This is the first part of an insight series by Tanner De Witt partner, Pádraig Walsh, in which he gives his legal perspective on security token offerings. In this article, he starts from the basics, and asks and answers what are security token offerings and why we should care.

What is a token?

A token is a digital asset that represents rights in respect of an application built on a blockchain protocol. The owner of the token has the ability to access, use, receive the benefit of or transfer those rights. For example, Basic Attention Token is a decentralized application built on the Ethereum protocol, and the BAT is the token related to usage on that dApp.

What would it look like if I saw one?

Digital code.

Is a virtual asset the same as a digital asset?

Digital assets apply across all technologies. Virtual assets have acquired a usage that is specific to the blockchain and crypto space. So, virtual asset means a digital asset in the crypto space.

The Hong Kong Securities and Futures Commission (SFC) described virtual assets as a digital representation of value, which is also known as “cryptocurrency”, “crypto-asset” or “digital token”. Then, the SFC described the features of virtual assets as including a means of payment, a right to present or future earnings, a right to access a product or service, or a hybrid of any of these. So, virtual asset means a digital asset in the crypto space.

You mentioned a blockchain protocol. What is that?

A protocol is a technology layer which exists independently without reference to or reliance on other protocols. A blockchain protocol uses blockchain technology, and is built on the internet protocol. Each blockchain protocol is independently created, and does not use other existing blockchain protocols. This is importance because a security token is a token issued by an application built on a blockchain protocol. So, one of the first decisions to make is which protocol to use. For example, the Bitcoin protocol has issued coins called bitcoin, which allow users of Bitcoin to transfer bitcoin.  Other examples of protocols include Ethereum, EOS, and Stellar.

And that’s the same as a coin, right?

Well, not really. A coin is the reward mined in a protocol, and which is then traded. A token is issued by an application built on a protocol, and only operates within that application (usually). But, once they come into existence, a coin and a token are quite similar.

Are there different types of tokens?

Here are the broad categories:

  • Utility tokens: A token with the primary purpose of providing access to, and buying or using a service provided on a blockchain platform. For example, STORJ is the token needed to make use of Storj, a decentralized cloud storage solution.
  • Payment (or currency) token: A token with the primary purpose of exchanging value or payment by users of a blockchain platform, for goods and services offered outside the platform. BTC is the classic example of a payment coin.
  • Security token: A token with the primary purpose of being a digital representation of a security instrument, or providing the rights and benefits of a security instrument. For examples, TZRO is the security token issued by tZero in its security token offering.
  • Asset token: A token with the primary purpose of being a digital representation of an ownership right in an underlying asset, or to revenue or profit generated by that asset. Asset tokens are a subset of security tokens. An early example of an asset coin is the Aspen coin issued in the tokenized asset offering in respect of the St. Regis resort in Aspen.
  • Hybrid token: A token that combines elements of these (and in future, other) categories of tokens.

These are evolving, and within these categories, there are tokens of many different stripes and colors.

What is the big fuss about security tokens?

One of the main problems is regulation. Many “utility” tokens can be classified as security tokens (or another form of regulated token). Also, even if a token is considered a utility token in one location, it could be considered a security token in another. It’s complicated, grey, uncertain and risky. There is much greater regulatory certainty if the token is treated by the project promoters as a security.

Regulation is a pretty heavy burden. Why would I want to take that on?

As the security token environment matures, the cost of a public offering will reduce. There will be disintermediation – less need for lawyers, brokers, registrars and other middlemen. The ongoing compliance process will become significantly automated. Think: securities compliance as a service (SCaaS). Regulation could become … attractive.

It is just about regulation then?

That is only one reason. There are quite a few practical benefits to security tokens. These generally arise from the use of blockchain technology in a securities context. These include:

1.  Increased liquidity: Security tokens reduce friction in security transfer. This increases the ease of selling the security, and reduces the illiquidity discount often attributed to private investments.

2.    Increased market depth: Security tokens increase the number of people able to participate in token trading. This can be done by fractionalization of the investment. So, an expensive investment may have an investment threshold too high for many to participate. If that can instead be divided into many fractional interests, the bar to investment can be reduced. Then, there are many more people who can participate. For instance, there may only be a handful of people in the world that could buy an original Andy Warhol. But there could be many more who could buy a security token that represents 1/1,000 of an Andy Warhol. That’s depth.

3.    Disintermediation: There should be less need, or even no need, for intermediaries who are essential to the current process. The share register will be automatically maintained in an irrefutable record. Transaction processing, clearing and settlement will be automated and almost instant. Assessment of permitted persons to participate will be governed by smart contracts, not lawyers.

We will tokenize the world!

Not quite. The best use case for security tokens is illiquid assets that are sensitive to the cost of capital but agnostic to the identity of investors.

Use English I can understand.

Well, let’s take a couple of examples.

Take a social enterprise business. The identity of the key stakeholders in the business is a critical feature. The notion that it could be anybody would be shocking. Not a good candidate for tokenization.

Real estate is illiquid. Cost of capital dictates the attractiveness of the investment. Lower the cost of capital, and market entry is attractive. The identity of the investors is not important. These characteristics make quality real estate asset a good use case for tokenization.