Security tokens are unique digital tokens issued on permissioned or permissionless blockchains, representing ownership of external assets or equity in a company. Governments and corporations can issue these tokens, which function similarly to traditional stocks, bonds, and other equity instruments.
What Is a Security Token Offering (STO)?
The emergence of Bitcoin in 2009 brought blockchain technology into the mainstream. Although cryptocurrencies and other blockchain-based fundraising methods initially gained a reputation for volatility and speculation, there is now broad consensus regarding the value of distributed ledger technology in the financial sector.
Major institutions in banking and technology, including JP Morgan, Square, and Facebook, have entered the blockchain space. In the future, we can expect more players to adopt blockchain as it plays an increasingly important role in payment systems—such as CBDCs and stablecoins—and in liquidity contexts through asset tokenization via Security Token Offerings.
The term 'token' often brings to mind Initial Coin Offerings (ICOs), a method popularized in 2017 for raising capital for crypto projects.
What Was an Initial Coin Offering (ICO)?
An ICO, or initial coin offering, shares a conceptual similarity with an Initial Public Offering (IPO), as both allow startups and entrepreneurs to raise funds. While securities are issued in exchange for investment in an IPO, coins or tokens are offered to investors in an ICO.
Although the ICO process is straightforward, the lack of regulatory clarity in the United States and abroad led to widespread fraud, illegal airdrops, and direct scams. The ICO craze of 2017 tarnished the reputation of blockchain and tokens for some time.
Despite this turbulent period, the transformative potential of blockchain technology remained evident. The distributed ledger industry continued to develop, seeking better technological benefits to bring new methods and value to traditional securities. This convergence gave rise to innovative tokens in the form of security tokens.
Understanding Security Tokens
A security token is a unique digital asset issued on a blockchain that represents ownership in an external asset or enterprise. Entities such as governments and corporations can issue security tokens that serve the same purpose as traditional stocks, bonds, and other equity instruments.
Use Cases for Security Tokens
Companies looking to distribute shares to investors can use security tokens, which offer benefits similar to traditional securities, including dividends, profit-sharing, and voting rights. Since security tokens are built on blockchain technology, they offer several significant advantages.
Transparency
On a blockchain network, all transactions are auditable—and in some cases, participant identities are visible. Anyone can review the ledger to track the issuance and ownership of both fungible and non-fungible tokens.
Instant Settlement
Permissions and settlements are major concerns for investors looking to transfer assets. Although trades can be executed quickly, the transfer of ownership can sometimes take days. On a public ledger, this process is automated and near-instantaneous.
Availability
Traditional financial markets operate on a schedule—typically only during business hours, due to manual processing requirements. In contrast, markets operating on blockchain networks are active 24/7, regardless of time zones.
Divisibility
Asset tokenization opens up investment opportunities to a broader audience, from Wall Street-backed hedge funds to retail investors on platforms like Robinhood. For example, a $10 million Picasso painting could be tokenized into 10,000 pieces, with each token worth $1,000. Tokenization democratizes access to assets and offers superior accessibility and flexibility.
A Closer Look at Security Token Offerings (STOs)
To better understand STOs and their importance, it’s helpful to first recognize why ICOs were regarded as a stain on the blockchain industry’s image.
Between 2016 and 2018, ICOs gained immense popularity, and investors were eager to pour money into this new form of fundraising. In Q1 2018, over $6.3 billion was locked in ICOs. Many expected these investments to grow over time. However, the bubble burst in Q4 2018 when the total "market cap" of all cryptocurrencies fell by more than $750 billion. The U.S. Securities and Exchange Commission (SEC) was initially hesitant to apply regulations around token offerings.
Soon after, regulatory bodies began issuing compliance guidelines. Most notably, SEC Chair Jay Clayton stated that all ICOs should be considered securities; Switzerland’s FINMA also released guidance classifying tokens under existing securities laws. These and other statements led many blockchain founders to protest, claiming their projects offered utility tokens rather than securities. The regulatory uncertainty surrounding ICOs drove entrepreneurs and investors away from the market.
Regulators now require token offerings to comply with existing securities laws and regulations—thus, the Security Token Offering (STO) was born. STOs are very similar to ICOs but adhere to securities laws in the jurisdictions where the tokens are offered. Because STOs comply with relevant rules, they create additional legal obligations for issuing equity in a company.
*The first company to offer an STO was the U.S.-based Praetorian Group, which registered its platform with the SEC on March 6, 2018. The platform was registered as a crypto real estate investment platform.
