Security tokens: Everything you need to know

The internet of value represents a revolution in many areas of our lives. Specifically, it allows for a radical change in the traditional financial environment.

In today's reading, we will address the "Security Tokens", an element of the web 3.0 that allows for the optimization of a wide range of financial assets thanks to the blockchain ecosystem.

In this case, technology allows us to provide these assets with certain improvements, such as greater liquidity, availability, and flexibility. That is, the assets themselves do not improve, but their management is simplified, offering many advantages to all participating actors, including investors.

However, the issuance and sale of these Security Tokens is not merely a technological matter, as regulatory bodies have classified them as traditional financial assets in an attempt to protect the citizen investor (and to participate in the benefits of this entire new environment).

Next, we will see what Security Tokens are exactly, what the advantages of using them are, and the regulatory requirements surrounding them.

What are security tokens?

A Security Token is a crypto asset hosted on a blockchain network that represents a traditional financial asset (bonds, futures, debt, company shares, gold...). But what does this mean?

Security

To understand what Security Tokens are, we must first understand the traditional concept of "Security." This English term refers to financial assets or securities. It is, therefore, an investment financial instrument. They are represented in legal documents that confirm ownership rights or loan issuance by the holder.

A security is any promissory note, stock, securities future, bond, obligation, evidence of indebtedness, certificate of interest, or any other financial security.

We can find different types of securities or financial instruments: debt securities, equity securities, hybrid securities, derivative securities, etc.

Whether an asset or security is considered a "security" depends on the jurisdiction, with no clearly defined criteria. Often, it cannot be clearly defined when something is a security or not, thus requiring a legal analysis. However, it is important to be able to determine this, as securities markets are strictly regulated. For this purpose, the Howey Test is generally used, which we will examine in detail in the next section.

Security Token

A Security Token is a type of digital asset that represents a traditional Security on a blockchain network. In essence, a Security Token is a tokenized Security. Tokenization, in this context, involves digitally representing a value or a right — such as a right of ownership, usufruct, use, or participation in a company — through a token on a blockchain network. This process allows these assets to be easily stored, transmitted, exchanged, and even collateralized via the blockchain, facilitating access to markets that operate on a peer-to-peer (P2P) model, eliminating the need for intermediaries.

Characteristics and Advantages of Security Tokens

1. Decentralization and Security:
   • Being blockchain-based, Security Tokens leverage blockchain technology to offer enhanced security, transparency, and censorship resistance. Decentralization ensures that transactions are immutable and verifiable by multiple nodes on the network.
2. Interoperability and Efficiency:
   • Security Tokens can interact with other tokens and systems across different blockchains, promoting greater interoperability. This facilitates integration with other financial platforms and reduces the costs and time associated with traditional intermediation.
3. Global Access and Liquidity:
   • Tokenization allows investors to access global markets without the geographical barriers that traditionally limit investment in financial assets. Furthermore, the liquidity of Security Tokens can significantly improve, as they can be easily traded on digital trading platforms and specialized exchanges.
4. Cost Reduction and Simplified Processes:
   • By eliminating the need for intermediaries such as banks, brokers, and registrars, Security Tokens significantly reduce operational costs and fees. Additionally, they simplify the processes of issuing and managing securities, making transactions faster and less prone to errors.
5. Regulatory Compliance and Transparency:
   • Security Tokens can embed compliance and identity verification mechanisms directly into their smart contracts, facilitating regulatory adherence and increasing transparency. This is crucial for meeting financial regulations and protecting investors.

Applications and Use Cases of Security Tokens

1. Tokenization of Traditional Assets:
   • They can represent physical assets such as real estate, art, and other tangible assets. This opens up new investment opportunities, allowing investors to purchase fractions of these assets, diversifying their portfolios with less capital.
2. Shares and Equity in Companies:
   • Security Tokens can represent shares and equity in companies, facilitating the more efficient issuance and trading of securities. This democratizes access to investments in private companies and startups, allowing for greater participation from retail investors.
3. Bonds and Debt:
   • They can tokenize bonds and other debt instruments, making their issuance, management, and trading easier. This can also include the issuance of public and private debt with clearer and more efficient terms.
4. Investment Funds and Real Estate Funds:
   • The tokenization of investment funds and real estate funds allows investors to access these vehicles with less capital and greater liquidity, diversifying their investments without traditional restrictions.
5. Smart Contracts and Automation:
   • Security Tokens use smart contracts to automate processes such as dividend payments, interest, and profit distribution. This reduces the need for human intervention and increases transaction efficiency and accuracy.

