Explainer: What’s a Security Token?

Security token offerings, or STOs, are garnering increasing interest among crypto-enthusiasts. An improvement on their dubious cousin, the ICO, STOs are expected to be a regulatory compliant way of democratizing access to investor capital.

Security tokens are digital representations of a real-world financial security such as a stock, bond, or derivative. Using stocks as an example, when an investor purchases shares in a company, the shares’ represent a percentage ownership of that company. That ownership will typically bring along with it financial rights, such as voting rights and rights to receive any dividends paid out.

One can think of a STO in much the same way, except an investor would purchase a token that represents ownership of the company in question. The notable difference lies in the fact that STOs utilize blockchain technology to record transactions, which would represent transfers of ownership from one party to another. Any dividend payments could also be recorded on the blockchain.

How do STOs differ from ICOs?
STOs do bear resemblances to initial coin offerings in that they are both token offerings. The key differentiator lies in the classification of those issued tokens.

Tokens issued from an ICO are typically classified as utility tokens, or tokens that grant access to the issuing company’s product or service. Using Augur, the decentralized predictions market, as an example, investors in Augur’s August 2015 ICO received its native reputation token (REP) in exchange for bitcoin or ether. It took until July 2018, when Augur’s official mainnet was launched, for investors to be able to use their REP tokens to participate in the network. The REP tokens permit users to trade, report, and dispute the outcome of events.

In contrast, people who participate in STOs are strictly investors, not users. One example of a recent high-profile STO is tZERO. A subsidiary of the American online retailer Overstock, tZERO aims to solve some of the inefficiencies of traditional financial markets through the use of private blockchains. The STO raised a total of $134 million and then imposed a 90-day token lockup for compliance reasons; the lockup ended on January 10, 2019. One financial incentive for holding the tZERO token is that token holders receive 10 percent of adjusted gross revenue on a quarterly basis.

STOs possess one key advantage that stands to make them a promising funding mechanism of choice for prospective entrepreneurs, namely, the ease of access to investor capital when compared with other funding mechanisms.

As long as regulatory compliance is ensured, entrepreneurs could in practice issue tokens representing a percentage ownership in their venture. The key difference between this and the hysteria of the 2017 ICO boom being ownership of tokens represents an actual stake in the given company.

The recent fundraising effort by the popular cryptocurrency media publication Hacker Noon is an excellent example of how the STO funding model could be implemented. Currently in the process of completing its equity crowdfunding, in which investors receive common shares for investing, an STO would work in a similar way except the investor would receive a Hacker Noon token (a move the site says it is considering in future fundraising efforts).

STOs stand to democratise the fundraising process in a regulatory compliant way, which ICOs failed to do. Digitizing securities offers material advantages to large financial intuitions in the form of increased liquidity and faster trade-settlement times.

The boom of ICOs in 2017 was an important precursor to STOs, educating us on the possibility of a token-fuelled economy; it will take STOs to fully realize that vision.