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Equity Tokens vs Security Tokens
Learning the differences between equity tokens vs security tokens is a smart way to better your overall crypto investment strategy. While most crypto investors are familiar with traditional utility tokens such as Ethereum, both security, and equity tokens are fairly new to the space. These tokens vary from utility tokens in many different ways.
Protect Your Investment
Different tokens have different legal regulations. Currently, equity, debt, and security tokens fall under standard securities transaction laws, whereas, utility, currency, and asset tokens do not require SEC approval. Let’s take a moment to examine some key differences between equity tokens vs security tokens.
Know the Difference – Security Tokens
According to the SEC, one can perform the “Howey Test” to determine if a token falls under securities regulations. The Howie test is a series of questions that include:
- Did You Invest Money?
- Do You Expect Profit?
- Did You Invest in a Common Enterprise?
- Are Profits dependent on a Third-parties Effort?
If you answer yes to these questions, you are investing in a security token. Security token holders do not have any ownership rights to the entity they invested in. Instead, they are guaranteed a percentage of the profits generated from the entity. Security tokens come in many forms:
- Digital Mutual Funds
- Digital ETFs
- Non-equity Investments Against Capital
Additionally, security tokens cannot be transferred without meeting certain regulations. These regulations include AML and KYC requirements. This makes security tokens less liquidable than their utility token counterparts that can be traded anonymously.
Notable Security Token Platforms
There are a number of notable security token platforms operating in the cryptospace today. Polymath, Securitize, and Harbor are three of the most established platforms available today. Each offers enterprise users an easy option to issue and maintain security tokens.
Security Token Protocols
Security tokens contain their regulatory compliance directly within their protocol. By including these regulations in the tokens smart contract, security token issuers can guarantee their product remains compliant throughout all stages of its lifecycle. Below are the most popular security token protocols currently in use.
ERC-1400 / ERC-1404
The ERC-1400 entered the market in December 2020. This protocol is the brainchild of Polymath’s development team and Stephane Gosselin. Develops knew that if they could utilize a varied ERC-20 protocol that this would allow for the greatest amount of interoperability within the market. The ERC-20 protocol is by far the most widely used utility token issuance standard available.
Stephane Gosselin via SlidesLive
The team sought to create a security token standard that could function on the Ethereum blockchain. Additionally, the team wanted a protocol that contained no partitions. Today, the ERC-1400 standard is used by many firms globally.
ST-20 – Polymath
Polymath took their concept a step further when they created the ST-20 protocol. The ST-20 token standard functions similar to the ERC-1400 but with one main advantage, ST-20 tokens are able to remain compliant when traded on decentralized exchanges (DEX). Polymath proved this theory earlier in the month via a test with the DEX Loopring.
DS-Token – Securitize
The DS-token standard is the brainchild of the popular token issuance platform Securitize. Securitize utilizes a Compliance Service to ensure that their tokens are handled in a legal manner. The tokens must get approval from this on-chain registry to verify investor status before executing any trades. This means all DS-token holders have an identifying hash.
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Secondary market compliance continues to be a hot button topic in the industry. Just this month, the DTCC released a paper outlining how these secondary market concerns need to be addressed to ensure fair market practices. Currently, the DTCC is the third-party custodial exchange for traditional securities markets. The firm replaced the old paper transfer methods used in the 1970s. Last year, the DTCC handled over four-quadrillion in securities transactions in the US alone.
Equity tokens function more like a traditional stock asset. In other words, equity token holders possess some form of ownership in their investments. Their tokens represent how much ownership percentage they actually have. In most instances, equity tokens represent a third-party asset, property, or venture. Equity tokens come in many forms:
- Options Contracts
- Tokenized Real Estate
- Tokenized Ventures
Equity tokens continue to see the most use in real estate crowdfunding platforms such as Atlant. These platforms allow investors to spread their funds more freely across the market. Real estate equity tokens represent a share of ownership in a particular property. This strategy enables investors to join multiple investments with less capital. Additionally, these platforms lower the entry bar for real estate investments and facilitate more market activity.
Equity Tokens vs Security Tokens Standards
Currently, equity tokens share the same protocols as security tokens, but in the near future, you can expect to see equity token specific standards emerge. For the time being, security token protocols can perform all the necessary functions required by equity tokens. Additionally, ERC-based equity tokens gain a bit more interoperability when compared to what a future equity token standard might include.
Notable Equity Token Projects
One of the most publicized equity token projects entered the market in October 2020 under the name Media Shower. The Media Shower platform enables companies to create and issue equity tokens. Speaking on the venture, Media Shower’s CEO, John Hargrave explained how the concept opens the doors for new investment opportunities on all levels.
SEC vs ICO
The SEC started cracking down on the ICO market in 2020 after it revealed that it believed that most offerings were really tokenized securities. Failure to seek SEC approval when dealing with security tokens can result in hefty fines and even jail time. Since that time, there have been multiple highly publicized cases, with many currently underway.
In most instances, the SEC went after these firms for selling securities illegally. Company officials paid fines and were forced to return investors funds. In one instance, a company by the name of Gladius was able to avoid major fines by self-reporting their ICO. Consequently, the firm returned all investor funds as part of the deal.
