What are security tokens and Security Token Offerings (STOs)?

Security tokens are digital equivalents of securities, certifying ownership and giving holders the right to pursue their investment interests (rights to shares, dividends, a share of profits, and so on). These rights are recorded in a smart contract, and the tokens themselves are traded on exchanges. Their circulation follows the legal norms of financial regulators in various countries, such as the U.S. Securities and Exchange Commission (SEC) or the Swiss Financial Market Supervisory Authority (FINMA).

Anthony Pompliano, a managing partner at Morgan Creek Capital, in his article “The Official Guide to Tokenized Securities” defines security tokens as “digital assets that are subject to federal securities laws, something between tokens and traditional financial products”. He also describes security tokens as “programmable ownership”, which can extend to any asset—public or private equity, debt, real estate, and so on.

Given their legal characteristics, security tokens are treated very differently from so‑called utility tokens. The latter are popular among ICOs, serving as a means of accessing a company’s product or service. Unlike utility tokens, security tokens are tied to real securities, meaning they are considered investments, and issuing companies face extra regulatory requirements, including disclosure.

Security tokens also address one of ICOs’ biggest problems: the lack of compensation if a project fails or organisers act fraudulently. In addition, they can serve as a risk‑hedging tool in strategies such as the Simple Agreement for Future Tokens (SAFT). This model is considered safer because it lets accredited investors acquire tokens after a project launches, yet risks remain: funds are committed not to tokens but, in effect, to a promise to receive them in future.

A key advantage over traditional financial products is the elimination of intermediaries such as banks and other organisations. That creates a very different environment for investment and dealmaking.

In his article The Security Token Thesis, Stephen McKeon, a finance professor at the University of Oregon and an adviser to Harbor (which raised $28m to build a protocol for issuing and trading security tokens), lists the following key benefits of this asset class:

• 24/7 market access
• Fractional ownership
• Fast settlement
• Lower transaction costs
  Increased market liquidity
• The ability to automate compliance procedures
• Simplified exchange/trading operations for such assets
• The possibility of creating an ecosystem of related services

The stance of America’s SEC has long been central to what should be considered a security. To understand the U.S. regulator’s approach, go back to 1946 in Florida, where a firm called Howey Company, which owned orange groves, offered investors an unusual deal. Buyers would acquire a plot with a grove, and Howey Company gave a clearly drafted undertaking to operate it and pay them a share of the income.

The SEC intervened, deciding the arrangement was an investment contract and that participants should be properly protected. Howey Company challenged the decision, arguing it was merely selling land. The case reached the U.S. Supreme Court, which sided with the Commission, laying the groundwork for defining what counts as a security.

After the company that clashed with the authorities came the Howey Test, under which a transaction is classified as a security if an investor answers “yes” to all four of the following questions:

1. There is an investment of money.
2. There is an expectation of profit.
3. The money is invested in a common enterprise.
4. Any profit and its size depend not on the investor’s efforts but on those of the counterparty or a third party (a promoter).

This is the test the SEC applies today to ICOs and tokens; if the answer to all four is affirmative, the investor is about to invest in security tokens.

By widespread reckoning, the Security Token Offering (STO) is the next evolutionary step after the ICO boom, steering the industry towards a more regulated and transparent market. Yet STOs and ICOs are different fundraising mechanisms for different situations.

Above all, STOs involve issuing digital assets in full compliance with securities law. That should ensure stronger investor protections and lower regulatory risk for token issuers. STOs also target a different audience—only professional (accredited) investors may participate.

Under U.S. law, this category includes persons who meet at least one of the following:

• Annual income of more than $200,000 for an individual or $300,000 for a married couple, maintained over the past two years and expected in the current year in which the person plans to invest;
• Net assets exceeding $1m, excluding the value of a primary residence;
• An organisation with assets over $5m, such as a venture or purpose‑specific fund;
• A company all of whose members are accredited investors.

There are also many technical details that investors need to know to take part in an STO, and organisers to raise funds. In particular, when conducting an STO in the U.S., issuers should take into account the Securities Act of 1933, notably Regulation D, Regulation A+ and Regulation S. These describe different scenarios in which companies may offer securities (security tokens) to investors.

The crypto industry—above all ICOs—is often seen as a kind of Wild West redux, where might and the ability to pull off a scheme prevail. As noted, STOs take much of this out of the grey zone, but that also means the sector forfeits some familiar advantages.

High barrier to entry. Because investing in security tokens is limited to accredited investors, a significant part of the crypto community is automatically excluded, including entirely law‑abiding participants.

Higher costs for issuers. Despite lower transaction costs, launching an STO entails considerable bureaucracy. That means higher spending on lawyers and other specialists to ensure a smooth launch. As a result, given the costs, STOs are better suited to companies at later stages of development (Series A and beyond).

Anthony Pompliano, in his work on security tokens, also suggests that the “flip side of the coin” is that, when the intermediary is removed, its functions shift to buyer and seller. He notes that parties traditionally responsible for preparing marketing materials, attracting investors, ensuring a high level of regulatory compliance and successfully closing deals are excluded from the process. This claim, however, is open to dispute—many companies successfully develop in‑house marketing departments rather than outsourcing such tasks.

For all the promise, investor opportunities remain limited. Big crypto platforms, such as Binance, and major stock exchanges like Nasdaq, have announced plans to work in this area. Yet at the start of 2019 there were very few licensed trading venues offering such instruments.

Among them is tZero, which officially launched in January. The first token to trade on tZero was KODAKCoin, designed for the KODAKOne digital‑images platform. This token allows professional and amateur photographers to receive payment for licensing their work, a share of the platform’s total revenue, and to sell ownership rights to their works using the secure KODAKOne platform.

At the end of 2018, the startup Harbor launched a platform for distributing security tokens, inviting investors to register to buy stakes in The Hub, a residential complex in South Carolina. A total of 955 stakes were offered as security tokens at $21,000 each.

Also worth noting are other startups specialising in technology and financial solutions for this field. Among the creators of the SRC‑20 protocol, regarded as a cryptographic standard for security tokens, liquidity providers and other solution vendors are Brock Pierce’s Blockchain Capital, Polymath, Securitize, Templum, Securrency, OpenFinance Network and Orderbook by Ambisafe.

During 2019, the situation could change substantially, and competition in this market is expected to increase.

Even as some projects still strive to avoid having their tokens classified as securities, the broader trend points that way. Whether that is good or bad has no simple answer.

On the one hand, the arrival of institutional investors—here meaning accredited investors—could transform the industry’s landscape and give it an important boost. On the other, by their nature security tokens are fundamentally different from cryptocurrencies in the usual sense. A sizeable slice of the community flatly refuses to accept the new rules, offering its own solutions based on the Bitcoin blockchain and, not without reason, believing that the future lies with a truly distributed network whose robust security rests on Proof‑of‑Work.

At the same time, players who will continue to adhere to the principles of traditional ICOs should not be discounted. They may move to other jurisdictions, change the rules in places, but will in general keep offering investment opportunities to a broader set of users.

The trend is clear, though the transition will not be simple. Beyond complying with financial regulators’ rules, the sector needs the requisite infrastructure. And that may prove an even harder task than simply buying bitcoin.