The advent of Bitcoin in 2009 made Blockchain mainstream. While crypto and other blockchain-related finance has earned a reputation for being volatile and speculative, there is broad consensus on the value of blockchain technology and other forms of distributed ledger technology in finance.

Major banking and technology institutions such as JP Morgan, Square and Facebook have entered the blockchain space. This year, we will see more names as blockchain begins to play an increasing role in payment systems, including CBDCs and stablecoins, and the liquidity context, through asset tokenization through security token offerings.

The word ‘tokens’ immediately conjures up thoughts about ICOs, a method of raising capital for cryptocurrency projects and popularized in 2017, which is where we’ll start.

What is an Initial Coin Offering (ICO)?

ICO, short for initial coin offering, is similar in concept to initial public offering (IPO) as both allow startups and entrepreneurs to raise funds. While bonds are issued in exchange for investing in an IPO, coins or tokens are offered to investors in ICOs.

The process by which a company ICOs is easy, but the lack of worldwide regulation around ICOs has led to fraudulent crowd sales, illegal airdrops and direct scams. The ICO craze in 2017 tarnished the reputation of blockchain and tokens for a brief period.

But during these turbulent times, blockchain’s utility as a transformative technology remained strong. The distributed ledger and blockchain industry has remained low, looking for a better combination of technological benefits to bring new methods and value to collateralized financial product offerings. The confluence of these two brought together innovative tokens in the form of a “security token”.

What is a security token?

A security token is a unique token issued on a permissioned or permissioned blockchain, representing a stake in an asset that has some sort of collateral, for example; Stocks, bonds and other financial products.

What are the uses of a security token?

A company that wants to distribute shares to investors can use a security token that offers the same benefits you would expect from traditional bonds, such as stock, voting rights, and dividends. As the technology that underpins the securities tokens is blockchain, the advantages are numerous.

Transparency

On a blockchain network, everything is auditable, including sometimes the identities of participants. Everyone can view the ledger to track possessions and issuance of specific fungible and non-fungible tokens.

instant settlement

Clearing and settlements are a central concern of investors looking to transfer assets. Although negotiations are carried out quickly, the reassignment of ownership can take days. In a public ledger, the process is automated and fast.

Availability

Existing financial markets run according to their schedules—typically only during business hours as manual effort is required, and only for a fixed period of time. A market running on a blockchain network, on the other hand, is active all the time, regardless of the time of day.

Divisibility

Asset tokenization opens up a plethora of investment opportunities for everyone from large Wall Street-backed hedge funds to retail investors trading on the secondary market. For example, a Picasso artwork worth $10 million can be converted into 10,000 fractions — so each piece is worth $1,000. Tokenization democratizes access to assets and offers superior levels of accessibility and decentrality.

What is a security token offering?

To better understand STOs and why we need them, we must first understand why ICOs have been seen as a stain on the overall picture of the blockchain industry.

From 2016 to 2018, ICOs were in demand — and investors didn’t mind pouring their money into this new form of fundraising. In the first quarter of 2018, more than $6.3 billion in capital was locked up in ICOs. The expectation was that these investments would appreciate in value over time. However, the bubble burst in the fourth quarter of 2018, when the “market cap” of all cryptocurrencies dropped by more than $750 billion. The United States Securities and Exchange Commission (SEC) was still timid in implementing regulation on token offerings.

Soon after, regulatory bodies began to make announcements on the subject of compliance. Most notable from SEC chief Jayy Clayton: He declared all ICO titles; Swiss FINMA also issued guidelines classifying tokens, under existing legislation, as securities. These and other pronouncements about ICOs have prompted many blockchain founders to protest; they claimed that their projects offered utility tokens and were not bonds. The regulatory shadow that hung over ICOs drove entrepreneurs and investors away from the market.

Regulators today want token offerings to remain compliant with existing securities laws and rules — hence, the Security Token offering was born. The STO is very similar to the ICO, and complies with the securities legislation of places where the token is being offered for investment. As STOs comply with related laws and rules, they create additional legal obligations for issuing these offerings.

*The first company to offer an STO was the US-based Praetorian Group, which registered the platform on March 6, 2018 with the SEC. The platform is listed as a tokenized real estate investment platform.

Types of security tokens

Three different categories of security tokens are available on the market:

equity tokens

An equity token is similar to traditional stock, except for the way ownership is registered and transferred. Traditionally, stock tracking is recorded in a database, with stock ownership printed and certified on paper certificates. Instead, an equity token is registered on the blockchain (an immutable ledger) kept up-to-date by tens, hundreds, or sometimes even thousands of networked computers around the world. Share token holders are entitled to a share of the company’s profit and are entitled to vote. Equity tokens offer three main benefits for a company’s decision making, financial outlook and regulatory frameworks:

Investors can participate in the vote respecting securities laws.

Startups have access to new and potentially more democratized fundraising models.

Regulators have a new, more transparent framework for evaluating a project’s fundraising.

debt tokens

A debt token represents a short-term loan at an interest rate, in the amount given by investors as a loan to a company — it could be real estate mortgages, corporate bonds, or another type of structured debt. The price of a debt token is dictated by ‘risk’ and ‘dividend’; this is primarily because an average default risk cannot be priced the same for a real estate mortgage and a bond for a pre-IPO organization. In blockchain terms, a smart contract lives on the network, which represents debt security. In this contract, repayment terms are included, dictating the dividend model and the risk factors of the underlying debt.

Asset-backed tokens

These tokens represent ownership of assets such as real estate, art, carbon credits or commodities. Blockchain, being secure, immutable and transparent, allows for a reliable record of transactions; reduces fraud and improves settlement time, thus making it a natural fit for commodity trading. Asset-backed tokens are digital assets with characteristics similar to any commodity such as gold, silver and oil, which in turn add value to these traded tokens.

The emergence of security tokens is not just for revenue liquidity distribution structures, but also opens up several possibilities for investments as well as selling the dividend part of a total equity or just fractions of shares in the secondary market (Exchanges). Sellers or brokers, on the other hand, can group the tokens by voting and sell them smoothly. Decentralized autonomous organizations (DAOs) can even include human shareholders by encoding voting choices in their smart contracts. The possibilities are limited only to the imagination.

But, it should be kept in mind that STO is still a relatively new concept as the infrastructure around these tokens is still in its infancy.