Equity vs Security Tokens – Brothers from Another Mother
Each token type provides you with a unique investment opportunity. Be sure to consider your options fully. Also, always keep in mind that both equity and security tokens require approval prior to any transactions. These requirements can affect your ability to trade these tokens in the secondary market.
More to Come
For now, the cryptospace continues to grow as the advantages of blockchain technology continue to be better understood by traditional investment firms. You can expect to see more standards and token types emerge as these trends continue.
Stablecoins within Digital Securities
Utility Tokens vs Security Tokens
David Hamilton is a full-time journalist and a long-time bitcoinist. He specializes in writing articles on the blockchain. His articles have been published in multiple bitcoin publications including Bitcoinlightning.com
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What is Equity Crowdfunding?
Equity crowdfunding occurs when private companies raise capital from the public through the sale of securities. These financial instruments can include shares, convertible notes, revenue shares, debts, and tokens. Today, equity crowdfunding is an important part of the global financial markets because it provides SMEs a more cost-effective strategy to raise capital versus traditional IPOs.
Interestingly, equity crowdfunding is a relatively new investment tool. President Obama enabled equity crowdfunding back in 2020 when he signed the JOBS Act, but it wasn’t until the last five years that the practice became popular. One of the reasons it took so long for equity crowdfunding to gain popularity is that it took until May 2020 for key regulations to come into effect.
How Does Equity Crowdfunding Work?
Equity crowdfunding works very similar in function to the popular crowdfunding website, Kickstarter. Basically, investors seek out private firms that meet their criteria. Once a suitable investment is found, an investor visits a funding portal website that gives them access to the opportunity and its details. Here, investors are able to explore different equity crowdfunding investment opportunities for the firm.
Key Differences from Kickstarter
Unlike Kickstarter, investors don’t receive early access to a product or service for their contributions. Instead, investors in equity crowdfunding campaigns seek to make a profit for their participation. In most instances, investors receive shares, rights, and other benefits for their investment.
Kickstarter via Homepage
Different than Stocks
It’s important to understand why equity crowdfunding provides entrepreneurs with different opportunities compared to trading shares on the stock markets. For one, equity crowdfunding firms are private companies and in most instances, startups. In the past, IPOs were the only form of crowdfunding a company could engage in. This practice restricted access to the markets for SMEs for many entrepreneurs.
Many companies simply lacked the funding to cover the huge financial and legal requirements needed to host an Initial Public Offering (IPO). In turn, only the largest firms could generate the funding needed to launch an IPO successfully. Consequently, studies show that IPOs continue to see a decline in use as more affordable options are now available.
Additionally, these practices left investors out of the loop as well. Many IPOs are only open to accredited investors. Accredited investors make at least $200,000 per year, or can show over $1 million in assets. Notably, your assets must exclude your home. As you could imagine, this system left your average investors shut out from the most lucrative investments.
Thanks to the rise of equity crowdfunding platforms, now everyone has access to these valuable opportunities. Prior to the rise in internet crowdfunding platforms, investors were mostly VC and angel investors. These were the only individuals that had the funding to both make a major investment and wait for the mandatory lockup period before receiving returns.
No Lockup Period
Notably, investors that participated in private equity crowdfunding before the 2020 regulations implemented had to wait to access their funds for a designated lockup period, similarly to IPOs. During this time, investors were unable to trade or cash out their investment. This lock-up left investors exposed to major losses. Thankfully, the new regulations opened the door for secondary trading of these financial instruments via Alternative Trading Systems (ATS). In this way, ATS provide much-needed liquidity to the market.
Benefits of Equity Crowdfunding
Aside from the obvious financial gains equity crowdfunding brings to the table, there are plenty of other reasons why a firm would follow this strategy. For one, businesses gain strong brand support from investors. Each investor in your firm acts as a brand ambassador for your company. Since these investors need you to succeed in order to make a profit, they will often diligently spread the word about your business and products.
There are also managerial aspects that make equity crowdfunding a more attractive option to consider. For one, an entrepreneur raising capital via equity crowdfunding has total control over the offering. The entrepreneur can chose the valuation, how much capital to raise, what to sell, how much to sell, and at what price. They can even specify a minimum funding goal to ensure the firm receives enough backing to proceed with its plans. In comparison, a company engaged in an IPO is beholden to its investor’s terms.
Keep it Reasonable
Of course, with all of this flexibility also comes new responsibilities. Only companies that can produce a reasonable valuation and terms see success in the equity crowdfunding space. Investors are looking for great opportunities with minimal risk.
Crowdfunding Regulations and Rules
There are some key requirements a company must first meet prior to launching an equity crowdfunding campaign. First, the firm has to be privately owned and not listed on any stock exchange globally. Secondly, all investors must prove their identity and that they are over the age of 18. Additionally, many equity crowdfunding campaigns include limits on how much capital an individual can invest based on their income and net worth.
Currently, each region has its own equity crowdfunding regulations in place. In the US, there are two main types of equity crowdfunding campaigns – Regulation Crowdfunding and Regulation A+. Both provide SMEs with a more efficient and less-costly alternative than hosting an IPO.
