A security token is a security — a tradable financial asset, like a company share (e.g. Apple) you buy on the NYSE or Euronext — yet in a pure digital form. It represents an actual underlying value, which can be any kind of asset, equity, or debt.
A Security Token Offering (or STO) is a new financing method based on blockchain technology. An STO is best described as a process, in which fractional ownership of equity, debt, or assets is offered in exchange for money. It is, to a certain extent, similar to crowdfunding and IPO, although far more advanced thanks to the introduction of the digital security token.
The digital security token is a 3rd generation blockchain token and is used in and after the STO as the fractional representation instrument of the underlying value. Digital security tokens are compliant with financial laws and regulations, and fully programmable, which means that the fractional ownership characteristics will be programmed into the digital token, automatically facilitating and allowing ownership rights.
As 2140 Consulting is a Security Token Offering advisory firm, it is important to share that not all publicly offered security tokens are based on the same principles of underlying value representation. In short, a security token is meant to represent value in a legally regulated manner, but how exactly is that value represented by the token?
Possibility N1: The Security Token Represents A Security
The most obvious value representation of a security token is when it is representing another (non-tokenized) security. This happens for instance when the security token is representing a company share certificate which, for instance, grants profit participation rights to the owner.
In this case, security tokenization (and supporting blockchain technology) is used as a method for automation of the share certificate registry. The automated and digitized registry will save time and costs for the share certificate issuer. At the same time it creates an advantage for investors, as they now will have the possibility to buy and sell share certificates instantly and 24/7 via the security tokens, making all sorts of middleman fees in this process obsolete. The blockchain software supporting this automated registry will allow and validate the distribution, management and transfer of security tokens.
Possibility N2: The Security Token Itself Is A Security
In security tokenization, it becomes really interesting when the security token itself is a security, and not merely a representation of it. This is the case when a security token represents tokenholder rights related to an underlying asset such as real estate or art for instance, which by itself are not securities.
Using this form of value representation by security tokens, we are able to make illiquid assets liquid. A real estate building can be tokenized and sold to investors brick by brick, with every tokenholder able to trade his/her tokens instantly. Similarly, a Picasso artwork can be tokenized, sold, and subsequently traded per square millimetre.
Looking at N2, it is clear that this possibility represents the true power of tokenization. It makes illiquid assets liquid in a simple and cost-efficient way, and fosters inclusion and the democratization of investment at the same time. After all, someone with “only” 1,000 Euro to invest can now do this in real estate or in a Picasso work of art, something which was not possible until now.
Possibility N3: The Security Token Represents Actual Ownership
In the above paragraphs we speak of value representation by security tokens, but we do not speak about ownership. That is right. Currently, security tokens do not represent ownership, they represent rights to something.
A voting right, a profit or revenue participation right, a settlement right, a transferability right, and so on — are all possible rights that can legally be part of the token, and as such are granted to the tokenholder. If you want to read more on the legal basics of ownership, token classification and tokenholder rights, please take a look at our previous article.
Can a security token however represent actual ownership? In theory: yes. In practice: not yet. Given that most jurisdictions still do not foresee the possibility of issuing shares or stocks with voting rights in the form of tokens (= equity tokenization), such jurisdictions would not consider equity tokenholders as direct owners of the underlying company.
Therefore, we advise you to be careful when exploring STO’s with so-called “equity characteristics”, and to read the accompanying legal documentation well. In most cases, you will read that the security token is not representing direct ownership with voting rights included, but that it’s solely securing a profit or revenue participation right to the tokenholder, without voting rights regarding the strategy and management of the underlying company.
Although the above paragraph sounds rather disappointing, it is the simple consequence of a global legislative backlog in respect to innovative financial technology. We are quite sure however that this backlog will be cleared in the years to come, paving the way for full equity tokenization in the near future.
And What About Possibility N4?
Just as it is the case with equity tokenholders, an asset tokenholder (possibility N2) is currently not the owner of his/her fraction of the asset. He/she solely owns the token, which represents some kind of right (e.g. life rent) regarding the asset. Furthermore, security tokens are issued via a legal entity, which is called the “token issuing company”. The token issuing company owns the (tokenized) asset, and as such can issue tokens granting token investors a right with respect to the asset.
So if you want to issue a token that directly represents ownership with respect to an asset, you understand that the token emitting company and the asset will need to be some kind of “merged asseted company”, which in our humble opinion, unfortunately finds no equal in the existing legal company forms today.
Even more, if we would live in a world where “merged asseted companies” exist, you might be able to issue tokens directly granting ownership with respect to the asset, but who is going to manage the asset and/or the issuing company? The majority tokenholder? A consortium of tokenholders? Another company with a mandate to do so? Lots of possibilities, lots of challenges.
An easier solution might be however to make equity tokenization — with inclusion of voting rights in respect to the underlying company — fully legally possible. In that case, an underlying asset will be owned by the token issuing company, and the token issuing company will be directly owned by the token holders. Again, this will lead us to the question of who exactly should be managing the company holding the asset, but at least in this way we can build further on the management and compliance solutions that have been developed throughout the years in the traditional public securitization area.
Given the above explanation, this does not mean that asset and equity tokenizations are not taking place, on the contrary. Over 300 STO’s (conservative estimate) are expected to see the light in 2021. Most of them will be executed with profit participation rights, but without direct voting rights, which is in many cases more than sufficient for the token investors, and not at all a showstopper.
So while there are currently some challenges around actual ownership representation via security tokens, we do see that regulators are starting to take action — some countries quicker than others — to review and adapt traditional legislative frameworks. It is therefore only a matter of time for regulation to catch up and take down these barriers.
In the meantime, you can already perfectly run your STO with specific tokenholder rights. We at 2140 can help you navigate through this whole process.
Written by 2140 Consulting. 2140 Consulting is specialized in Security Token Offering (STO) advisory. Feel free to get in touch.
Originally posted on Medium.