the entire asset.
That the Security Token world does not know weekends or opening times is another advantage over the traditional financial system — allowing all participants 24/7 global access in the Security Token market, which will provide even more liquidity to the market.
Efficiency & Scalability:
Blockchain technology with smart contracts have the potential to replace many of the current inefficiencies in the financial industry. By reducing costs by removing third parts of the back office banks still need, by automating KYC and AML process, by reducing complexity and paperwork with managing securities, by decreasing the reliance on lawyers (in the long-run) due to the use of smart contracts ect.
Transparency:
It becomes the perfect infrastructure to document ownership of securities in a fully transparent way. This will make reporting and auditing much easier which will help to prevent fraud, mispricing, arbitrage, manipulation by financial institutions and corruption.
Security tokens initiatives by big financial institutions
BTG Pactual, the largest investment bank in Latin America was the first investment bank to officially launch a Security Token Offering (STO) on Ethereum of more than $3 million in 2019.
While major French banks remain aloof from crypto-currencies like Bitcoin or Ethereum, they are nonetheless active in tokenization of financial assets.
BNP Paribas in a press release dated July 12 2022, presented its collaboration with EDF ENR in the first tokenization of a bond for a renewable energy project. For this project, BNP Paribas structured, tokenized and distributed a bond intended to finance a solar energy project carried out by EDF through its subsidiary EDF ENR.
For BNP, as for its competitors, the challenge is to enable its institutional clients to store, issue and settle digital securities alongside their traditional assets in a secure, compliant and scalable manner.
If you like this article, check this article on tokenisation and social development https://naomiehalioua.medium.com/how-can-tokenization-power-sustainable-and-social-development-a611a61f0bf7
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