What Is A Security Token & Security Token Offering (STO)?

Traditional real-world assets lack various features such as accessibility, divisibility, and liquidity. For these reasons, these asset classes are unsuitable for short-term trading and have less retail investor participation. 

The buying and selling process involved with illiquid assets like real estate consists of a time-consuming process involving finding a potential buyer or seller within a budget. Then, the buyer or seller needs to go through a lengthy registration process and pay broker fees and other charges. 

Here, security tokens emerge as a smart solution for all these problems with traditional assets. These digital tokens help users reduce the settlement period, increase the liquidity of the assets, and provide improved accessibility.

The involvement of government bodies that follow strict regulatory requirements adds more trust for the token investors. For this reason, the security tokens are expected to achieve a trading volume growth of over $162 trillion by 2030. 

This article breaks down the concept of security tokens and explains what Security Token Offerings (STOs) are.

What Are Security Tokens?

Security tokens are digital assets that represent the ownership of traditional assets such as stocks, real estate, bonds, and more. These tokens are issued on the blockchain through a process known as tokenization. 

Security tokens help remove friction related to the existing capital market, including high transaction time and fees. Moreover, regulatory requirements must be met to create security tokens. 

Converting traditional assets to digital security tokens saves a lot of time and manual effort. The smart contracts help projects execute codes based on the provided set of instructions and conditions automatically.  

Benefits of Security Tokens

Security tokens have various benefits over traditional securities, including the following.

1. Market Access

Investors can buy, sell, or trade their security tokens without bothering about the market timings that existed with traditional markets. 

For example, the trading hours of the world's prominent stock exchanges, the New York Stock Exchange (NYSE) and NASDAQ, are limited between 9:30 a.m. and 4:00 p.m. ET from Monday to Friday.

For security tokens, investors can access the market around the clock. Simply put, users can buy or sell security tokens at midnight, on weekends or holidays.

2. Cross-Border Transactions

Security tokens bring global investors under one hood. Therefore, investors who used to own assets that belonged to only their countries can explore other worldwide investment opportunities. 

For example, an investor from a remote Asian village can buy security tokens representing a portion of a residential property in Canada or the USA. As a result, investors now have the freedom to explore tangible assets that had limited investment possibilities previously.

3. Fractional Ownership

Fractional ownership of assets allows users to own a part of valuable asset classes without paying a high price. 

For example, a tokenized painting by a famous painter can be divided into thousands or millions of tokens, making it affordable for retail investors. 

Fractional ownership is not limited to paintings; it can be applied to other high value assets, including precious metals, real estate, or high-cost equities. Here, investors can allocate their small capital to assets that were too expensive before the introduction of asset tokenization and security tokens.

4. Faster Settlement

Assets like stock settlement for U.S. securities take T+1 (trade date plus one day) to transfer securities from the buyer to the seller. For real estate, these settlement processes can take many days or weeks, depending on various market conditions.

However, security tokens offer one of the quickest settlements regarding asset transfer. For example, if you buy a security token, the buyer receives the payment within a few minutes, and you'll have the token details in your crypto wallet.

5. Improved liquidity

Expensive and tangible asset classes like real estate and paintings fall under the category of illiquid assets. For this reason, finding a potential buyer during a bad market condition can be tedious and time-consuming.

Security tokens representing real estate and paintings and fractionalization features improve liquidity. As a result, owners of traditionally illiquid assets can now sell their tokens on marketplaces without seeking buyers.

6. Reduced Intermediaries and Cost

Security tokens allow inventors to own traditional assets without dealing with clearing houses, brokers, or custodians. For example, to buy a digital security token representing a property, the investor doesn't need the service of an agent. 

Eliminating middlemen plays an important role in cost reduction. Now, with security tokens, investors don't need to pay the broker fee, commission, or other service fees for agencies.

Types of Security Tokens

Security tokens are of three types:

1. Asset-backed tokens
2. Equity tokens
3. Debt tokens

1. Asset-Backed Tokens

Asset-backed tokens represent real-world assets like commodities, precious metals, or real estate. The token's price varies in real time based on the asset it represents. 

These security tokens allow investors to diversify their portfolios using multiple asset classes. 

For example, you can split and invest your capital in tokens that represent silver, oil, or gold.

