Around this time last year, 2019 was declared as the year of security tokens. It was going to be the next big thing after Bitcoin, utility tokens, and blockchain technology in general. And yet, many with an interest in fintech or cryptocurrency still don't fully understand what security tokens are and how they actually work.
So, without further ado, here is the world's simplest explanation of security tokens in layman's terms.
What are securities?
Before we go into security tokens, we must first understand what a security — the first half of the term — is. In the world of finance, a security is technically defined as a certificate declaring credit or the ownership of a real-world asset. In short, it is a financial instrument that you can trade.
The Balance divides securities into three categories, namely: debt, equity, or derivative. Debt is pretty self-explanatory, and investors who buy debt securities are basically lending money to banks, which pay it back with interest. The perfect example of equity securities are stocks. With it, you are essentially buying shares in a company without necessarily owning it — unless you are capable of buying all the shares, which is highly unlikely. Lastly, derivative securities give you the option to trade other securities depending on what was agreed upon. An example of this is a futures contract or a swap.
What are security tokens?
Remember that a token, in general terms, is a representation of something — say, a value or a stake in an ecosystem. So security tokens are securities in cryptographic token form, and Anthony Xie defines it as a tokenized representation of a real-world asset. Again, these assets can be in the form of the aforementioned examples.
Compared to utility tokens, security tokens are investments through which token holders receive dividends, or a sum paid regularly. Meanwhile, utility tokens don't function in the same way. Think of utility tokens as arcade tokens that you can use to exchange for a toy. When you have a certain amount of tokens, you can use these to gain access to a product or a service offered by a company.
Another thing to know about security tokens is how they're obtained. Remember what an initial coin offering (ICO) is? It is essentially crowdfunding in cryptocurrency terms. A guide by FXCM on security token offerings points out that this process is similar to an ICO, where security tokens are sold instead of cryptocurrencies. This way, investors are using blockchain technology to purchase tokens that correspond to real-world assets.
What are the benefits of security tokens?
So, what's with all the initial hype for security tokens?
Because security tokens are backed by real assets, regulation needs to be strict. Security Token Alliance founder Frederik Bussler notes the efficient compliance of security tokens with government regulations — a persistent problem that cryptocurrencies in general have. Smart contracts can be used to automate operations, such as paying off dividends to each of the token-holders in a timely manner. This creates trust among financial institutions and their investors, while automation creates a more efficient and cost-cutting solution to trading.
The reason security tokens haven't lived up to their hype, however, is the lack of mainstream adoption. The Tokenistreports that important deals fell through, especially ones that were highly publicized, and the interest was still limited to a small group of investors. However, there's still a lot of promise that security tokens will take off in the coming years. The key is to find a way to raise the demand for "highly sought-after assets" such as basic consumer goods, and then bring this to a wider market.
Written for decentralize.today