Regulation Crowdfunding allows companies to raise up to $1.07M annually. Currently, these companies can start raising capital for free after filing a Form C with the SEC. Importantly, if the firm seeks to raise more than $107,000, an independent CPA must review the company’s financials for the past two fiscal years.
Regulation A+ companies can raise up to $50M annually. Companies that seek to go this route must first undergo a financial audit for the past two fiscal years. Additionally, they must hire a securities attorney in order to create a Form 1-A. This form must get submitted to the SEC for qualification. Unfortunately, the qualification can take some time to complete. On average it takes 3-5 months at the minimum.
Importantly, companies are unable to raise funds during this time frame, but, they are able to collect investor information to better rate investor excitement levels. This practice is called “testing the waters” and it’s a powerful tool that enables firms to receive valuable market feedback prior to the official launch of their crowdfunding strategy.
What is Real Estate Crowdfunding?
Importantly, equity crowdfunding platforms have given way to a new way to invest in commercial real estate, real estate crowdfunding. Real estate crowdfunding involves a group of investors who each contribute money to a specific real estate deal. Importantly, this strategy lowers the entry bar for investors and provides real estate owners access to global capital. As such, the practice has exploded in popularity in recent years, especially since the introduction of blockchain technology.
How Real Estate Crowdfunding Works
In most real estate crowdfunding transactions, a developer or experienced real estate professional identifies an investment opportunity. This real estate professional may decide that they don’t want to fund the entire project. This decision could be because of a lack of funds or a desire to utilize other peoples funding to complete the project. Either way, the professional would then open the opportunity to investors.
There are three key players in any crowdfunded real estate investment. All crowdfunding real estate ventures begin with the sponsor. The sponsor is the individual or company that identifies, plans, and oversees the investment. Their responsibilities can include purchasing the asset, organizing needed work, arranging the financing, and handling the eventual sale of the property. For their labors, sponsors require a certain share of any profits they earn.
The second key component of any crowdfunding real estate transaction is the platform. Think of these platforms as the middleman between investors and sponsors. Their primary purpose is to link investors and sponsors. As such, they are also responsible for collecting funds from investors. Along with this task comes a host of other responsibilities such as verifying standards, guarantying that investors meet the requirements for investment, advertising deals to potential investors, and dealing with regulatory issues.
StartEngine Equity Crowdfunding via Homepage
The investor is the final piece of the puzzle. An investor trades their funds for some form of income distributions from the profit the property generates. Additionally, they will receive a proportional payout from any eventual profitable sale of the property. In some instances, certain voting rights are a part of the deal. for example, these rights could include whether or not to accept an offer on the property.
Advantages of Crowdfunded Real Estate
There are some major advantages realized through real estate crowdfunding strategies. For one, there is a much higher potential for increased returns when compared to other major asset classes. Additionally, investors gain access to assets that may otherwise be inaccessible to them. A such, crowdfunding real estate is an awesome way to diversify your portfolio.
Importantly, equity crowdfunded real estate platforms usually focus on a specific property. This is opposed to real estate investment trusts (REITs) that can involve billions in properties. Consequently, crowdfunded real estate investors can enjoy the benefits of single-property investments without the financial exposure of actually becoming a landlord. In the end, these investors get the best of both worlds. They receive an income as well as a targeted lump-sum return without major risk exposure.
Top Crowdfunding Websites
Now that you have a firm understanding of what equity crowdfunding is, and how it benefits the entire market, you are ready to explore some of the top platforms providing these services. Importantly, many of these companies now utilize blockchain technology to reduce the overall costs needed to manage and implement their equity crowdfunding concepts.
SeedInvest was founded in 2020 and launched in 2020. The platform is unique in that it has a stricter acceptance policy. Only handpicked start-ups in upcoming future tech industries gain access to this powerful tool. Specifically, a firm needs to deal with blockchain, augmented reality, 3d printing, artificial intelligence, robotics, or space technologies. Importantly, SeedInvest‘s pickiness has paid off as the firm has successfully helped raise money for over 150 companies to date.
The Austin-based crowdfunding platform Microventures entered the market in 2009. The company focuses solely on late-stage companies as part of its niche market. Late Stage companies are firms that are expected to go public within the next couple of years. As such, these companies are usually well-known players in the sector. For example, you can invest in SpaceX, Lyft, Pinterest, and Robinhood via Microventures. Importantly, the company only allows accredited investors to join because each investment ranges from the $5000 to $50000 range.
WeFunder entered the market in 2020. This San-Francisco-based firm originated from the Y Combinator accelerator program. Importantly, the Y Combinator helped launch some of the most successful ventures to date. These ventures include companies such as Coinbase and Airbnb. Also, due to the fact that WeFunder is one of the oldest platforms in the market, the company participated in writing the JOBS Act with the Obama administration.
Fundable entered the market on May 22, 2020, as a rewards-based investment vehicle. Investors would pledge funds in exchange for pre-orders. In 2020, the firm switched over to a true equity crowdfunding strategy. Notably, Fundable’s equity crowdfunding tools are only available to accredited investors at this time.
StartEngine entered the market in 2020 with the goal to provide more flexibility for entrepreneurs in the space. Unlike most of the competition, StartEngine is laxer on what type of firms and investors can utilize its services. As such, investors need to use a little more due diligence when investing on the platform. Importantly, StartEngine showcased its abilities after successfully raising $10M via a self-hosted STO in 2020.
