Security Tokens are referred to as the future form of cryptocurrency. What is security token like? Let's discuss it holistically from the start.
What is a Token?
It's quite complicated to explain the definition of a token. In its general definition, tokens are representations of a particular ecosystem. It can be valuable, betting, in the form of voting rights, or whatever. Tokens are not limited to one particular role, can fulfill many roles in their original ecosystem.
Tokens are different from cryptocurrency coins. Cryptocurrency coins, such as Bitcoin, Bitcoin Cash, Ethereum, etc., can be platform free. They are a form of currency outside their environment. In general, cryptocurrency coins are the most familiar form of cryptocurrency.
However, OmiseGO, Golem, etc., are examples of tokens that are on a particular platform (Ethereum, for example). Tokens represent assets or utilities owned by the company and they usually give them to investors during a public sale called the ICO (Initial Coin Offering).
What is ICO?
ICO or Initial Coin Offering is basically the sale of crowd sales, a crowdfunding version of cryptocurrency. ICO has been truly revolutionary and successfully completed tasks, such as:
ICO has provided the easiest path so that DAPP developers can get the funds needed for their projects.
Anyone can invest in an interesting project by buying tokens from certain DAPP and becoming part of the project (Work Tokens).
So how does ICO work?
First, developers issue a limited number of tokens. By limiting the number of tokens, they make sure that the token has value in accordance with ICO objectives. Tokens can have predetermined static prices or can increase or decrease depending on crowd sale.
The transaction is easy. If you want to buy tokens, you only need to send a certain amount of ether to the address of the crowd sale. When the contract learns that the transaction is complete, they get the appropriate number of tokens. Because everything in Ethereum is decentralized, ICOs are considered successful if distributed well and the majority of chunks are not owned by one entity.
Howey Test
In 1946, the United States Supreme Court handled a monumental case. The case is the SEC against Howey, about making a test that determines whether a particular agreement requires an investment contract or not.
Long story short, two Florida-based corporate defendants offer real estate contracts for land tracts with citrus groves. The defendants offered the buyer the choice by renting land that had been bought back to the defendant, who would then choose the land, then harvest, collect and market oranges. Because most buyers are not farmers and do not have agricultural expertise, they like to rent land back to the defendants.
However, this was considered illegal by the SEC (United States Securities and Exchange Commission) and the defendant was immediately prosecuted. According to the SEC, the defendant violated the law by not filling in the security registration statement. Through a lease back investigation from the defendant, it was determined that this included securities. The US Supreme Court decided correctly.
They develop a test that can determine whether a transaction is an investment contract or not. If so, the transaction will be deemed to require securities registration. Transactions will be called investment contracts if they meet the following criteria:
- is an investment in the form of money
- investment is a public company
- there are expectations of profit from the promoter or third parties
- The term 'public company' has multiple meanings. However, many federal courts define it as a horizontal company where investors collect money and assets to invest in projects. Even though the original Howey Test used the term 'money', the next extended case included investments and assets other than money.
In addition, there are other important things to consider to determine securities. Profit arising from investment, is there investor intervention or not? If no, assets are usually referred to as securities.
So how does this relate to ICO and tokens? If the token meets the three criteria above, it is considered a security.
Other Alternative Tests
It turned out that the Howey Test was not the only test the court could use to determine whether an investment included securities or not. In 1990, the US Supreme Court developed test family resemblance as a way of making contracts showing that their contracts had "family resemblance" to other investments so that they could not be called securities.
Some states have their own securities registration requirements which are often called 'Blue Sky' laws. According to Wikipedia, the 'Blue Sky' law was first enforced in Kansas in 1911 at the urging of its banking commissioner, Joseph Norman Dolley, and became a model for similar laws in other states. Today, the law of 'Sky Blue' from 40 of the 50 countries is patterned after the Uniform Security Act of 1956. Historically, federal securities laws and 'Blue Sky' laws have complemented and duplicated.
DAO and SEC
Howey Tests and securities were a source of debate in the crypto community after the DAO tokens failed through the Howey Test and were considered securities by the SEC.
DAO developers say: there is a decentralized project and there is no way for them to get funding, because they need money to make money. We will write code and sell tokens and, in return, people who buy tokens will get whatever benefits the project generates. We work on the code, they have a project. The project will develop and all will get profit.
Meanwhile, according to the SEC, it is securities. This is based on the Howey Test which states that there is an investment of money. And public companies. With profit expectations, especially from other businesses.
