There’s been a lot of confusion in the cryptosphere regarding which tokens qualify as securities under the widely convoluted U.S. Securities and Exchange Commission (SEC) guidelines. And now, the agency has gone out of its way to further demystify this class of assets.
So What is a Security Token?
Security tokens have some striking properties and one of those is that they have tradable value, meaning they can be exchanged or sold. In many cases, they are purveyed by a company seeking initial capital to further the development of a concept. Investors are usually promised direct financial returns through the appreciation of asset-value and this makes them somewhat similar to company shares.
The only difference is that security tokens derive their value from an external tradable asset. It could be part of a company or real estate, for example, but the ‘shares’ are blockchain based.
Security Tokens vs Utility Tokens
Security tokens contrast greatly with utility tokens. Investors of the latter are offered exclusive access to certain services or products provided by the issuing company. A start-up can, for example, propose pre-orders of certain items or provide coupons to its service offerings.
While businesses involved in issuing security tokens undertake Initial Coin Offering events, those that offer utility tokens prefer to label their undertakings as token distribution events (TDEs) or token generation events (TGEs).
SEC Guidelines Regarding Security Tokens
The SEC recently issued a set of guidelines outlining the types of tokens that qualify as securities. The framework which was drafted by the agency’s Strategic Hub for Innovation and Financial Technology (FinHub) division was distinctly provided as a guideline and not a legally binding protocol.
According to a recent press release issued by Bill Hinman, the Director of Division of Corporation Finance, the just-released parameters should be viewed as an analysis tool designed to help investors, SEC staff, and market participants to better assess whether a token qualifies as a security or not. The procedures also offer insight on what types of tokens qualify for an exemption from this categorization.
Enterprises looking to undertake Initial Coin Offerings (ICOs) are obliged to determine whether their offering is categorized as a security. This is because the class of investments is directly regulated by federal laws and the SEC. Failing to register an Initial Coin Offering (ICO) is likely to attract penalties. Some fines run into millions.
The published SEC guidelines include applying the Howey test to determine whether a token qualifies as an investment contract or not. Factors underscored include whether the endeavor is a common enterprise, investment of money is involved and if there is an expectation of profits. If the three conditions are met, then the financing instrument automatically qualifies as a security token.
Security tokens are required to comply with SEC guidelines, including its elaborate anti-fraud provisions which are primarily designed to zap illegal ICOs and protect investors. The agency is allowed to bring civil and criminal proceedings against infringing parties and impose penalties. Anti-fraud procedures also allow investors to request a refund in case of a breach.