Challenges and Considerations

1. Regulation and Compliance:
   • While tokenization offers many advantages, it also presents significant regulatory challenges. Legal frameworks and regulations surrounding Security Tokens are still developing in many jurisdictions, which can create uncertainty for investors and issuers.
2. Adoption and Education:
   • The adoption of Security Tokens requires a deep understanding of both blockchain technology and traditional financial markets. Education and training for market participants are essential to overcome entry barriers and foster widespread adoption.
3. Security and Scalability:
   • Blockchain security is fundamental, but the scalability of blockchain networks remains a challenge. Scalability solutions, such as sidechains and layer 2 solutions, are under development to improve the capacity and speed of Security Token transactions.
4. Interoperability between Platforms:
   • Interoperability between different blockchains and trading platforms is crucial for the liquidity and functionality of Security Tokens. Standards and protocols are being developed to improve interoperability and facilitate the integration of different systems.

Future of Security Tokens

The future of Security Tokens looks promising, with growing interest and development in the blockchain and decentralized finance (DeFi) space. More countries and regulators are expected to adopt clear and friendly legal frameworks for Security Tokens, promoting their growth and expansion in the global market. The evolution of technology and collaboration between financial and technological sector players will continue to drive innovation and adoption of this new class of digital assets.

How to differentiate a security token? (Howey Test)

To determine if a particular crypto asset meets the requirements to be considered a financial instrument (Security Token), the well-known "Howey Test" must be applied.

It can be applied to any contract, scheme, or transaction, in both the traditional financial world and the crypto environment.

According to this test, an investment contract exists provided the following requirements are met:

• There is an investment of money in a common enterprise.
• There is an expectation of economic return.
• The return is derived from the efforts of others.

If all three questions are answered affirmatively, we can confidently determine that the token or crypto asset in question is a Security Token.

Regulation of security tokens (Spain and USA)

In Spain, Security Tokens are considered financial instruments under Article 2 of the consolidated text of the Securities Market Law, and their initial issuances (primary market) are regulated by Articles 33 et seq. of the same law, in addition to complying with European-level directives and regulations.

In Europe, the MiCA regulation governs all types of non-financial crypto-assets, which will not be subject to securities market law. It allows for obtaining a license for the entire community (European) market.

For the regulation of financial instruments (Security Tokens), we must refer to the recent Regulation (EU) 2022/858 on a pilot regime for market infrastructures based on distributed ledger technology, and amending Regulations (EU) No 600/2014 and (EU) No 909/2014 and Directive 2014/65/EU (MiFID II).

The aforementioned Regulation (EU) 2022/858 will allow for the tokenization of the following from March 23, 2023:

-Shares of public limited companies (issuers with a market capitalization of less than 500 million euros).

-Bonds and other forms of debt.

-Units in collective investment undertakings (managed assets with a value exceeding 500 million euros).

It will therefore be possible to tokenize financial instruments and organize markets around them.

However, the tokenization of real rights over real estate assets is not contemplated, as these are recorded in the property registry, and modifying them requires a public deed and registration in the registry itself.

To be able to tokenize real rights, the regulation would first have to be amended (specifically, the mortgage law).

Finally, we highlight the eIDAS II regulation, which aims to create a digital identity for all EU citizens. As the record is stored on a distributed blockchain and is considered incorruptible, it can be used as privileged evidence in court.

However, it is currently only a draft, and the regulation currently in force is the original eIDAS, Regulation (EU) 910/2014.

In the USA, Security Tokens are supervised by the Securities and Exchange Commission (or SEC), and must comply with the provisions of the Securities Act of 1933 like any other security.

Now that we understand the legislative environment to consider when working with a Security Token, let's analyze the advantages of using them.

Benefits of security tokens

Technological advantages:

• Programmability: Automation of processes adapted to business operations, for both investors and issuers (automated dividend distribution, governance via the token, management of the investment cap table, collateralization, etc.)
• Regulation: Regulation can be managed automatically with Smart Contracts, allowing for the management of token rights or permissions.
• Liquidity: Access to global markets 24/7/365.
• Fractional ownership: Further facilitating liquidity for investors and issuers (stocks, bonds, commercial paper, funds, real estate property rights, and other instruments).
• Transparency and immutability: For regulators, in addition to facilitating audits and processes by offering full transparency to investors.
• Efficiency: Eliminates friction and intermediaries, thanks to process automation and the trust generated between parties.

Advantages of the Internet of Value ecosystem:

• Wallets: Ability to determine ownership and transfer it in a standardized manner as an integration mechanism. There's no need to build an entire infrastructure; instead, existing infrastructure is utilized.
• Custodians: Technological infrastructure for crypto-asset custody, easily applicable to security tokens.
• Stablecoins. Availability of tokens representing 1:1 fiat values for payments or collections on security tokens.
• Other crypto assets. Integration with other value representations on the blockchain, enabling more complex, high-value financial integrations.

Advantages over the decentralization of traditional assets:

Decentralization is a concept not simply defined in absolute terms, but rather exists on a spectrum. In the context of security tokens, although they are not completely decentralized (as there is typically a promoter or issuer responsible for the asset and with regulatory obligations), they do exhibit a higher degree of decentralization than their traditional counterparts, thanks to the use of the blockchain ecosystem.