Types of Security Tokens
There are three main categories of security tokens available in the market:
Equity Tokens
Equity tokens are similar to traditional stocks, differing primarily in how ownership is recorded and transferred. Traditionally, share ownership is tracked in a database, with stock ownership printed and certified on paper certificates. In contrast, equity tokens are recorded on an immutable, continuously updated ledger maintained by dozens, hundreds, or even thousands of computers connected to a global network.
Holders of equity tokens are entitled to a share of the company’s profits and often have voting rights. Equity tokens offer three main benefits for corporate decision-making, financial oversight, and regulatory frameworks:
- Investors can participate in voting while remaining compliant with securities laws.
- Startups gain access to a new and potentially more democratic fundraising model.
- Regulators have a newer, more transparent framework for evaluating project fundraising.
Debt Tokens
Debt tokens represent short-term loans with interest rates. These are amounts lent by investors to companies and can include property mortgages, corporate bonds, or other structured debt instruments. The price of a debt token is determined by 'risk' and 'dividend' factors—mainly because medium default risk cannot be priced the same for a property mortgage and a pre-IPO bond.
In the context of blockchain, a smart contract on the network represents the debt security. This contract includes repayment terms, specifying dividend models and risk factors associated with the underlying debt.
Asset-Backed Tokens
These tokens represent ownership of tangible assets such as real estate, art, carbon credits, or commodities. Blockchain’s secure, immutable, and transparent nature enables trustworthy transaction records—reducing fraud and improving settlement times, making it a natural fit for commodity trading.
Asset-backed tokens are digital assets with characteristics similar to commodities like gold, silver, and oil, which in turn provide value to the tokens being traded.
The Growth and Future of STOs and STO Platforms
Blockchain’s value lies in its permanence, security, and transparency—each crucial for market confidence, trust, security, efficiency, and overall health. These attributes are already being incorporated into new standards for public securities offerings because the benefits are vast, and importantly, the infrastructure is already available.
In 2020, the market capitalization of security tokens grew by 500%, reaching $449 million. In January 2021 alone, security token infrastructure companies raised over $30 million in capital. In another report, Plutoneo predicted an 85% compound annual growth rate (CAGR) in the European token market from 2018 to 2024.
On the institutional side, the STO market has seen significant activity, including the launch of 1X, the World Bank’s $33.8 million Bond-i issuance, a $20 million tokenized bond transaction by Santander, and a collaboration between Allinfra and Asia’s largest REIT, Link REIT.
The emergence of security tokens goes beyond liquidity and revenue distribution frameworks. Instead, security tokens open up a wide range of investment possibilities. Retail investors in certain security tokens can sell dividend shares of full or fractional equity interests on secondary markets. Brokers, on the other hand, can bundle voting security tokens and sell them seamlessly.
Decentralized Autonomous Organizations (DAOs) can include human shareholders who encode voting preferences into their smart contracts. The possibilities are limited only by the imagination.
It is important to remember, however, that STOs are still a relatively new concept, and the infrastructure around security tokens is in its early stages. Nevertheless, security tokens are here to stay, and more are undoubtedly on the way. As blockchain technology continues to revolutionize the financial space, the STO market is certainly one to watch in the coming years.
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Frequently Asked Questions
What is the main difference between an ICO and an STO?
ICOs are generally unregulated and offer utility tokens, while STOs are regulated and represent ownership in an asset or company, complying with securities laws. STOs provide investors with legal protections and rights that ICOs typically do not.
Are security tokens tradeable on public exchanges?
Yes, security tokens can be traded on regulated security token exchanges. These platforms operate in compliance with financial regulations, providing liquidity while ensuring investor protection and legal compliance.
What kinds of assets can be tokenized?
Virtually any asset of value can be tokenized, including real estate, company shares, bonds, commodities, fine art, and even intellectual property. Tokenization democratizes access by allowing fractional ownership of high-value assets.
How do security tokens benefit investors?
Security tokens offer increased liquidity, fractional ownership opportunities, transparency through blockchain record-keeping, and faster settlement times. They also provide legal rights and protections akin to traditional securities.
Do security tokens pay dividends?
Yes, many security tokens are designed to pay dividends or distribute profits to token holders. These distributions are often automated via smart contracts, ensuring timely and transparent payments.
What regulatory bodies oversee security tokens?
In the United States, the SEC regulates security tokens under existing securities laws. Other countries have their own regulatory bodies, such as the FCA in the UK and FINMA in Switzerland, which apply local securities regulations to tokenized assets.