Equity Crowdfunding – The Future is Today
Today, equity crowdfunding is an essential tool used by startups to access capital markets. Consequently, you can expect to see this style of crowdfunding increase in adoption due to its lower costs and more efficient business model. Thankfully, blockchain technology continues to streamline the entire equity crowdfunding process. If the trends continue, equity crowdfunding is set to overtake the stock market as the premier crowdfunding strategy in the coming decades.
What are Digital Assets?
The definition of a digital asset is “anything that exists in binary data which is self-contained, uniquely identifiable, and has a value or ability to use.” When the term originated in the mid-90s, digital assets were items such as videos, images, audio, and documentation. Since then, technological advances have given the term new life.
Enter the Blockchain
Blockchain technology didn’t change the meaning of digital assets, but it did make the term cover a broader range of items. Importantly, many digital assets have the potential to disrupt entire industries and even the global market moving forward. Today, inventions such as cryptocurrencies are part of the digital asset revolution.
Why Did Blockchain Create More Digital Assets?
To understand why digital assets evolved so much, you need to first study why blockchain technology creates new efficiency in the market, and even new markets. Simply put, a blockchain is nothing more than a giant network of computers that simultaneously verifies data on a digital ledger. This network enables data to be stored, unaltered, and verified via code.
The transparency blockchain technology brings to the world is unprecedented. This technology allows people, for the first time in history, to unequivocally prove certain aspects of a digital asset. You can prove items such as ownership, authenticity, transaction history, and location without the need to involve third-parties. As such, blockchain technology ushered back in the age of bilateral exchange.
The ability to erase the middleman comes from blockchain’s programmability. Blockchain digital assets utilize rules that are built into the code of the network, and, or, the token itself. Importantly, these standards receive continuous auditing via the network. This coding has advanced significantly since the emergence of blockchain tech. Today, advanced integrated protocols known as smart contracts are at the core of the digital asset revolution.
Bitcoin – The Code that Changed the World Forever
Bitcoin represented the biggest change to the meaning of the term digital asset to date. This coding was the first time someone attempted to combine cryptography and blockchain technology to create a digital asset successfully. In essence, the Bitcoin whitepaper was the beginning of the digitization of the economy. Discussing the impact of Bitcoin globally, Marc Lowell Andreessen, the father of the internet browser said: “We’ll all look back in 20 years and conclude that bitcoin was as an influential platform for innovation as the internet itself.”
Digital Assets – The Bitcoin Whitepaper
2008 Financial Collapse
To understand the motivation behind the Bitcoin concept, you need to take a look at the economic state of the world in 2008. The international banking system was in the middle of a crisis. In multiple instances, governments and central banks altered regulations to further their debt holding capabilities. It was this perceived instability of fractional-reserve banking that led the anonymous founder of Bitcoin, Satoshi Nakamoto to seek to create a decentralized international economy. This new open market would be free from the stranglehold of government and borders.
Bitcoin – The Start of an Industry
As the Bitcoin concept began to gain international attention, so to did the coin’s value. In less than five years, other developers started to create their own coins. These coins such as Litecoin, Ethereum, and Monero all utilized blockchain technology to secure their value. Although these coins utilized similar technology, each digital asset had a different approach to the market.
For example, Litecoin sought to be the silver to Bitcoin’s gold, whereas Ethereum wanted to provide developers an alternative to Bitcoin’s scripting limitations. Monero took a totally different approach, creating a digital asset that focused primarily on privacy.
Digital Assets as an Asset Class
Today, blockchain technology allows us to tokenize nearly everything we own. Consequently, items that were once non-liquid such as debt can now be traded between anyone, anywhere, in person, or across the internet. This ability to tokenize any item creates entirely new digital asset classes in the market. These new asset classes continue to develop. As such, lawmakers continue to adjust regulations to account for the new efficiency that these services bring.
As the world of digital assets continues to grow, also has the desire for regulators and investors to categorize the different types of tokens in existence. Token taxonomy is the classification of digital assets on the blockchain. Importantly, token taxonomy will play a prominent role in the markets moving forward because the classification of a digital asset determines its issuance and trading capabilities. For example, security tokens must adhere to securities regulations. If not, there are legal repercussions. The three main types of token classifications are:
- Cryptocurrency – This type of digital asset includes traditional cryptocurrencies such as Bitcoin and Litecoin. These tokens usually function as a form of digital cash. As such, they are decentralized and offer a true peer-to-peer exchange protocol.
- Utility Token – This type of digital asset operates within the ecosystem of a platform to derive value and complete various tasks. Importantly, it doesn’t represent any direct ownership or investment in a firm.
- Security Token – Security tokens are any token that by design represents a share of ownership or an investment in a company. Usually, these tokens are found in highly-regulated markets such as real estate, securities, or stock markets.
Tokenization – Changing Markets Forever
Digital assets such as security tokens continue to disrupt the real estate market. For example, platforms such as Red Swan allow property owners to tokenize their real estate. The firm recently partnered with Polymath to tokenize $2.2 billion in commercial property across the US. Tokenized properties offer some huge advantages over traditional real estate sales. For one, the entire sales process is faster and requires less involvement from third-party organizations. Also, tokenized properties can transfer ownership in seconds.
