Cryptocurrencies are often viewed as competitors to traditional financial institutions. However, in the case of security tokens, Web3 developers are fusing aspects of blockchain with standard financial services. These digital assets are similar to securities that people can purchase at brokerage houses that comply with the Securities and Exchange Commission’s (SEC) guidelines and policies. These houses are on the blockchain.
Security tokens are a unique innovation that promises to offer more financial options to retail investors. However, it can be difficult for newcomers to clearly define what’s a security token. For that reason, let’s understand how security tokens differ from other cryptos to make more informed decisions before purchasing a digital asset.
What are securities in finance?
Before diving into what security tokens are, it's essential to review what qualifies as a "security" in a traditional market. Traditional securities are tradable instruments that grant an investor fractional ownership rights over a third-party asset.
For example, stocks in a company are securities. Government or corporate debt (i.e., bonds) is also classified as a security. People who trade in the derivatives financial market also use securities. After all, derivatives like futures or options "derive" their value from another security.
A defining feature of securities is that they’re centrally regulated. In the U.S., the SEC oversees the sale and trade of securities. This additional oversight gives many investors a sense of confidence that their securities are protected by federal law.
The SEC also has a clear formula known as the "Howey Test" that helps them determine whether a tradeable asset falls within their jurisdiction. Here are the four questions that SEC regulators use in the "Howey Test" to define a security:
- Did someone have to invest money in the enterprise?
- Was this investment in a common enterprise?
- Did investors expect a profit?
- Are these profits "solely" related to a third party's efforts?
If regulators say "yes" to all the above criteria, it's legally bound to the SEC. Anything that qualifies as a security must also abide by all the rules set by SEC regulators.
What are security tokens?
Not all cryptocurrencies are securities, but many are. Today, many Web3 projects launch security token offerings that meet the Howey Test criteria. Therefore, the SEC would like them to comply with securities laws. Just like traditional securities, these blockchain-based tokens represent ownership of an asset controlled by a third party.
For instance, some decentralized platforms are experimenting with tokenized versions of stocks and derivatives. In fact, there are a few companies offering tokenized real estate investing. All the tokens offered on these trading platforms are on public ledgers and use blockchain technology. However, since these tokens are connected with standard securities and meet SEC regulations, they qualify as "security tokens."
These security tokens aren't "currencies" per se because they aren't intended to be used for daily transactions. Token holders can't use a security token to buy goods and services until they sell their tokens for a currency on a trading platform. Just as you can't pay for things with stock investments, you can't use security tokens until you realize gains or losses. However, since security tokens have great liquidity, it’s relatively easy to transfer their value.
In contrast, people can use "coins" like Bitcoin for daily transactions. Unlike a security token, Bitcoin doesn't represent ownership outside of itself. Also, there's no third party that "owns" or is directly responsible for Bitcoin, which means it doesn't qualify as a security per the SEC.
It's important to mention a nuanced distinction between "security tokens" and "utility tokens." Both are cryptocurrencies, but utility tokens offer holders utility in the applications where they natively exist.
For example, many metaverse games like Axie Infinity or The Sandbox have utility tokens that players can use to exchange for in-game digital goods. In this case, the tokens don't represent a "stake" in the gaming company; they have a purpose (i.e., utility) within their respective ecosystems. Because of this, utility tokens don't need to register with the SEC.
Are cryptocurrencies securities?
Only cryptocurrencies that meet the Howey Test's standards should be considered securities. However, there are many controversies over which digital assets fall into this bucket.
To date, Bitcoin is the only cryptocurrency the SEC has clearly said is not a security. It's impossible to pin down a "third party" that's responsible for Bitcoin's price fluctuations. Bitcoin founder Satoshi Nakamoto is anonymous, and there's no central entity "running" the Bitcoin network. Therefore, the SEC considers Bitcoin a "commodity."
