Security Token Academy Frequently Asked Questions

What is a security token?

A security token is a type of tokenized asset (e.g. stock), classed as a security under the laws of a governing jurisdiction (e.g. United States), issued, tracked, and traded using a blockchain (e.g. Ethereum).

Security tokens are also referred to as digital securities, tokenized securities, and blockchain-based securities.

Are security tokens treated the same as “regular” securities by securities regulators?

Today, most jurisdictions aim to treat security tokens using the exact same laws and regulations as “regular” securities. The difference between “security tokens” and “securities” is one of form -- not substance.

Security tokens are unique in that they are created and issued inside of a digital wrapper (i.e. a digital token), allowing the security to be owned, tracked, and traded in a blockchain-based environment. This digital wrapper, in conjunction with a trustless blockchain database, aims to empower our global pool of assets in new and innovative ways.

What are some of the benefits of security tokens?

There are a number of potential benefits that security tokens and blockchain-based transfers of assets could bring to our private and public securities markets:

• 24/7 Markets. Today, major U.S. stock market exchanges have limited daily trading hours, and are closed on weekends. Blockchain ecosystems empower a technology stack that operates non-stop, which could one day extend to our private and public securities markets -- creating additional forms of value.
• Fractional Ownership. For many retail investors, it’s non-trivial to come up with the resources to buy single high value assets, like commercial real estate or fine art. Today, an investor can either forego exposure of that expensive asset category entirely, or obtain exposure through an intermediary (REIT). Due to the unique divisibility of blockchain-based securities, fractionalization can provide non-intermediated access to previously inaccessible categories of expensive assets.
• Rapid Settlement. Today, public market exchanges like NASDAQ and NYSE can execute trades quickly, but settling ownership of those trades is typically two days (Trade + 2 Days). Alternatively, private market securities can often take weeks or months to trade or transfer. With security tokens, ownership claims will have the ability to trade and settle in seconds or minutes.
• Cost Reduction. One of the most attractive benefits for security tokens are the proposed reduction in back-office and administrative costs associated with today’s issuance and management of securities. For example, when startups are acquired, reconciling capitalization tables to the underlying purchasing agreements and option grants can be costly -- when ownership claims are tokenized, cap tables are reconciled in real time by code.
• Increased Liquidity and Market Depth. Many private securities today, like Limited Partner (LP) interests in a fund, are relatively illiquid -- which means the ownership interests are costly to trade and will affect the asset’s price. Tokenized funds could allow fund managers to invest in illiquid assets without fear of redemptions, while fund investors are able to access liquidity in secondary markets. As a result of these deeper markets and improved investor liquidity, one might also expect an increase in an asset’s value.
• Automated Compliance. Today, regulatory compliance for securities is typically documented through a series of separate ledgers -- each constructed by entities that facilitate issuance and/or secondary trade. Only through reconciliation of these segregated ledgers is ownership and compliance legally validated. With security tokens, which are built on a model leveraging transparent and immutable blockchain ledgers, regulators will have a far easier time keeping track of compliance issues, system manipulation, or fraud.
• Asset Interoperability. Today’s centralized solutions for electronic value transfer of securities lack compatibility -- they don’t talk to each other. With standardized digital formatting, security tokens will be able to reference each other contractually and automatically.
• Design Space Expansion. Security tokens will allow us to build in contractual features to securities that have previously been impossible to execute. For example, features can be built within the digital wrapper of a security token to help shape corporate governance -- the longer you hold the stock, the more votes you may be able to get. Or, new forms of access rights -- a minority owner of a restaurant could gain access to priority seating or off-menu items. With security tokens, new forms of value could be un-bundled and re-bundled to blockchain-based securities.

You can learn more about these security token benefits in Security Token Stories Episode #2 between STA’s Derek Edward Schloss and Stephen McKeon, Professor of Finance at University of Oregon.

What is a blockchain?

A blockchain is a type of database. Like other databases, a blockchain can store information about transactions and events that have occurred in the past. However, a blockchain is a special type of database because multiple copies of its contents are shared across many computers simultaneously -- a kind of “distributed” database.

It’s important to note that blockchains are distinct from other types of distributed databases due to the unique method by which all participants are able to simultaneously agree—or, form consensus—as to the contents of a blockchain's stored information. As a result, participants can be sure that they’re looking at the same historical data as all other participants, and that no actor was able to improperly manipulate the ledger’s historical data.