Digital Assets are Everywhere
Today, digital assets are everywhere we look. Every single currency, asset, supply chain, and even reward point has the potential for tokenization. As such, the term digital asset will continue to encompass a growing number of items. For now, tokenization appears to be the path towards the future.
What Are Security Tokens? [The Most Comprehensive Guide]
Go on YouTube right now and search for Security Tokens.
You will probably get results like:
- Why are Security Tokens the future?
- Are Security Tokens the next big thing?
So, it seems like there is a lot of hype behind security tokens nowadays. In this guide, we are going to learn everything about security tokens and see if they are worth your time or not.
Firstly, let’s briefly define security tokens. In a traditional sense, securities can represent an ownership position in a publicly-traded corporation, a creditor relationship with a governmental body/corporation, or rights to ownership as represented by an option. A security token is a tokenized, digital form of these traditional securities. Before we go any deeper, let’s revisit the basics.
What are Tokens?
It can be a little complicated to pinpoint on an exact definition of a “token”. To give you a very wide, non-generalized definition, a token is a representation of something in its particular ecosystem. It could value, stake, voting right, or anything. A token is not limited to one particular role; it can fulfill a lot of roles in its native ecosystem.
Before we go any further, however, we must make one more difference clear. The difference between a cryptocurrency coin and a token.
A cryptocurrency coin, like Bitcoin, Bitcoin Cash, Ethereum, etc. can be is independent of a platform. They can be used as a form of currency outside their native environment. Basically, these are the “cryptocurrencies” that we are all familiar with.
However, on the other hand, OmiseGO, Golem, etc. are examples of tokens which exist on a particular platform, in this case, Ethereum.
A token, represent an asset or utility that a company has and they usually give it away to their investors during a public sale called ICO (Initial Coin Offering).’
What Are ICOs?
ICOs or Initial Coin Offerings are basically crowd sales, the cryptocurrency version of crowdfunding. The ICOs have been truly revolutionary and have managed to accomplish amazing tasks:
- They have provided the simplest path by which DAPP developers can get the required funding for their project.
- Anyone can become invested in a project they are interested in by purchasing the tokens of that particular DAPP and become a part of the project themselves. (We are talking about Work Tokens here).
So, how does an ICO work?
Firstly, the developer issues a limited amount of tokens. By keeping a limited amount of tokens they are ensuring that the tokens itself have a value and the ICO has a goal to aim for. The tokens can either have a static pre-determined price or it may increase or decrease depending on how the crowd sale is going.
The transaction is a pretty simple one. If someone wants to buy the tokens they send a particular amount of ether to the crowd-sale address. When the contract acknowledges that this transaction is done, they receive their corresponding amount of tokens. Since everything on Ethereum is decentralized, an ICO is considered a success if it is properly well-distributed and a majority of its chunk is not owned by one entity.
The recently concluded EOS ICO which raised a whopping 4 billion dollars in a year is till date the biggest ICO ever.
Also, as TechCrunch points out , ICOs delivered at least 3.5x more capital to blockchain startups than Venture Capitals since 2020
How Does a Token Gain Value?
So, before we continue and classify our tokens, let’s look at what functions a token can serve in order to gain value.
As William Mougayar points out in his Medium article , there are three tenets to token value and they are:
These three are locked up in a triangle and they look like this:
Each token role has its own set of features and purpose which are detailed in the following table:
Let’s examine each of the roles that a token can take up:
By taking possession of a particular token, the holder gets a certain amount of rights within the ecosystem. Eg. by having DAO coins in your possession, you could have had voting rights inside the DAO to decide which projects get funding and which don’t.
The tokens create an internal economic system within the confines of the project itself. The tokens can help the buyers and sellers trade value within the ecosystem. This helps people gain rewards upon completion of particular tasks. This creation and maintenance of individual, internal economies are one of the most important tasks of Tokens.
It can also act as a toll gateway in order for you to use certain functionalities of a particular system. Eg. in Golem, you need to have GNT (golem tokens) to gain access to the benefits of the Golem supercomputer.
The token can also enable the holders to enrich the user experience inside the confines of the particular environment. Eg. In Brave (a web browser), holders of BAT (tokens used in Brave) will get the rights to enrich customer experience by using their tokens to add advertisements or other attention based services on the Brave platform.
Can be used as a store of value which can be used to conduct transactions both inside and outside the given ecosystem.
Helps in the equitable distribution of profits or other related financial benefits among investors in a particular project.
So, how does this all help in token valuation?
In order to become more valuable, a token must fulfill more than one of these properties. In fact, more properties that a token can have, higher its valuation
Alright, so now we know what a token is, how a company distributes token and where a token can gain value from.
Before we go any further, it is important to know what the Howey test is.
What is a security token: The Howey Test
In 1946, the Supreme Court handled a monumental case. The case was SEC vs Howey which would lay down the foundation for the, now infamous Howey Test. The case was about establishing a test of whether a particular arrangement involves an investment contract or not.
