An Introduction to Security Tokens
Lately, there has been a lot of talk about Security Tokens, especially with Overstock’s tZero Security Token Exchange Platform garnering a lot of attention. Despite the word being tossed around the cryptoasset space so much, many still do not fully understand what it means to be a security token — and the implications this will have in the future. Any project that has raised money via an Initial Coin Offering (ICO) runs the risk of being classified as a security token and could be subjected to security regulations under the SEC.
First, we will distinguish between two common type of tokens: Utility Tokens and Security Tokens.
NOTE: This analysis does not include information about cryptocurrencies used as a store of value/medium of exchange or currency specific projects (Bitcoin, Bitcoin Cash, Decred, Monero, ZCash, etc.). Nor will we address stablecoins – coins collateralized to assets – such as Tether.
Utility vs. Security
The tokens we are talking about in this paper revolve around access to a service, platform, or project that aims to solve a real-world problem via the use of a blockchain. The first type we will discuss is a Utility Token.
Utility tokens may also be referred to as application coins, user tokens, or network access tokens. There are several examples of these in use today, including Siacoin (SIA) for data storage, Basic Attention Token (BAT) for internet advertising, Golem (GNT) for computational power, Dent for mobile data, and Populous for invoice financing. What each of these have in common is that they provide access to the service or platform that is the basis of the cryptoasset project.
For an example of how these work, we will use SiaCoin – we’ll just pretend that SiaCoin was offered via an ICO and not mined from its inception. SiaCoin provides a platform for the buying and selling of data storage. Sellers offer up storage space in a contract on the platform and buyers accept that contract for a price, paid for in SiaCoin. This reinforces SiaCoin’s classification as a Utility Token. SiaCoin does not entitle holders of the token to any profits made on the platform, does not denote any ownership interest in the Sia project, nor does it give the holders any voting rights for decisions made in regards to the platform or the Sia Project as a whole. The tokens value is derived from within the platform itself. The specific use of the token on the platform – solely being a medium of exchange for data storage within the bounds of the Sia platform – is vital for its classification as a Utility token. Despite being classified as a Utility Token, projects such as SiaCoin are still susceptible to future SEC regulations as the space evolves.
Security tokens serve purposes such as the token representing shares of ownership in the project itself, a tool for profit/loss sharing, giving the holder status as a creditor/lender, giving the holder a claim in bankruptcy as an equity interest holder/creditor, or giving the holder the right to repayment of purchase price and/or payments of interest.
An example of a security token would be the SiaFund Token. 10,000 SiaFund tokens were issued as a means of funding the Sia project, and 1,159 were initially sold in an IPO in 2014. As of recently, Nebulous – the parent company funding most of the Sia Project – still holds 8,741 SiaFund tokens and recently hosted a Tokenized Security Offering (TSO) in compliance with SEC regulation to sell an additional 750 SiaFund Tokens.
Here are a couple of important details that help make the SiaFund Token a Security Token: SiaFund Tokens were offered to the public in exchange for money, holders of the SiaFund token are entitled to 3.9% of the fees from every transaction made on the Sia network, and funds from the sale of the SiaFund Tokens are being used to fund the Sia Project venture. It is important, therefore, that the Sia team took the time to register the sale of SiaFund Tokens with the SEC as a Tokenized Securities Offering (TSO) and only offered the sale to qualified investors.
So SiaFund Tokens are considered a Security Token, but why do these qualities make it a security and how do I know what other coins can be considered securities?
Classifying the SiaFund Token as a Security
The most common way to determine if an offering is considered a security – therefore subject to SEC securities regulations – is theHowey Test. The Howey Test states that an offering is considered a security if:
- 1It is an Investment (of either money or assets)
- 2 Investment is made in a common enterprise
- 3 There is an expectation of profit
- 4 Profits come primarily from the efforts of a promoter/third party (holder of the offering cannot reasonably have a large influence on if the investment will be profitable)
In the case of the SiaFund Token, the purchasers of the token are investing money or digital assets for the token. Furthermore, the investment is in a common enterprise as the investments are pooled and each investors shares evenly in the profits of the project. Token holders reasonably expect profit from the investment – in this case from the fee distribution mechanism. The success of the project is heavily reliant on the efforts of a promoting third party (SiaCoin development team) who will strive to capture a share of the market.
This outlines the details surrounding what classifies a token as a security. Until recently, the SEC has been passive, content with letting the space foster innovation. Increased public interest over the past year has forced them to take a more active stance, publishing guidelines for what constitutes a security token and their thoughts on the overall ICO environment. For more information regarding the complications in classifying tokens as a security – and what this means for the token – read part two of this series here: Classifying Security Tokens and the Associated Implications.