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Blockchain Explained

What Is a Security Token? A Comprehensive Guide


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Rob Behnke

April 18th, 2024


A security token is a digital representation of real-world assets like real estate, bonds, ETFs, and stocks. 

Moving into 2024-25, tokenization of assets is emerging as a promising narrative welcoming institutional investors, and financial service providers into the space. For example, the world's largest asset management company, BlackRock, recently launched BUIDL, a tokenized fund on the Ethereum network.

In partnership with Securitize, BlackRock uses blockchain technology to implement the tokenization of Real World Assets (RWA). In the process, they aim to provide digital ownership rights across a wide range of asset classes.

“I believe the next generation for markets, the next generation for securities, will be tokenization of securities."

— Larry Fink | CEO, BlackRock

HSBC has also tokenized gold for its retail investors in Hong Kong. The minted HSBC Gold Token is sold to users through their online banking and mobile app. 

Securities tokens blend traditional investment avenues with blockchain innovation, providing a new paradigm for asset ownership.

This article discusses what securities tokens are, and how they are changing the investment landscape. 

What Is a Security Token?

We find security tokens at the intersection of blockchain and financial securities. These digital counterparts (of traditional financial securities) offer a secure and regulated approach to raising capital, while also contributing to the democratization of asset ownership.

Simply put, tokenization involves converting ownership rights or physical assets into unique tokens.

Tokenization

Source: Halborn

Think of a security token as a digital chameleon — a cryptographic token that embodies ownership information of an investment product, all recorded on a blockchain. Using smart contracts, these tokens automate processes and ensure compliance, bringing the future of asset management to your fingertips.

Tokenizing assets provide traditionally illiquid traditional assets like real estate increased liquidity by fractional ownership. For example, a plot worth $100,000 can be distributed in the form of 1,000 security tokens worth $100 each. 

Consequently, more people can afford valuable assets as they can own a small portion with fewer investment funds. Secondary market trading further helps increase the liquidity of high-value assets.

Additionally, security tokens also have benefits such as:

  • Transparency: Blockchain helps to store data on ownership and transaction history, preventing possible foul plays.

  • No Middleman: The removal of traditional brokers from the system allows faster trading and eliminates brokerages.

  • Asset Diversification: Security tokens allow you to buy security tokens from different asset classes to diversify one's portfolio.

  • Low Entry Ticket: As security tokens are minted in large numbers, the price of a single token is affordable for retail investors.

  • 24/7 Market Access: You can buy and sell your security tokens at any point in time, regardless of weekends or public holidays. 

Security token projects in the space include Polymath, tZero, Harbor, and Securitize. These tokens provide legal rights and protections to investors, unlike other tokens.

Purpose of Security Tokens

Security tokens wear multiple hats. Here are a few:

  • Represent legal ownership of a physical or digital asset

  • Democratize ownership through provable provenance and immutability

  • Enhance liquidity of assets through digitization

  • Provide access to a wider range of investors

From real estate to fine art, these tokens are helping create a more inclusive investment landscape.

How Do Security Tokens Work?

Security tokens are created using a smart contract and exist on the deployed blockchain network. The network participants can independently verify the ownership of these tokens to ensure the security, immutability, and transparency of transactions.

Anyone can verify the transaction history of security tokens as they are minted on an immutable public ledger.

The tokenization broadly involves three steps:

  • Selecting the asset

  • Creating the smart contract

  • Issuing the security tokens

1. Asset Selection

The tokenization process is not limited to a specific type of asset. Whether it’s equities, commodities, fine art, or intellectual property, the potential for fractional ownership, enhanced liquidity, and market demand make them suitable candidates for tokenization, especially for traditionally illiquid assets.

2. Smart Contract Creation

Smart contracts are like the architects in the tokenization process. They automate token behavior and compliance checks, making transactions and functions occur without manual intervention. Their programmability ensures adherence to legal regulations and even allows for features such as automated dividend payments.

3. Security Tokens Issuance

Issuing security tokens involves conducting a Security Token Offering (STO) on a blockchain platform, marking the stage where securities morph into digital tokens. This process distinguishes STOs from Initial Coin Offerings, as STOs offer tokens that are subject to securities regulations.

Security Token Offerings (STO) 

Security Token Offerings (STOs) involve selling security tokens to the public through exchanges. Government agencies regulate STOs through securities laws, making them safer for companies to raise investments.

The Initial Coin Offerings (ICOs) boom in 2017 also paved the way for illegal activities that caught the regulator's attention. According to a report by advisory firm Satis Group, 80% of all ICOs in 2017 were scams. 

Considering the possibility of scams, STOs were introduced to protect investors' funds. Therefore, to offer security tokens, it's mandatory to follow securities regulations, documentation, regulatory requirements, and verifications based on the jurisdiction of the listing. 

Additionally, accredited investors must complete their Know Your Customer (KYC) and Anti-Money Laundering (AML) verifications to be eligible to buy security tokens.