To keep a long story short, two Florida-based corporate defendants offered real estate contracts for tracts of land with citrus groves. The defendants offered buyers the option of leasing any purchased land back to the defendants, who would then tend to the land, and harvest, pool, and market the citrus. As most of the buyers were not farmers and did not have the agricultural expertise, they were happy to lease the land back to the defendants.
However, this was deemed illegal by the U.S. Securities and Exchange Commission (SEC) and the defendants were promptly sued.
According to the SEC, the defendants broke the law by not filing a securities registration statement. Upon investigating the defendant’s leaseback and finding that it was indeed a security, the Supreme Court made a true landmark decision.
They developed a test which will be used to determine whether a certain transaction is an investment contract or not. If it is, then it will be subject to securities registration requirement.
The said transaction will be called an investment contract if it fulfills the following criteria:
- It is an investment of money
- The investment is in a common enterprise
- There is an expectation of profit from the work of the promoters or the third party.
The term “common enterprise” is open to interpretation. However, many federal courts have defined a common enterprise as a horizontal enterprise where the investors pool in their money and assets to invest in a project.
Even though the original Howey Tests used the term “money”, later cases expanded that to include other investments and assets other than money.
Plus, there is another important thing to consider while determining securities. The profits that come from the investment, is it in the investor’s control or is it completely out of it? If it is not in the investor’s control, then the asset has usually declared a security.
So, how is this relevant for ICO and tokens? If the token meets all the three aforementioned criteria, then it is regarded as a security.
All these three elements have to be met for a coin to classify as security.
Other Alternative Tests
Turns out that the Howey Test is not the only test that courts can use to find out whether a given investment is a security or not.
In 1990, the Supreme Court developed a family resemblance test which provided a way for contract creators to show that their contract has a “family resemblance” to other investments and hence cannot be called securities.
Certain states have their own securities registration requirements which are sometimes called “Blue Sky” laws.
“The first blue sky law was enacted in Kansas in 1911 at the urging of its banking commissioner, Joseph Norman Dolley, and served as a model for similar statutes in other states. Between 1911 and 1933, 47 states adopted blue-sky statutes (Nevada was the lone holdout). Today, the blue sky laws of 40 of the 50 states are patterned after the Uniform Securities Act of 1956. Historically, the federal securities laws and the state blue sky laws complemented and often duplicated one another.”
The DAO and SEC
The Howey Test and securities have become a source of intense debate in the crypto-community after the DAO tokens failed to pass the Howey Test and were deemed securities by the SEC.
This article by Ash Bennington for Coindesk, breaks down why the Dao was deemed a security in the form of a tale:
“Not so long ago, a group of developers started a DAO.
The DAO developers said:
“There are all these decentralized projects and there’s no way for them to get funding – because they need money to make money.”
Tell you what. We’re going to write code and sell a token and, in exchange, people who buy the token will get whatever profits are made from those projects.
We’ll work the code. They’ll pick the projects. The projects will flourish and everyone will profit.
The SEC said: “That’s a security.”
The DAO developers said: “No, no. That’s just selling tokens.”
Ultimately, the SEC said: “That’s a security” – because of the application of the Howey Test: There was an investment of money. And a common enterprise. With the expectation of profit, primarily from the efforts of others.”
So, why was this investigation and ruling done in the first place?
Well, it was because of the infamous DAO hack. We have covered this in detail before, but just to give you an overview :
- There was a flaw in the Dao smart contract
- The hacker exploited that flaw to execute a re-entrancy attack.
- Over $!50 million worth of ether was siphoned away.
Because a lot of people invested and got back nothing in return, the SEC intervened to “protect” the interest of the investors and deemed the tokens a security.
As SEC CEO Jay Clayton puts it , “The SEC is studying the effects of the distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”
This decision was met with mixed reception in the Crypto community:
Brad Garlinghouse, Ripple Ceo, said,
“Regulators aren’t going away – and shouldn’t. For generations, they have protected from fraud (some is happening w/ the ICO market).”
Roger Ver, Bitcoin.com founder, however, disagreed with the decision,
“Call this what it is: A bunch of strangers in a far-off land threatening peaceful people all over the world with violence if they don’t obey.”
Ok, so till now we know what tokens are and what the Howey Testis. So, now let’s get into the two major classifications of tokens.
Types of Tokens
The SEC and FINMA have broken down tokens into two broad categories:
- Utility Tokens
- Security Tokens
Because most of the ICOs are investment opportunities in the company itself, most tokens qualify as securities. However, if the token doesn’t qualify according to the Howey test, then it classifies as utility tokens. These tokens simply provide users with a product and/or service. Think of them like gateway tokens.
As Jeremy Epstein, the CEO of Never Stop Marketing, explains, Utility tokens can:
- Give holders a right to use the network
- Give holders a right to take advantage of the network by voting
Since there is an upper cap on the maximum token availability, the value of the tokens may go up because of the supply-demand equation.
Security Tokens Crypto
Finally, we come to security tokens.
So what exactly are they?
A crypto token that passes the Howey Test is deemed a security token. These usually derive their value from an external, tradable asset. Because the tokens are deemed a security, they are subject to federal securities and regulations. If the ICO doesn’t follow the regulations, then they could be subject to penalties.