Why was this investigation and decision made too? Because this is a famous DAO hack. There is a weakness in the DAO smart contract. Hackers who exploited the weakness attacked him again, nearly $ 150 million was lost. Because many people invest and get nothing in return, the SEC intervenes to 'protect' the interests of investors and regard tokens as securities.
As the SEC CEO said, Jay Clayton, the SEC was studying the effects of distributed ledgers and other innovative technologies and also encouraged market participants to participate. We are looking for innovative and useful ways to increase capital, ensuring that investors and markets are protected.
Types of Tokens
Utility Tokens
Because most ICOs are investment opportunities from companies, most tokens function as securities. However, if the token does not meet the requirements of the Howey test, it includes the token utility. This token provides users with products or services. Like the gateway token.
As explained by Jeremy Epstein, CEO of Never Stop Marketing, Utility Tokens can give holders the right to use the network and the right to take advantage of the network by voting. Because there is a maximum willingness token, the value of the token can increase due to the supply-demand equation.
Security Token
Crypto tokens that meet the Howey Test become security tokens. These tokens usually obtain value from external assets and can be traded. Because tokens are considered securities, they are under the responsibility of federal securities and regulations. If the ICO does not follow regulations, they can get a penalty. However, if all regulations are met, this token is very strong.
What Regulations Bind Security Tokens?
Because the Security Token is related to federal security regulations, they must comply with it from the start. Therefore, in the United States, Security Tokens need to follow the following regulations:
- Regulation D
- A + regulation
- Regulation S
Regulation D allows certain offers not to be listed in the 'Form D' provided by the SEC that has been filled in by the creator after the securities have been sold. This individual offering security can request an offer from an investor in accordance with Section 506C. Section 506C needs verification that the investor is indeed authorized and also the information provided as long because the application is free from false or dishonest statements.
A + regulation allows creators to offer SEC-approved security to investors who have not been accredited through public offers up to $ 50 million in investment. In order to meet the requirements for registering security, issuance of Regulation A + can take more time than other options. For the same reason, the issuance of Regulation A + will be more expensive than other options.
Regulation S occurs when security bids are executed in countries outside the United States and are therefore not subject to registration requirements under section 5 of the 1993 Act. Creators are still required to follow the security regulations of the countries where they are executed.
Why is Security Token Important?
Since assets are represented by security tokens, assets become a bridge between the financial system and the blockchain world. So what are the changes brought by security tokens?
- Restore credibility: At present, the ICO area is very uncertain. There is a deficit of accountability due to lack of regulations for token utilities. If the ICO wants to gain credibility again, ICO must combine the crypto world with traditional finance.
- Improving Traditional Finance: Traditional financial transactions can be more expensive because all costs are related to intermediaries such as banks. Security tokens remove the need for intermediaries who also reduce costs. In the future, smart contracts will eliminate the complexity, costs and use of paper.
- Speed up Execution: Traditional financial institutions involve many intermediaries who also increase execution time. By eliminating intermediaries, securities provide faster execution time for issuing security tokens. Because it is faster, security tokens will definitely be an attractive investment.
- Opportunities for Free Markets: Investment transactions are currently localized. That is, investors from China will find it difficult to invest in private companies in the US, and vice versa. By using security tokens, creators can market their offer to anyone via the internet. This opens opportunities for free markets that will help improve asset valuation.
- Large Amount of Investors: Because creators can show their transactions through the internet, the investor base will increase. This is another incentive for creators.
- Reducing Lawyer Services: In the future, the security token project will use a smart contract that automatically provides service functions through software. These functions are provided by lawyers who are added to potential intermediaries involved in the project.
- Reduced Institutional Manipulation: Because the number of intermediaries has declined, the chances of corruption and manipulation by financial institutions have also declined, and can even be lost from the investment process.
- Easier Liquidation: Secondary trading on security tokens will be made simple through the licensed security token trading platform and it will be easy for investors to liquidate security tokens.
Does Security Token Have Weaknesses?
Eliminating intermediaries is usually considered an advantage. However, this can lead to shifting responsibility from transactions to buyers or sellers. Intermediaries such as financial institutions serve important functions of ecosystems such as handling guarantees, preparation of marketing materials, investor interest requests, high-level securities insurance, and compliance with regulations. Many critics feel that creators cannot carry out these functions without traditional financial institutions.