JUNE 29, 2021
Security tokens explained
What are security tokens?
In traditional finance, securities are tradable financial assets used to raise capital in private or public markets. To put it simply, they are investments that allow you to own something without physically holding on to them - like stocks and bonds.
There are primarily three types of securities, namely:
- Equities: Where you gain rights to ownership that may even pay dividends or a share in profits. This can be represented by an option or a position in a publicly-traded corporation via stock.
- Debt: Debt represents an obligation for repayment of a loan. This can be issued by a government or a corporation where effectively the buyer lends the issuer money in exchange for rights to receive interest payments and, at maturity, his principal. Government bonds, mortgage-backed bonds and corporate bonds are all examples of debt securities.
- Hybrid: A type of security that combines features of debt securities with features of equity securities.
Security tokens execute the same functions as traditional securities, with the key difference being that transactions are recorded on the blockchain ledger. Like a cryptocurrency, these tokens digitally represent the asset ownership and give the added advantage of allowing fractional transactions, thus making the partial ownership of assets possible. These security tokens, in return, promise the investor equity in a company, profit-sharing, or even voting rights, to name a few examples. As such, they’re typically linked to a business and are governed by security laws, meaning there are stricter guidelines on purchasing and transferring security tokens.
What makes security tokens particularly attractive and disruptive to traditional financial instruments is the ability and flexibility to use smart contracts. A self-executing smart contract integrated within a token can be coded to represent anything from ownership of equity to the legal structure of owning a physical property. The contract can be set to pay out dividends, incur interest or even lay out terms of agreements between buyers and sellers which would govern all benefits and rules associated, as well as comply with any regulatory framework.
How security tokens work
In order to understand how security tokens really work, here are three scenarios in which we may see their use.
1. Fractional investments
Generally speaking, small retail investors like you or I do not have easy access to investment brokers, nor do we have a substantial amount of capital to start investing in order to make it worthwhile once all transactional and brokerage fees are taken into account. Security tokens can help overcome this by being listed directly on exchanges where the end-user can invest using either their cryptocurrency or fiat money with as little or as much as they want.
If you wanted to buy a slice of Tesla today (TSLA), you would need at least $583 (at the time of writing) to receive one stock which can be inaccessible to some people. The tokenisation of the stock solves this or having stocks represented as tokens on the blockchain. These assets are pegged to the company’s value as seen on public stock exchanges and are backed by physical shares, similar to how stablecoins are linked to their counterparts. This allows investors to trade equity shares with cryptocurrencies. In its tokenised form, investors can buy fractional shares of the company through smaller values of the token, thus allowing you to grow your invested capital to the same percentage as the stock growth.
2. Raising capital
The most common way for corporations to raise funds is via an IPO or initial public offering. This is where a company will sell shares that give the holders rights to dividends or voting. However, companies issuing these shares are considered securities and are highly regulated by institutions to ensure the protection of the investors and corporations. Given these circumstances, the process of a company launching an IPO is not simple and requires a lot of time and money.
Security tokens can be used to facilitate IPOs through what is now known as a Security Token Offering (STO). An STO can be likened to an IPO but fundamentally solves problems usually encountered with such sales. IPOs are generally reserved for accredited investors. Small retail investors like you and I would have a hard time buying into such assets, and even if we did have such an opportunity, our funds would most probably be drained by the high fees associated with it.
Borders are removed with STOs, and the need for specialised brokerage firms or investment banks are bypassed going beyond geographical jurisdictions. This alone opens up a much larger pool of investors who simply need an account with the platform they wish to invest in.
There are no time limitations with the trading of STOs as in conventional markets. You can buy and sell your tokens virtually 365 days a year, 24 hours a day if you wish.
With all these great advantages, more and more corporations are moving towards using STOs to raise capital rather than the conventional IPO, thus giving the investor a more transparent offering using blockchain technology.
3. Real estate tokenisation
Real estate tokenisation is the method of converting the financial value of real-world assets into blockchain-based digital tokens that represent a certain number of shares in the property.
Tokenisation allows asset owners to raise funds or capital quicker and more efficiently through STOs, giving them access to a much larger potential pool of investors, which may include smaller investors who ordinarily would not be able to afford a full real asset. These smaller investors can now buy just a fraction and gain the same advantages as someone with deeper pockets.
As a result, this significantly removes barriers to entry into real estate while increasing the liquidity of assets. The payment of rents and homeowners association fees can also be transacted using the tokens simplifying the process. They can also be traded 24 hours a day, 365 days a year and are not bound by any conventional rules and jurisdictions, giving full and direct control over investment holdings.
Security tokens: the next big investment boom?
As the momentum on cryptocurrency increases and the mass adoption of more and more people continues, traditional institutional investors have no choice but to embrace the disruption and join the race. The fact is blockchain technology is proving to be far superior and efficient in developing and executing financial instruments; it is only a matter of time before security tokens become an integral part of your diversified portfolio.
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