Although Bitcoin seems safe from a security designation, the future fate of other tokens isn't as certain. There are debates over whether Ethereum's use cases make it a utility token.
In 2020, the SEC charged the crypto project Ripple with offering an unregistered security with its XRP token. SEC officials have also gone after crypto exchanges like Coinbase for offering tokens it deems "securities."
Unfortunately, there are still no clear guidelines from the SEC on what constitutes a security token versus a utility token. However, since this is such a major topic in the crypto space, there are a few broad arguments on both sides of this issue.
Arguments for cryptos as securities
If a cryptocurrency acts as an investment contract between the investor and the issuer, it should fall under the SEC's oversight. When a clear third party wants to raise funds and expects profit, the SEC will likely request projects to register with them before issuing tokens.
These rules also apply to centralized lending companies that offer clients crypto rewards for depositing their tokens. Notably, the SEC ordered the New Jersey-based crypto lender BlockFi to stop offering its BlockFi Interest Accounts (BIAs) to U.S. investors. The SEC argued that BlockFi's interest product qualified as a security due to the expectation of profits.
Arguments against cryptos being securities
If a cryptocurrency isn't tied to a central authority or comes with an expectation of profit, it's likely not a security token. Since Bitcoin is the prime example of a crypto asset that doesn't pass the SEC's Howey Test, it functions as a transactional currency without a clear central issuer.
Utility tokens shouldn't fall within the SEC's jurisdiction because these tokens are designed to serve a function rather than act as an investment vehicle. If there's no clear expectation of profit and the token issuer puts out their token for functional purposes, it's probably not a security. However, without clear guidelines from the SEC, it remains difficult to separate utility and security tokens.
Stablecoins are another type of cryptocurrency that don’t qualify as security tokens. Although stablecoins like USD Coin (USDC) and USD Tether (USDT) have a third-party issuer, they don't promise to increase in value. Indeed, the "value" of stablecoins is that they remain at a fixed price, usually pegged to the U.S. dollar.
Why do people care if cryptos are securities?
Some people are concerned about cryptocurrencies' "security status" due to potential regulations. If more cryptos qualify as securities, they’ll have to comply with mandates from the SEC. Since many in the crypto industry promote decentralization, some perceive increased SEC oversight as a threat to Web3’s future. People may even have to verify user identity through Know Your Customer (KYC), which will further the challenges in adoption.
Also, if cryptos are classified as securities, they’ll be subject to different tax and auditing laws. The federal government would have greater control over how these tokens are issued on the public or private market. Some traditional investors feel more comfortable investing in cryptocurrencies that meet SEC standards, but crypto purists may feel these regulations run counter to the spirit of decentralization.
What is secure token service?
Secure token service is an online service that issues security tokens.
How do security tokens work for average investors?
Even if retail investors don't plan to buy security tokens, these cryptocurrencies can significantly impact the industry's future.
If the SEC classifies more cryptocurrencies as securities, it will fundamentally change their legal status in the U.S. This means security tokens not only have to meet SEC guidelines but they’re also subject to different tax practices. Token holders will have to report their security token investments yearly as they would other securities like stocks.
Security tokens may also change how retail investors trade digital assets. If crypto exchanges offer security tokens, they need to meet more rigorous standards than those that only offer non-securities like Bitcoin. This may alter the secure token service for buying and selling digital assets. The SEC could put increased legal pressure on crypto exchanges in the future, which may influence how much information investors have to give to comply with federal statutes.
While security tokens offer a unique way for investors to access many financial services, they can complicate regulation in the crypto industry. It’ll be crucial for those involved in cryptocurrency to monitor how agencies like the SEC define security crypto tokens and take the appropriate actions for their situation.
One company that you don’t have to think about in terms of security is Worldcoin. We’re a new organization that aims to put a share of our cryptocurrency for free in the hands of every individual on the planet. We also aim to ensure the complete privacy and anonymity of our users. Subscribe to our blog to know more about us and the world of crypto.