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Basics of a Security Token

by Christie Olsen, Michael Penfield
May 27, 2021

Technology, updated regulations, and a new breed of fintechs are making investments more accessible and efficient on a multitude of levels. Securities like private company stocks, bonds, real estate interests, and soon even more traditional assets like public Exchange Traded Funds will become fully digital thanks in big part to blockchain technology. With the emergence of digital asset securities, the evolution of financial markets is poised to enter a new age.

Introduction to a Digital Asset Security

A digital asset security is defined as a digital asset that meets the definition of a “security” under federal securities laws. This digital representation of an asset, which is also a security, is verified and recorded on a distributed ledger and may represent a fractionalized interest in an underlying asset or a bundle of assets.

The Securities and Exchange Commission (SEC) now recognizes the term digital asset securities and ruled in 2018 that issuers must adhere to the same regulations as issuers of traditional securities. The SEC considers digital asset securities under their domain, and laws apply to them in the same way as traditional securities.

Digital asset securities are known by a variety of names, and the terms are often used interchangeably. They are synonymous with digital securities and equity tokens and are often referred to as security tokens. A “token” in blockchain parlance refers to a unit registered in the distributed ledger. However, in understanding these terms, it is essential to distinguish that not all digital assets are considered digital asset securities.

Comparing Digital Asset Securities to other Digital Assets

A digital asset is anything in the digital domain that has use rights attached. Digital art forms like photography, music, and cinema are all examples of digital assets. Also, any form of property may be considered a digital asset if the evidence of ownership is held in digital form. However, when ownership of a digital asset is onboarded to the blockchain, registered with the SEC, and sold to investors, it becomes a digital asset security.

Digital asset securities come in the form of tokens. These security tokens represent a financial interest in an asset. Investors pay for tokens using fiat currencies like the U.S. dollar or cryptocurrencies such as Bitcoin or Ethereum. It is fundamental to understand that while both digital asset securities and cryptocurrencies are tokens, comparing them is akin to comparing a share of stock to a dollar bill. A share of stock represents ownership in a company, and a dollar bill represents purchasing power.

Other types of security tokens include utility and non-fungible tokens (“NFTs”). Utility tokens give owners a defined benefit like access to a particular platform or system. NFTs are unique and not interchangeable. However, they may appreciate in value and sell the same as security or utility tokens.

Digital Asset Securities vs. Traditional Shares in the Private Markets

Digital Securities convey the same rights of ownership as traditional certificate or book-entry shares. Both offer the rights to receive dividends and other benefits of ownership. The key difference, however, lies in the location of the security.

Traditional private securities are moved in a paper-based, manual system that generally involves a slow and time-consuming process. Digital securities, on the other hand, are stored in the distributed ledger (blockchain) as tokens and exist only in digital form. And although tokens do not exist on paper, they represent the same interest in a company’s equity as traditional shares. While digital securities must go through the same regulatory process as traditional offerings, they are processed and moved in a dramatically streamlined process.

Public securities are traded on exchanges and networks like the NYSE or the NASDAQ market. They require an extensive network of brokers, dealers, clearing agents, custody providers, and transfer agents to handle their movement and storage. However, this traditional network is being disrupted as securities are digitized, stored, and managed in distributed networks rather than cumbersome and costly physical storage systems.

Benefits of Digital Asset Securities

With blockchain technology, security tokens are now digitally traded and portable. All transaction records and legal documents are stored on the blockchain, which significantly removes friction and speeds up the investment process. Digital securities are held in personal digital wallets and may be transferred to someone in whole or in part, making it possible to give or trade a portion of a share quickly.

The seamless practice of issuing digital securities can be customized through smart contracts to allow users the benefits of automated compliance while reducing costs and the potential for fraud. Independent verification is strengthened with the use of blockchain and smart contracts.

Contributing Writers: Michael Penfield, Christie Olsen

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