Existing securities regulations surrounding security tokens will increase user adoption in the coming years. Moreover, the security token market is expected to reach $3 billion by 2025, with a 56.9% compounded annual growth rate. 

Expected Market Growth Security Token Offerings

Source: CoinDesk

Next, we'll explore the different types of security tokens.

The 3 Types of Security Tokens

Security Tokens can be broken down into three types:

1. Equity Tokens

Equity tokens are the digital representation of stocks of publicly listed companies. This type of token provides the buyer with dividends, ownership, and voting rights.  

Founders can raise funds for their startups by offering equity tokens to the public, making startup investing accessible to individual investors. 

2. Asset-backed Tokens

Asset-backed tokens provide ownership of real-world assets like gold, fine art, real estate, and more. The price of such tokens is determined based on the overall value of the underlying asset.

Here, you can choose the security token that is associated with your favorite asset class. For example, if you believe in investing in commodities, you can buy tokens that represent silver or gold.

3. Debt Tokens

Buying a debt token is similar to providing a short-term loan to an entity. In return, the token holder receives interest in the form of dividends.

Dividends paid to investors depend on the risk. Moreover, lenders and borrowers decide the terms related to the dividend payout rate and duration.

Trading and Secondary Markets for Security Tokens

Trading security tokens opens up a whole new arena in the secondary markets. Various options like DS Swap, Peer-to-Peer (P2P) transactions, or listing on exchanges enable investors to engage in trading activities.


Trading Platforms

Digital platforms have emerged as the new marketplace for trading security tokens and managing digital assets.

These platforms operate in regulated environments, ensuring compliance with authorities, and offer diverse offerings from tokenized versions of traditional financial instruments to making private markets more accessible.

Secondary Market Trading

The secondary market for security tokens offers several benefits:

  • It operates around the clock, providing continuous trading opportunities.

  • It enhances liquidity, making it easier for investors to buy and sell tokens.

  • It enables a seamless and rapid transfer of assets, with transactions settling within minutes.

These advantages make the secondary market an attractive option for investors in security tokens.

How Do Security Tokens Differ from Utility Tokens?

While utility tokens, too, fluctuate in value and are often used as an investment vehicle, they are fundamentally different from security tokens. The table below illustrates the differences across common parameters.

Parameters

Security Tokens

Utility Tokens

Purpose

Backed by real-world assets like real estate, company shares, or bonds.

Offer access to specific services or products within a project's ecosystem, often used for fee payments and feature access.

Ownership

Provide legal rights over real-world assets, often including profit-sharing and voting rights.

Generally do not offer ownership rights over RWAs.

Regulations

Subject to strict legal frameworks in offering STOs, enhancing their security.

Often unregulated, making ICOs/IDOs less secure than STOs.

Market Liquidity

Typically have lower liquidity due to regulations and the nature of the underlying assets.

Usually offer higher liquidity, making them more accessible for trading on various exchanges.

Investor Profile

Attracts traditional investors and those seeking assets tied to real-world value and legal protections.

Appeals to individuals interested in specific blockchain projects and the utility offered within those projects.

Risk Profile

Generally considered lower risk due to regulatory oversight and asset backing. However, it depends on the asset's performance.

Higher risk due to lack of regulation and dependency on the success and adoption of the underlying project.

Usage

Primarily used for investment purposes and as a digital representation of a stake in an asset.

Used within a specific ecosystem, for activities like accessing services, voting on project decisions, or as a medium of exchange.

Compliance Needs

Requires adherence to securities laws, including KYC and AML procedures.

Less stringent compliance requirements, though this can vary based on jurisdiction and specific token characteristics.


Oracle Manipulation: A Critical Threat to Security Token Integrity

Security tokens, due to their inherent reliance on external data feeds for price determination or triggering contract logic, introduce a unique attack surface centered on the trustworthiness of oracles.

Ethereum smart contracts, for example, can't directly fetch external data. Oracles act as intermediaries, with the data pushed onto the blockchain (usually via a transaction from the Oracle provider).

In the case of a centralized price feed oracle, a single, compromised data point from a traditional market API or feed could directly impact the security token's price on the blockchain.

An attacker could target the underlying source of market data rather than the blockchain itself, which would inadvertently reflect on the blockchain.

This is also known as the “Garbage in, garbage out” problem because the output of the smart contract, i.e., the security token price, is only as good as the input from the price feed oracle, which could be corrupted with “garbage data”.

Decentralized oracles can help reduce the risk significantly as the presence of multiple independent oracles would ensure price data is reliable.

Conclusion 

Security tokens offer a new door to retail investors to own a part of expensive assets. The possibility of enabling fractional ownership helps to provide increased liquidity to the underlying assets.

The strict regulatory policies behind the security token offerings also act as a trust factor. Considering all these reasons, these tokens have the potential to increase the participation of retail investors.