However, if all the regulations are properly met, then these tokens have immensely powerful use-cases.
What Regulations Are Security Tokens Subjected to?
Anthony Pompliano does an admirable job of explaining the kind of regulations that security tokens will be subjected to in this article.
According to him, because Security Tokens are subject to federal security regulations, they are compliant from the first day itself. So, in USA, security tokens need to follow these regulations:
- Regulation D
- Regulation A+
- Regulation S
Regulation D will allow a particular offering to avoid being registered by the SEC provided “Form D” has been filled by the creators after the securities have been sold. The individual who is offering this security may solicit offerings from investors in compliance with Section 506C.
So what does Section 506C require?
It requires a verification that the investors are indeed accredited and the information which has been providing during the solicitation is “free from false or misleading statements.
This exemption will allow the creator to offer SEC-approved security to non-accredited investors through a general solicitation for up to $50 million in investment.
In order for the requirement to register the security, the issuance of Regulation A+ can take a lot more time compared to other options. For the same reason, Regulation A+ issuance will be more expensive than any other option.
This happens when a security offering is executed in a country apart from the US and is therefore not subjected to the registration requirement under section 5 of the 1993 Act. The creators are still required to follow the security regulations of the country where they are supposed to be executed.
NOTE: As Anthony Pompliano notes in his article, the above summaries are merely his interpretation. They should not be construed as legal or investment advice and you should consult a lawyer for any and all questions you have.
Why are Security Tokens Important?
Since the assets which are represented by the security tokens already exist in the “real world”, they act like a bridge between legacy finance and the blockchain world. So what are the exact changes that security tokens are bringing along with them?
#1 Bringing Credibility Back
As of right now, the ICO space is a little dicey, to say the least. There is a real deficit of accountability in the space because of a lack of regulation for utility tokens. In order for the ICO space to regain some credibility, it should make sense to somehow amalgamate the crypto space and the legacy finance space together.
#2 Improving Traditional Finance
Traditional financial transactions can be a little expensive because of all the fees associated with the middlemen like bankers. Security tokens remove the need for middlemen which reduces fees. In the future, smart contracts may reduce the complexity, costs, and paper works.
#3 Speeding up Execution
Traditional financial institutions have a lot of middlemen involved which simply increases the execution time. By removing these middlemen, securities allow for faster execution time for the successful issuance of security tokens. Because of this increased speed, the security tokens are bound to become attractive investments.
#4 Exposure to Free Market
Investment transactions today are extremely localized.
What do we mean by that?
Chinese investors find it extremely hard to invest in private US companies and vice-versa. So, how are security tokens going to help here?
Well, by using security tokens, creators can market their deals to anyone on the internet. This exposure to the free market helps in increasing asset valuation. Also, this increased exposure leads to….
#5 Huge Number of Investors
Since creators can now present their deals to anyone on the internet, the investor base increases exponentially.
This is another huge incentive for creators.
#6 Reducing Lawyer Service
In the future, there security token projects will use smart contracts which will automate service provider functions through software. These functions are currently provided by players such as lawyers which add on to the potential middlemen involved in the project.
#7 Lack of Institution Manipulation
Because the number of middlemen decreases drastically, the chances of corruption and manipulation by financial institutions decrease drastically and may even be removed from the investment process.
#8 Easier Liquidation
Secondary trading on security tokens will be made simple through licensed security token trading platforms and it will be extremely easy for investors to liquidate security tokens.
Having said that, not everything is sunshine and rainbows, there are some disadvantages of security tokens.
Do Security Tokens have a Weakness?
The removal of the middlemen is usually seen as a huge advantage. However, you can’t have your cake and eat it as well. There are some disadvantages which will invariably come along with security tokens. Removal of middlemen leads to the shifting of responsibilities onto the buyer or the seller in the transaction.
These middlemen i.e. financial institutions serve a lot of important functions in the ecosystem such deal underwriting, preparation of marketing materials, solicitation of investor interest, insurance of high levels of security, and compliance regulation.
Many critics feel that the creators won’t be able to successfully execute these functions without traditional financial institutions. We need to wait and watch if these fears have any basis or not.
Conclusion: Security Tokens?
The crypto community breath a sigh of relief when SEC has ruled Bitcoin and Ethereum to not be securities. As of right now, security tokens have a far less share of the market as compared to utility tokens, however, security tokens are something which can become huge in 2020 and needs to be embraced by everyone soon. It is believed that tons of capital is going to flow from Wall Street to security tokens instead of utility tokens.
This shift is happening because security tokens are considered to be safer because of the strict regulations.
SPICE Venture Capital founder Carlos Domingo expertly summarized his thoughts of the potential size of the security token market:
“It’s inevitable that security tokens will transform equity just as bitcoin has transformed currency, because they afford the owner a direct, liquid economic interest and the expedited delivery of proceeds. Every type of ownership can be tokenized, which is a massive multi-trillion dollar addressable market.”
What Are Security Tokens & Why Is The Market Bullish About It?
CoinSutra » Cryptocurrency » What Are Security Tokens & Why Is The Market Bullish About It?
Security Tokens can well be the next big megatrend of the blockchain revolution.
