As the blockchain industry continues to mature, the use of security tokens as a way to raise capital is becoming increasingly popular. Security tokens are digital assets that represent ownership in a company or other investment, and they are subject to a variety of regulations to ensure investor protection. In this article, we will provide an in-depth guide to the regulations around security tokens, covering everything from their definition to their legal status and how they are regulated.
What are Security Tokens?
Security tokens are digital tokens that represent ownership in a company or other investment. Unlike utility tokens, which are used as currency or for access to a product or service, security tokens are considered investment contracts and are subject to securities laws. Security tokens can represent ownership in a wide range of assets, including stocks, bonds, real estate, and other alternative assets. Security Tokens have been used to raise funds against future revenue streams, this would be particularly useful for straight revenue plays like battery storerage.
As an example, a 10MWH battery storage project in the UK would typically cost £5M -£7M from inception to launch. It would typically generate £1 million per annum in revenue.
To give you an idea of that potential market:
There is now 2.4GW/2.6GWh across 161 sites of operational energy storage in the UK. The requirement for net zero by 2050 is 150GW of electrical storage. That is potentially £15 billion per annum in revenue for those sites. If just some of these are funded by security token holders sharing in that revenue it is a massive opportunity.
Legal Status of Security Tokens
The legal status of security tokens is a complex issue that varies by jurisdiction. In the United States, the Securities and Exchange Commission (SEC) has taken the position that most security tokens are securities and therefore subject to securities laws. In the UK they are regulated as securities but could, depending on how they are structured have different rules applied. For example, if the structure is as debt then other rules can apply. If the way that the security tokens are structured a certain way they could be seen as a ‘collective investment scheme’.
So in our above example, buying into the contractual revenue directly, would be a security, where the tokens were secured on asset it is likley to be debt and if holders have bought into an enterprise where the managemnet buy battery storage assets and shares the profits with hodlers that is likley to be a collective investment scheme.
Other countries have taken different approaches, with some recognizing security tokens as a separate asset class and others treating them as securities.
Regulations around Security Tokens
The regulations surrounding security tokens are intended to protect investors from fraud and ensure that issuers comply with securities laws. These regulations vary by jurisdiction, but typically include requirements for disclosure, registration, and compliance with securities laws. Some of the most common regulations around security tokens include:
Issuers of security tokens are typically required to provide investors with detailed information about the investment, including financial statements, risks, and other relevant information. This information is usually provided in a prospectus or other offering document and is intended to help investors make informed decisions about the investment.
In many jurisdictions, security tokens are subject to registration requirements with securities regulators. This process involves submitting detailed information about the investment to regulators and obtaining approval before offering the tokens to the public.
Compliance with Securities Laws
Security tokens are subject to the same securities laws as traditional securities, including laws around insider trading, market manipulation, and other fraudulent activities. Issuers of security tokens are required to comply with these laws to ensure that investors are protected.
Many jurisdictions impose offering and sales restrictions on security tokens to ensure that only qualified investors can purchase them. These restrictions may include limits on the number of investors or the minimum investment amount, and they are intended to protect less experienced investors from risky investments.
Secondary Trading Restrictions
Secondary trading of security tokens is subject to a variety of restrictions to ensure that only qualified investors can trade them. These restrictions may include limitations on the platforms where tokens can be traded or requirements for third-party custodians to hold the tokens. In the case of security tokens over ASMX connectedplatforms, these are traded as listed securities on an exchange, so are available to a wider type of investor community
Anti-Money Laundering (AML) and Know-Your-Customer (KYC) Requirements
Issuers of security tokens are required to comply with AML and KYC requirements to prevent the tokens from being used for illegal activities. These requirements may include verifying the identity of investors and monitoring transactions to detect suspicious activity.
The Legal Framework for Security Tokens
The legal framework for security tokens is still evolving, but several key regulatory bodies and legal frameworks have emerged. These include:
Securities and Exchange Commission (SEC)
The SEC is the primary regulatory body for securities in the United States and has taken a strong stance on security tokens. The SEC has issued guidance on how security tokens should be treated under securities laws and has taken enforcement action against issuers that violate securities laws.
This is probably one of the best ways of thinking about whether your offering is a security or not. The Howey Test is a legal framework in the USA that has been used by courts to determine whether an investment is a security. The test considers whether the investment involves an ‘investment of money’, a ‘common enterprise’, and an ‘expectation of profits from the efforts of others’.
If you apply that simple test against your project you have your answer. Buy an NFT that gives you revenue from the efforts of others… security! Buy a crypto that has an inbuilt mechanism for the price to go up?… it’s a security. You have the ability to use it over a platform as ‘currency’ but you trade it like an equity? Probaby a security. Put it like this, your Costa Coffee beena collection is used to buy free coffee when you get 8 beans, that is utility, if those ‘beans’ are on a blockchain, trading on an exchange and you buy it with expectation of profit..but can also use it to buy coffee…
Security Token Offerings (STOs)
STOs are a type of crowdfunding that allows companies to raise capital by issuing security tokens. STOs are subject to securities laws and typically require disclosure and registration with securities regulators.
Blockchain Regulatory Sandbox
Some jurisdictions have established blockchain regulatory sandboxes to allow issuers of security tokens to test new technologies and approaches in a controlled environment. These sandboxes can provide a way for issuers to innovate while still complying with securities laws.
Q: Are security tokens the same as utility tokens?
A: No, security tokens are investment contracts and are subject to securities laws, while utility tokens are used as currency or for access to a product or service.
Q: How are security tokens regulated?
A: Security tokens are regulated by securities regulators in the jurisdictions where they are offered. These regulations typically include requirements for disclosure, registration, and compliance with securities laws.
Q: What are the benefits of security tokens?
A: Security tokens offer a number of benefits over traditional securities, including increased liquidity, lower transaction costs, and fractional ownership.
The regulations around security tokens are complex and vary by jurisdiction, but they are intended to protect investors from fraud and ensure that issuers comply with securities laws. Investors and issuers alike must understand these regulations to make informed decisions and ensure compliance. As the use of security tokens continues to grow, it’s likely that the legal framework will continue to evolve to accommodate new technologies and approaches. By staying informed and engaged with the regulatory landscape, investors and issuers can take advantage of the benefits of security tokens while still complying with the law.