What Is a Security Token?
A security token is a digital asset that represents a slice of ownership of or rights to an asset or a company. A token on a blockchain is a long string of numbers and letters generated by a hashing algorithm. Transferring ownership of an asset to a blockchain and assigning it a token is called “tokenization.” Combining the two ideas creates a security token, a digital representation of ownership of or rights to an asset that has been tokenized and stored on a blockchain.
Key Takeaways
- Security tokens are digital assets that represent transferred ownership rights or asset value to a blockchain token.
- A security token is created using a process called tokenization.
- Security tokens are not yet available to retail U.S. investors, but many institutions are working to get them approved by regulators.
- The Securities and Exchange Commission must approve security tokens.
Understanding Security Tokens
Understanding tokenization is crucial for understanding security tokens. Anything can be tokenized: for example, you can create a token that signifies the ownership and registration of a car. The car’s vehicle identification number (VIN) could be entered in a block on a blockchain along with the owner’s name, address, and other information required by a state to register a vehicle. The state’s motor vehicle department could use a blockchain interface program to enter the information into their blockchain, which could generate a token that signified ownership. The token (the hashed version of the information) could be sold and purchased, transferring ownership of the car.
A security token is created similarly—a company inputs what the token represents, and the token is generated. The company would then offer this token in exchange or another appropriate investment platform for investors. Ownership of that token would then be recorded on the blockchain and tagged with the owner’s blockchain address.
The idea behind tokenizing ownership of a company or an asset isn’t necessarily new. For example, companies used to give paper stock certificates to investors who purchased stocks. The paper certificate was a token that represented ownership or other rights granted to the investor. A digital security token is no different, except it is digital and has undergone a blockchain tokenization process.
Important
Tokens are viewed as securities by regulators when they meet the criteria set by the Howey test; that is, there is an investment of money, a common enterprise, and a reasonable expectation of profit through the effort of others.
A security token might take one of a few different forms to be identified—it could have an image assigned to it that could be displayed in a digital wallet along with its value. On the other hand, it might only be a number your wallet keeps track of. The wallet could display your holdings, value, and any dividend distributions. Your wallet might also provide quick access to a prospectus or annual reports.
How Are Security Tokens Different From Cryptocurrencies?
Security tokens and cryptocurrencies are nearly identical. They are created by and stored on a blockchain. They are both tokens, but the crucial difference lies in their purpose, intended use, and actual use. A cryptocurrency is designed to be used as currency, money, or payment method. A security token is intended to be used the same way a stock, bond, certificate, or other investment asset is used.
Many cryptocurrencies have been introduced which were not intended to be used as investment instruments. For example, Bitcoin was created to be used as a decentralized currency. But when investors and traders noticed an opportunity to generate returns from Bitcoin when it was listed on cryptocurrency exchanges, it began to be treated as a security token even though it was not designed as one.
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Ethereum’s native token, ether, was developed to be used to pay transaction fees within the Ethereum network. In that respect, ether is a cryptocurrency. However, because it is being traded on exchanges and held for its increasing value, investors treat it as a security token.
But BTC and ETH are not designed to be used as security tokens, and there is no expectation of profits from the developers; they do not currently meet the criteria to be considered securities by the SEC.
What Is a Security Token Example?
A security token represents rights of ownership, transfer of value, or promise of returns that are tokenized on a blockchain. It is intended to be treated as an investment instrument. Backed, an investment company, has tokenized Nvidia stocks and issued bNVDA—a token that represents an Nvidia stock held with a licensed custodian. bNVDA is traded on INX, a security token exchange.
What Is the Primary Purpose of a Security Token?
A security token’s primary purpose is to record ownership of an underlying asset on a blockchain. These tokens also allow investors interested in blockchain investing to access investment opportunities that exist in regulated markets.
What Does a Security Token Do?
A security token is a digital representation of an underlying asset designed to be treated as an investment.
The Bottom Line
A security token is the blockchain equivalent of a securitized asset traded on the stock market. It is a sequence of numbers and letters that is linked to fractional or total ownership of an asset, with the intent to raise funds, generate returns, or pay dividends. These tokens, like stocks, must be registered with the Securities and Exchange Commission.
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