Before the security tokens, we have seen the emergence of these trends in the blockchain revolution:
Had you put forth a question related to security tokens to somebody a couple of years ago, I bet there would have been no answer.
That is because no such thing existed then, but if you dig now, you will find a plethora of information on security tokens.
In this article, let’s see what security tokens are and what the buzz is all about.
What Are Security Tokens?
To understand what security tokens are, it is crucial to understand securities.
Securities are tradable financial assets such as bonds, debentures, notes, options, shares (stocks), and warrants. And if we take the example of stocks, you might understand that it is a way to own a part in a company without taking actual possession of it.
Companies and governments use this method to raise money from capital markets from various investors. And then these investors are promised a return back programme in the form of dividends or interest rates or share of company’s profit in some form or other.
When these things are done through a cryptographic token, it is called a ‘Security Token’.
In simpler terms, security tokens are cryptographic tokens that pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders. This takes care of the liquidity issues.
Previously, with traditional paper backed assets like company’s shares or bonds or real estate, liquidity was a problem, but the cryptographic representation of all these things in a token form can take care of that issue.
Imagine, your dividends being paid to you on a specific date upon meeting a certain condition via a smart contract!
All these programmabilities can bring in a lot of automation and swiftness to the whole process because after all, you are creating programmable security. And this type of security can do all things that a traditional form can and more.
Moreover, there is sufficient demand for such type of security tokens because security’s regulations in the respective jurisdictions govern them.
For example, in the US, a litmus test called the ‘Howey Test‘, is employed to judge whether or not the crypto is a security token. Here is what a ‘Howey Test’ is:
The “Howey Test” is a test created by the Supreme Court for determining whether certain transactions qualify as “investment contracts.” If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.
A security is found to exist when all four of these elements exist:
- Investment of money
- In a common enterprise
- With an expectation of profits
- From the efforts of others
Why Is Market Bullish About It?
In my opinion, the market is bullish due to the unlimited use cases that these tokens bring with them. Of course, it is an unchartered territory, but big bankers and institutional investors are betting high on its prospects.
- It brings in the much-needed regulation in the market required for cryptographic tokens.
- As a result, such projects will have more support from the investors and will have their trust.
- This will bring more liquidity to the securities market.
- Will be more cost-effective, secure, & fast in trading.
- Will bring more automation to the securities market where an entire back office can be removed or minimized.
- Lastly, more and more companies want to leverage the power of blockchains, smart contracts in their business which they can surely do through such programmable security tokens
Moreover, this will require the development of a whole new infrastructure for security tokens because the old model is too old now. Securities token will need:
Also, the reason why everyone is bullish is that they can see tremendous opportunity in this space.
Example of some of the SEC regulated ‘security tokens’ that are developing the base infrastructure for the securitization of real-world assets and their liquidity are:
Beware of security tokens that try to act like utility tokens and are unregulated by the SEC.
For this, one needs to understand the difference between a security and a utility token. Therefore, here is our exclusive guide to help you out: Understanding The Difference Between Security Tokens & Utility Tokens.
Stay safe and don’t get caught in trouble in this world of digital money!
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SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities
U.S. Securities Laws May Apply to Offers, Sales, and Trading of Interests in Virtual Organizations
FOR IMMEDIATE RELEASE
Washington D.C., July 25, 2020 —
The Securities and Exchange Commission issued an investigative report today cautioning market participants that offers and sales of digital assets by “virtual” organizations are subject to the requirements of the federal securities laws. Such offers and sales, conducted by organizations using distributed ledger or blockchain technology, have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.
The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws. The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors’ protection.
“The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us,” said SEC Chairman Jay Clayton. “We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”
“Investors need the essential facts behind any investment opportunity so they can make fully informed decisions, and today’s Report confirms that sponsors of offerings conducted through the use of distributed ledger or blockchain technology must comply with the securities laws,” said William Hinman, Director of the Division of Corporation Finance.
The SEC’s Report stems from an inquiry that the agency’s Enforcement Division launched into whether The DAO and associated entities and individuals violated federal securities laws with unregistered offers and sales of DAO Tokens in exchange for “Ether,” a virtual currency. The DAO has been described as a “crowdfunding contract” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.
“The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.
Steven Peikin, Co-Director of the Enforcement Division added, “As the evolution of technology continues to influence how businesses operate and raise capital, market participants must remain cognizant of the application of the federal securities laws.”
In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.
The SEC’s Office of Investor Education and Advocacy today issued an investor bulletin educating investors about ICOs. As discussed in the Report, virtual coins or tokens may be securities and subject to the federal securities laws. The federal securities laws provide disclosure requirements and other important protections of which investors should be aware. In addition, the bulletin reminds investors of red flags of investment fraud, and that new technologies may be used to perpetrate investment schemes that may not comply with the federal securities laws.
The SEC’s investigation in this matter was conducted in the New York office by members of the SEC’s Distributed Ledger Technology Working Group (DLTWG) — Pamela Sawhney, Daphna A. Waxman, and Valerie A. Szczepanik, who heads the DLTWG — with assistance from others in the agency’s Divisions of Corporation Finance, Trading and Markets, and Investment Management. The investigation was supervised by Lara Shalov Mehraban.
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