Before blockchains, recording, storing, and managing information on a database required a centralized party. With blockchain, however, a central party is no longer required—opening up new opportunities for peer-to-peer value creation.

What is a tokenized asset?

An asset is any item of value. Assets can refer to things like cash, a home, a share in a company -- even precious metals and artwork.

Generally, assets can be categorized into the following three categories:

• Tangible Assets. Assets that have a physical presence (property, equipment, art).
• Intangible Assets. Assets that have no physical presence (patents, copyrights, trademarks).
• Financial Assets. Assets that have value based on a contract (stocks, bonds, derivatives).

Using these three categories, a tokenized asset is simply a digital entry (“token”), representing any item of value (“asset”), on a distributed database (“blockchain”).

Examples of tokenized assets include things like tokenized currencies (e.g. US Dollars), tokenized commodities (e.g. Oil), tokenized real property (e.g. Empire State Building), tokenized goods (e.g. Gift Card) or even tokenized securities (e.g. Apple Stock).

What is the legal definition of a security?

Generally, “securities” refer to assets like notes, stocks, bonds, futures, options, and investment contracts.

From a legal perspective, the U.S. Securities Act of 1933 defines a security as any “note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. (15 U.S. Code §77b(a)(1)).

Importantly, “investment contracts” are a category of security defined in the Securities Act of 1933. The U.S. Supreme Court’s Howey Test is used to determine whether certain transactions (offers, sales, distributions) qualify as “investment contracts” -- if so, then the transaction is a security subject to the regulatory oversight of the SEC.

Under the U.S. Supreme Court’s Howey Test, a financial instrument qualifies as an “investment contract” for the purposes of the Securities Act of 1933, if a person:

1. (1) Invests money;
2. (2) In a common enterprise;
3. (3) Expecting a profit;
4. (4) Predominantly from the effort of others.

What are some examples of how issuers, investors, and regulators can benefit from security tokens?

• Issuers. With security tokens, securities issuers might enjoy a larger investment pool, a wider geographic base of potential investors, and a reduction in the “cost of capital” typically associated with securities issuance -- in addition to cost reductions as a result of streamlined compliance and reporting.
• Investors. With security tokens, investors might enjoy improved settlement speeds, a wider range of trading times, more sovereign ownership of their assets, and efficiency improvements -- all of which may create significant cost savings for investors over time. In addition, fractionalizing assets using blockchain ledgers could deepen the investor base for certain categories of assets. By deepening the pool of potential investors and reducing existing frictions to trade (e.g. compliance, trading times, intermediaries), it’s possible that certain assets might enjoy improved liquidity over time.
• Regulators. With security tokens, regulators might benefit from improved visibility into assets, entities, and markets -- along with enjoying new forms of automated legal enforceability.

What are the major categories of entities helping build the security token industry?

• Issuance Platforms. Issuance platforms help provide asset owners the necessary tools to create, issue, and launch security tokens. Often integrated with issuance platforms, security token compliance providers will help issuers on these platforms engage in key services like KYC (“Know Your Customer”) and AML (“Anti Money Laundering”) identity verification.
  
  Example: Harbor, KoreConX, Securitize, Securrency, StartEngine, TokenSoft, Tokeny
• Trading Platforms. These platforms facilitate the secondary trading of security tokens.
  
  Example: tZERO
• Custodians. Custodians are third-party service providers that custody security tokens on behalf of their legal owners. Custodians safekeep digital assets and minimize the risk of their theft or loss.
  
  Example: Prime Trust, TokenSoft
• Cap Table Management. Cap Table Management platforms enable Broker-Dealers, Issuers, and Investors to visually manage portfolio data on a single platform -- including accurate capitalization tables, communications, and compliance.
  
  Example: Vertalo
• Transfer Agent. Transfer Agents are service providers tasked with tracking and managing securities transfer and ownership. This includes the ability to issue and cancel changes in ownership, act as an intermediary between an issuer and asset holder, and handle certificate theft, destruction, or loss.
  
  Example: Securitize
• Regulators. In the United States, the SEC regulates securities law at the federal level. FINRA, a self-regulatory organization (SRO), declares the rules that govern broker-dealers (BD) and other professionals within the securities industry.
  
