by Rodrigo Meirelles
You’ve heard the hype. To determine whether security tokens are worth your time, here are five things to know about them:
- First thing’s first: What’s a token?
A token is a digital representation of a company’s asset (e.g., stock shares) or utility in its native ecosystem, issued in full compliance with U.S. securities law. Contrary to popular belief, a token is not a cryptocurrency coin. Cryptocurrencies are not tied to a specific country and can be transferred across borders instantly and without international fees. Tokens, on the other hand, represent defined assets, such as real estate, property, debt, or different types of equity, etc. They are issued through a registered broker deal and secondarily traded on a registered Alternative Trading System (ATS). Similar to Bitcoin, tokens are distributed by companies with an initial coin offering (ICO)—the digital space’s equivalent to an Initial Public Offering (IPO).
Search the SEC site here for a full list of ATSs.
- If a crypto token meets three criteria, it is classified as a security token—one of two major categories.
There are utility tokens and security tokens. The major differences between the two are in the intended use and functionality of the tokens. Utility tokens are simply app coins or user tokens that enable future access to the products or services offered by a company. They are not created to be an investment. A security token is a digital asset that derives its value from an external asset that can be traded.
The Howey Test was formulated by the U.S. Securities and Exchange Commission (SEC) to help classify a cryptocurrency token as either a security or utility token. According to the Howey Test, in order for a crypto token to be deemed a security token, it must meet the following three criteria:
- An investment of money
- In a common enterprise
- With an expectation of profits predominantly from the efforts of others
- Security tokens are subject to many federal security regulations.
Security tokens are regulated by federal security regulations, and may be structured as securities products subject to registration under the Securities Act of 1933 or the Investment Company Act of 1940. These regulations make security tokens a safe investment and valuable in downturn markets.
- Security tokens have set many important changes into motion.
The advantage of security tokens is that they eliminate the need for an intermediary—some type of bank—in investment transactions. In addition to this, advantages include reducing fees associated with traditional financial transactions, the ability to issue securities faster, and free market exposure leading to more investors. Security tokens also solve the problem of liquidity for both issuing companies and the investor. Tokenized assets make securities simple, cheap, and fast.
- Security tokens have some disadvantages.
Without middlemen, responsibilities such as deal underwriting, preparation of marketing materials, and insurance of high levels of security and compliance regulation shift to the buyer or seller. Traditional investors argue that most potential investors lack the ability to perform these functions. Additionally, there are currently few security standards and best practices regarding tokenization in place.
WEX, which plays a key role in developing payments solutions for the fleet, healthcare, and corporate sectors, is actively exploring the value of blockchain and distributed ledger technologies (DLT) which legitimize tokens. As just one example, security tokens have the potential to enable new connected car services in insurance use cases where your payment, car VIN, and driver’s license can be tokenized into a digital fingerprint.
Come collaborate with us. Let’s tokenize the world together.
Rodrigo Meirelles is vice president of strategic partnerships and innovation at WEX. Reach out to him via LinkedIn.