What is Security Token
It’s not difficult to understand security token. If you split it to two words, ‘security’ means a certificate with intrinsic monetary value that can be traded, just like stock and bond. ‘Token’ means a voucher that used in exchange for good or services. When the two words combine, it means a digital token with the value of tradable asset, as a digital form of security.
Howey Test can help to identify whether the token is classified as security base on four guidelines. These include If there is money involved in investment, whether there is expectation of profits, also in a common enterprise, if there is effort involved from a promoter or a third party, then the token itself can be deemed as investment contract, a form of security.
In a generalized view, most of the tokens in the market are utility token. People bought it from the crowdfunding of startup for later access of products and services. The value of token derives from the faith of investor towards the company.
Just like traditional security, security token’s value derives from the asset behind, investor can get dividend from the token, so it can be seen as a digitalized security, and it is compatible to law as well.
Security token is nothing new, but a digital form of tradable security stored on blockchain, leveraging the integration of technology and security.
What is Security Token Offering
Security Token Offering (STO) is a financing tool by issuing asset backed token to the public. The token is a form of security which falls into the regulation framework, therefore one of its key features is compliance.
Before the token sale, the company need to consult lawyer and accountant regarding the disclosure of the organization structure and financial report. The identity of investor also needs to be clarified, all of these need to go through the process of Know Your Customer (KYC) and Anti-Money Laundering (AML), ensuring all parties involved are regulated and complied under the law.
Apart from that, STO can also enhance asset liquidity. With the long lockup period, property is difficult to trade in the market. But now we can utilize technology to segment the unit into numerous tokens with distributed ownership and sell to the public through the network. It helps releasing the value of illiquid assets and facilitate liquidity.
Although initial coin offering (ICO) serves as another way of financing, according to Bloomberg’s figures, nearly 78% of the overall projects in 2017 are scams, only 15% of which continued in development; and less than half were developing in a good form. When comparing with ICO, issuing STO requires a longer and more complicated procedure. But for the company and its investors, due to the fact that STO is backed by assets which gives the market more confidence and it is expected to continue to grow.
How STO works with Smart contract
For successful security token offering (STO), a smart contract is needed to connect all parties, and execute trading through the blockchain platform.
A traditional contract, or a typical paper contract is a written agreement which is enforceable by law, which needs validation of both parties. It involves complicated process where human error is commonly found.
Smart contract is written by programming language, when it runs on blockchain, computation will take on the job. When certain criteria are triggered, the contract terms will be executed and reviewed automatically. A more complicated situation will need more smart contracts to collaborate.
Take STO as an example, all participants need to verify their private key for investor identification through whitelist. When the review is completed, contract term will be executed instantly and certain amount of tokens will be sent to the address of investor. The transaction record will then be distributed to the nodes of different decentralized platform, making sure it is immutable. A more efficient trade can be achieved due to the automated process and elimination of intermediaries.
Due to the decentralized feature of blockchain and the transmitted data on smart contract is encrypted, smart contract has great potential with a wide range of applications in medical, real estate and even elections. A large number of companies in various countries are studying on the implementation of smart contracts for better efficiency and reducing human effort.
The Potential of STO Investment
The crypto space is still a niche market within the financial market in terms of capitalization or circulation. The emergence of security token offering (STO) may completely change the situation.
For investors, what they truly concern are the fundamental, the return of investment and liquidity. When we look at property market, especially the commercial block, it requires a high entrance capital of hundred thousands or even millions. In a long lockup period, investors always suffer from price volatility under the influence of market situation, which makes trading more difficult.
With STO, we can segment the property and sell it as tokens, all transactions storing on blockchain platform are instant. The lower risk and investment cost can attract more retail investor, fostering the development of the entire ecosystem.
Startups gain liquidity through funding such as private placement, however this kind of shares has limited liquidity since it is difficult to trade on different markets with different laws and regulation. As institutional investors, they may need to hold for several years. But with STO, the liquidity can be enhanced as the tokens can also be traded by retail investor, and even on secondary market. This is a win-win situation to all parties.
Some analysis predicts the STO market worth 78trillion USD with the high expectation of derived commercial value. A number of startups, or even institutional players see the potential of STO and are actively discovering the possibility for investment.