2. Equity Tokens

As the name indicates, equity tokens represent the shares of a publicly listed company. You can buy these security tokens to own a fraction of billion or trillion-dollar-valued companies. 

Here, unlike traditional stock exchanges, your ownership of the assets will be recorded in blockchain as soon as your payment is confirmed. 

Moreover, issuing equity tokens also allows startups to raise funds to expand their business activities.

3. Debt Tokens

Debt tokens are security tokens representing loans that investors provide to a company. Here, the investor receives an interest or dividend equivalent to the amount provided. 

In the case of these tokens, the interest rate, interest payout time, and other related terms and conditions are mutually agreed between the lender and borrower. 

Security token buyers are also privileged to choose security tokens that provide the best interest rate and options, such as daily interest payouts.

Security Tokens vs Utility Tokens

Criteria	Security Tokens	Utility Tokens
Definition	Represent ownership in real-world assets	Provide access to specific platform features
Investment	Expect financial returns tied to asset performance	Derive value from functionality within the platform
Regulation	Subject to securities regulations (STOs)	Regulatory status varies, often in a gray area
Legal Rights	Holders have legal rights, voting, profit-sharing	Provide access rights, limited governance
Stability	Value tends to be more stable and less speculative	Value may be more speculative, subject to market demand
Underlying Asset	Backed by tangible assets with intrinsic value	Derive value from functionality within the platform
Issuance	Involves regulated processes (STOs)	Commonly created through ICOs or TGEs

What are Security Token Offerings (STOs)?

Security token offerings (STOs) involve issuing security tokens to the public. This process is similar to the initial public offerings (IPOs) of the traditional finance world, but instead of stocks, tokens that represent assets are listed on various platforms. 

Earlier initial coin offerings (ICOs) were the popular method for raising capital for crypto projects. Ethereum's ICO in 2014, which raised over $18 million, is a prominent example of how even successful crypto projects depended on ICOs for funding.

The ICO-based funding started to grow exponentially in 2017 and reached its peak of $6,880 million in the first quarter of 2018. Following the rise in immense funding, regulators started to keep a watch on ICOs. 

Rising demand for initial coin offerings led to numerous ICO scams. As per a report by Satis Group LLC in 2018, 80% of ICOs were scams. Following the increase in scam projects, ICO funding went down a slippery slope in the second quarter of 2018.

Considering the scams that led to the loss of investor's funds, regulators planned to launch a secured version of ICOs. Finally, a highly secured token offering, STO, was introduced for the investors. 

What Is Deemed A Security? The Howey Test Explained

Security tokens are the product of tokenizing securities on the blockchain. But what do you consider a security in the first place?

The question of whether an asset qualifies as a security is typically addressed using a set of legal tests and criteria, particularly in the United States under the Securities Act of 1933. The most commonly applied test is the "Howey Test," established by the U.S. Supreme Court in the landmark case of SEC v. W.J. Howey Co. in 1946.

According to the Howey Test, an asset is considered a security if it meets the following criteria:

1. Investment of Money: There is an investment of money or other tangible or definable consideration (such as services or property).
2. Common Enterprise: The investment is made in a "common enterprise." This generally means that the investors' fortunes are tied together or with the promoter’s.
3. Profit Expectation: The investors have an expectation of profits from the investment.
4. Efforts of Others: The profits are expected to come primarily from the efforts of others. This typically means that the investor is relying on the managerial efforts or expertise of a third party, such as a promoter or company.

How Do STOs Work?

STO launch involves various processes that can be broadly classified into 6 phases.

1. Preparation

The initial phase of STOs involves developing ideas and includes selecting underlying assets. At this phase, a core team is placed, and advisors are appointed.

Developing the project's whitepaper begins by defining selected technologies and service providers. Capital needs are calculated and the target investor base is identified.

2. STO Design

In this phase, a corporate finance advisor is appointed to decide the type of security, its structure, offering duration, and token issuance-related valuations. A legal advisor is appointed to deal with investor requirements and other regulatory aspects related to STO.

The lockup periods for the STOs are also decided based on the project's requirements. Along with this, initial documentation including a term sheet has also been prepared.

3. Selection of Technology

Here, the technical team chooses the blockchain platform that suits the project. A technology service provider is onboarded to create the required digital security tokens.

The service provider also provides features for investors to complete their KYC/AML verification process and distribute a portal supporting crypto wallets.