Keys to Decentralization

1. Elimination of Intermediaries:
   • One of the most prominent aspects of security tokens is their ability to eliminate intermediaries. Through blockchain technology, investors can maintain direct custody of their securities without the need for third parties such as banks or custodial agents.
2. Immediate Proof of Ownership:
   • Security tokens allow for immediate and transparent proof of ownership. Every transaction and token transfer is recorded on the blockchain, providing complete and verifiable traceability.
3. Intermediary-Free Transfers:
   • The ability to transfer security tokens without the involvement of direct intermediaries is a significant advantage. Holders can securely and quickly transfer tokens via the blockchain, without needing to go through traditional intermediary entities.
4. Direct Payment Reception:
   • Distribution payments, such as dividends or interest, can be made directly to token holders' wallets. This not only streamlines the process but also reduces the costs and time associated with financial intermediaries.

Interdependence Between Physical and Digital Assets

When a physical asset is represented by a digital asset, an interdependence is established between the physical asset, an intermediary, and the digital asset. This dependence is often inevitable, as someone must maintain the link between both types of assets to ensure the security token's purpose is fulfilled.

For example, consider a security token that represents an economic right over a real estate project. For this security token to offer a return to its holders, the underlying real estate project must be managed efficiently. This management involves a series of operational and administrative tasks that depend on an "intermediary" or project manager.

Management of Physical and Digital Assets

1. Operational Management:
   • The management of the physical asset, as in the case of a real estate project, includes supervision of construction, maintenance, daily operations, and financial administration. The success of these tasks is crucial to ensure the project generates the expected returns.
2. Legal and Contractual Linkage:
   • The legal relationship between the security token and the physical asset must be clearly defined. This includes contracts that stipulate the rights and obligations of token holders and the project issuer or manager.
3. Audits and Compliance:
   • To maintain trust and transparency, regular audits of the project and the tokenization system are essential. These audits ensure that funds are used correctly and that project performance is accurately reported.

Advantages for Investors

Despite the need for an intermediary to manage the physical asset, security token holders enjoy several advantages in terms of decentralization:

1. Freedom of Trade:
   • Tokens can be traded on secondary markets without restrictions, providing investors with liquidity not available with many traditional assets.
2. Personal Custody:
   • Investors can custody their tokens in their own digital wallets, eliminating the need to rely on third parties for the security of their assets.
3. Access to Global Markets:
   • Tokenization opens the door to a global investor base, allowing for greater geographical diversification and potentially increasing the demand and value of tokens.
4. Transparency and Traceability:
   • All transactions are recorded on the blockchain, providing a complete and transparent history that can be verified by any participant in the network.

Challenges and Opportunities

1. Regulation:
   • Although security tokens offer numerous advantages, they must comply with current financial regulations. Regulations vary by jurisdiction, and compliance is essential for legitimacy and long-term sustainability.
2. Investor Education:
   • Understanding blockchain technology and security tokens is crucial for investors. Proper education and disclosure are necessary to foster trust and adoption.
3. Technological Innovation:
   • The continuous evolution of blockchain technology offers opportunities to improve the efficiency and functionality of security tokens. This includes the development of new solutions for scalability, interoperability, and security.

In summary, while security tokens do not completely eliminate the need for intermediaries, they offer a significant level of decentralization that improves the efficiency, transparency, and accessibility of financial markets. The tokenization of physical assets presents challenges but also opens new opportunities for investors and issuers in an increasingly interconnected and digitized global market.

Practical Use Cases for Security Tokens

Thanks to the advantages outlined, some players are leveraging this technology and the issuance of Security Tokens to create new business models.

One of the most interesting cases for enhancing a traditional asset is found in the real estate sector. This sector, traditionally solid and profitable for investors, had a series of limitations that the use of this technology precisely resolves.

The agility in managing the asset, transparency in the investment process, its increased liquidity, the democratization of access to investment... are some key elements generating very interesting use cases.

A clear example is Domoblock, a high-end real estate investment company that issues debt Security Tokens backed by real estate assets.

This way, anyone from 200 euros can passively invest in the real estate sector and liquidate their investment at any time by selling their stake in a secondary market.

Conclusion

The blockchain ecosystem provides valuable elements for digital asset management by standardizing mechanisms and user experiences.

The ability to represent stakes in a financial asset (a share, a fund participation, etc.) as a token on the blockchain means leveraging the entire surrounding infrastructure and, as a result, benefiting the asset.

For all of this to be possible, Security Tokens must behave in a standardized manner; and for that, regulation needs to consider the creation of a technological infrastructure that allows for the development of all the advantages mentioned in this article.

In short, and referring to what  Sergio Navarro, CEO of Domoblock " the real estate tokenization of assets allows any type of asset to be converted into a "financial instrument" by potentially transforming it into a medium of exchange that is easily tradable and convertible."

Are we aware of what this means?

Let us know in the comments.

By Jorge Infante Fernandez.