  Example: SEC, FINRA
• Broker-Dealers. Broker-Dealers are organizations which engage in the business of trading securities. When executing trades on behalf of a customer, the organization is called a broker. When executing for own account, they are called dealers.
  
  Examples: StartEngine
• Law Firms. Law firms and legal practitioners help provide the legal structure and regulatory compliance required for both security token issuance and lifecycle compliance.
  
  Example: Clifford Chance

Many of these early security token infrastructure companies and professional service providers are part of Security Token Academy’s growing list of Corporate Members and Professional Members. You can learn more on securitytokenacademy.com.

What is the difference between a registered securities offering and an exempt securities offering as it relates to STOs?

As security tokens are simply digital representations of securities, they are also subject to the same rules as non-tokenized securities offerings. In the United States, securities offerings made to U.S. residents must either be (1) registered with the SEC, or (2) exempt under the Securities Act of 1933.

There’s a number of benefits to conducting a registered offering -- issuers can generally solicit, sell to diverse investor pools across accredited and unaccredited investors, the securities are freely transferable for trading immediately upon sale, and issuing companies are not subject to regulatory limits on the amount raised.

In registered offerings, the issuer creates a public offering by filing a Form S-1. The S-1 requires companies to provide information on its planned use of capital proceeds, the business model, competition, and a prospectus of the security being sold. Once the S-1 is filed, the SEC will review the forms, and declare the registration effective. Once the company's registration statement is deemed effective, the company becomes subject to Exchange Act reporting requirements, which require that the company files annual reports on Form 10-K and quarterly reports on Form 10-Q with the SEC.

You can learn more about registered offerings on the SEC’s website here.

Alternatively, an issuer of securities may seek an exemption from registration. In 2012, the JOBS Act was signed into law, creating an updated regulatory framework for retail participation in exempt securities offerings under Reg CF, Reg D, and Reg A+. Before the JOBS Act, exempt securities offerings were only available to accredited investors. The JOBS Act enabled new access for all types of retail investors -- both accredited and non-accredited -- to participate in the growth of early stage companies. The most common types of exempt offerings as of 2019, along with a brief description, are listed below:

Regulation Crowdfunding (Reg CF) enables certain companies to offer and sell securities on an internet based platform through an intermediary that is a registered broker-dealer or registered funding portal.

Rule 506(b) does not permit the use of general solicitation, but allows issuers to sell securities to an unlimited number of accredited investors, and a small number of sophisticated non-accredited investors.

Rule 506(c) permits the use of general solicitation where all purchasers are accredited investors, and the issuer takes reasonable steps to verify that each purchaser is an accredited investor.

Regulation A is an exemption from registration for public offerings -- although offerings made pursuant to this exemption share many characteristics with registered offerings.

You can learn more about Reg CF, Reg D, and Reg A+ on the SEC’s website here.

What is an accredited investor?

As stated above, sales of securities must be registered with the SEC -- unless an exemption is used. If an exemption is to be used, it’s important for issuers to become familiar with the concept of accreditation, as a number of the qualifying exemptions require that offerings must be made to investors deemed to be accredited.

In the U.S., an accredited investor is typically any natural person with income exceeding $200k in each of the two most recent years, or joint income with a spouse exceeding $300k for those years, and a reasonable expectation of the same income level in the current year. Alternatively, an accredited investor can also be any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1.0M.

You can learn more about accredited investors in Security Token Stories Episode #6 between STA’s Derek Edward Schloss and Jor Law, Co-Founder at Verify Investor (STA Gold Corporate Member).

What is KYC/AML as it relates to financial service providers and securities offerings?

Firms must comply with the Bank Secrecy Act, and its regulations like Anti-Money Laundering (AML) rules. AML are the rules, regulations, and procedures that help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing -- including securities fraud and market manipulation. Know Your Customer (KYC) is a part of AML rules and regulations, and includes the verification of a customer’s identity before a firm can provide financial services.

FINRA reviews a firm’s compliance with AML rules under FINRA Rule 3310, which sets forth minimum standards for a firm’s written AML compliance program.

As security tokens are simply digital representations of securities, they are also subject to the same regulations as non-tokenized securities. Many security token issuance platforms today can help provide key identity services like KYC/AML for new issuers.