4. Choosing Financial Service Providers

A trusted broker is appointed to handle the sale of securities. Along with that, a custodian is appointed for safekeeping purposes. 

Transfer agents are onboarded to oversee the token issuance. This phase also involves selecting payment providers to support payment-related services while raising the capital.

5. Raising Capital

The project's offering documents are shared with the potential investors for review. Online and marketing activities, including social media campaigns, are used to promote the upcoming STO.

The interested initial investors sign the offering documents and wire money to the issuer. Finally, investors get tokens on their wallets.

6. Token Listing

Token listing is adding tokens to an exchange or trading platform. To do so, the token issuers need to complete documentation with the respective exchanges.

Next, a market maker is appointed to provide liquidity to the listed security tokens, facilitating a smooth trading interface for the investors. The token issuers need to publish reports regularly to update investors about the firm's development.

How To Participate In An STO? A Step-By-Step Guide

Note that the following information (including any examples) are merely for educational and illustration purposes. This is not an endorsement of any security products.

Investing in securities is governed by applicable laws and carries risk. Consult an authorized financial advisor before making investments.

Here’s how you can potentially participate in an STO in four steps.

1. Find the Right STO for You

Explore platforms like STOmarket or Securitize to discover STOs across various industries.

Importantly, don't take shortcuts! Research the STO thoroughly:

• Project Details: Read the whitepaper to understand the project's goals, the underlying asset, and the token's utility.
• Team Expertise: Research the team's background and experience in relevant fields.
• Token Economics: Analyze the token supply, distribution model, and potential returns.
• Underlying Asset: For asset-backed tokens, understand the asset's value and potential risks.
• Seek Guidance: Consider consulting a financial advisor with expertise in STOs for a second opinion.

2. Register on a Regulated Platform

Look for a platform with a good reputation and that holds the STO you're interested in. A website like The Tokenizer can help you put together a list of security token issuance platforms.

Once you’ve found a platform, complete the registration process, providing personal information and agreeing to terms.

KYC (Know Your Customer) and AML (Anti-Money Laundering) checks are mandatory. Be prepared to submit your government ID, proof of address, and other documentation.

3. Fund Your Account

Platforms typically support either fiat currencies (USD, EUR) or cryptocurrencies (ETH, BTC). Check the platform's options before committing.

Transfer the necessary funds into your platform account based on the STO's minimum investment amount.

4. Invest in the STO and Receive Your Tokens

When the STO goes live, use the funds in your account to purchase the desired amount of security tokens.

Once your purchase is successful, the security tokens will be deposited into your platform wallet or a compatible external crypto wallet (like MetaMask).

Key Differences Between STO and ICO

Security token offering (STO) and initial coin offering (ICO) might seem similar, as both are used to raise funds for projects. However, there are major differences between them.

Investor Safety

STOs were introduced to safeguard investors from potential scams from ICOs. Consequently, security token issuers must clearly define every detail related to the token ownership. 

However, ICOs come with greater risk as they lack regulatory oversight. Fake ICO projects creating bogus whitepapers to mill money of investors had become commonplace.

Underlying Asset

It's mandatory for STOs to represent a tangible or intangible asset that holds a real value in the traditional market. Here, the price of these security tokens depends on the value of their related assets in real-time. 

For ICOs, having an underlying asset is not compulsory. For this reason, investors can only rely on the crypto market demand for the price variation of tokens issued on ICOs.

Market Credibility

The involvement of government bodies and related regulations adds a trust factor for STOs. This credibility also attracts more retail and institutional investors. 

ICOs have lost a big part of their credibility during the ICO dip towards the end of 2018. A few good projects, like Ethereum, have been under the ICO success stories, but the numerous ICO-related scams have diminished ICOs' reputations.

Conclusion

Security tokens involve the digitization of real-world assets (securities) with blockchain technology. As a result, investors can own the assets and enjoy the benefits of transparency, fractionalization, and reduced fees, to name a few. 

Additionally, STOs allow global investors to participate in asset classes without any geographical restrictions. Moreover, the compulsory government requirements in security token issuance limit the foul players from entering this investment arena. 

The security tokens evolve with time, and more new asset classes might enter this space soon. Finally, with the introduction of security tokens, investors now have an ocean of regulated investment opportunities.