Securities Concepts & Blockchain Innovation

In the world of finance, securities play a pivotal role as financial instruments with inherent value and tradable attributes. From traditional stocks and bonds to complex derivatives like options, all fall under the broad umbrella of securities, offering investors a diverse range of asset allocation choices. However, in a legal sense, the concept of securities is more stringent and jurisdictional, differing across countries in terms of definition, issuance, and regulatory standards, emphasizing transparency and compliance.


The emergence of blockchain technology has been a tidal wave of innovation, reshaping the way securities are represented and the functioning of markets. This article aims to guide beginners into this emerging field by introducing security tokens - a new form of financial instrument that combines the characteristics of traditional securities with the advantages of blockchain technology. We will reveal how they leverage distributed ledger technology to optimize the structure of financial markets, enhance transaction efficiency, and potentially challenge and reshape existing securities issuance and management models within the boundaries of regulations.

Security Token Offering on the Blockchain

Security tokens, also known as safe or compliant tokens, are digital assets issued utilizing blockchain technology. They possess unique identifiers on the blockchain and represent partial ownership or debt claims in a company, asset, or project, functioning similarly to traditional financial instruments such as stocks and bonds. In other words, security tokens essentially transform real-world equity, debt, and other financial rights into programmable, tradable digital forms, with smart contracts automatically executing relevant rights allocation and transfer, realizing decentralized management and circulation of financial assets.

The Advantages and Case Studies of Security Tokens

In modern financial innovation, companies choose to issue security tokens as a new way to distribute equity, providing investors with voting rights and dividend benefits similar to traditional stocks. For example, a company can tokenize its shares through blockchain technology, where each token represents a portion of ownership in the company and comes with corresponding rights to profit distribution and decision-making.

There are several notable advantages of using security tokens:

1. Enhanced transparency: Transaction records of security tokens based on blockchain technology are public and tamper-proof. Smart contracts ensure traceability throughout the issuance, transfer, and holding process, while protecting anonymity. All participants can review the entire process.


2. Rapid settlement: In contrast to the cumbersome and time-consuming clearing and settlement process in traditional financial markets, changes in ownership of security tokens on the blockchain can be completed instantly, significantly improving asset liquidity.


3. 24/7 trading: Unlike the limited trading hours of traditional financial markets during weekdays, security tokens rely on the characteristics of digital asset markets to enable uninterrupted trading around the clock, greatly increasing market activity.


4. Flexible trading unit division: High-value assets such as art or real estate, after being tokenized, can be divided into smaller investment units, allowing small investors to enter areas that were previously inaccessible. For instance, a $5 million artwork can be split into 5,000 tokens, with each token costing only $1,000 for investment, broadening the investor base and enhancing capital utilization efficiency.


However, it is worth noting that to maintain effective management and facilitate voting right execution, some security tokens may set limits on the minimum token division unit to avoid overly fragmented ownership leading to management challenges. Therefore, when designing security tokens, it is essential to strike a balance between flexibility and practical operability.

Core Differences Between Security Tokens and Utility Tokens

While security tokens and utility tokens share similarities in issuance methods and technological implementation, such as being managed by smart contracts and tradable on the blockchain, they differ significantly in economic attributes, functional positioning, and regulatory requirements.


Firstly, utility tokens primarily serve as a means of payment or access rights for products and services within a project's ecosystem. Similar to a merchant loyalty point system, holders can redeem services with tokens, but they do not enjoy dividend rights when the project profits, and their value fluctuations largely depend on market supply and demand relations and investors' expectations of future projects. If the project fails, the value of utility tokens may plummet significantly, and investors typically have no legal protection.


On the contrary, security tokens are directly linked to real-world asset ownership or company equity and subject to strict financial regulation according to relevant laws and regulations. Investors who purchase security tokens are essentially buying a portion of the company's equity, debt, or other forms of revenue rights; therefore, upon successful operation of the project, they are entitled to share in the company's profits or losses. The STO (Security Token Offering) process during security token issuance follows rigorous securities issuance regulations in traditional financial markets, ensuring that investor rights are adequately protected. Compared to an IPO (Initial Public Offering), STO merely digitizes securities and utilizes blockchain technology to enhance efficiency and transparency.

Reasons for Token Securitization and Regulatory Considerations

Token securitization has emerged as a significant issue in the blockchain industry, driven primarily by the pursuit of legal clarity and compliance. With the rapid development of fintech, many issuers have attempted to raise funds through utility tokens; however, such tokens may substantially comply with Traditional security definitions, particularly when investors expect to derive profits from project initiators or third parties.


The U.S. Securities and Exchange Commission (SEC) employs the Howey Test as a standard for determining whether an investment contract constitutes a security, focusing on whether investors expect to profit from reliance on another's efforts. However, due to the unique characteristics of blockchain and digital assets, applying this test originates from traditional financial markets directly to new tokens presents challenges.


To adapt to the evolving financial market landscape, regulatory agencies worldwide are actively constructing new frameworks tailored to blockchain tokens. Although specific regulations differ across jurisdictions, most adhere to similar principles ensuring investor protection and preventing fraudulent activities. Consequently, token securitization aims to fall under the jurisdiction of existing financial regulations, enabling businesses to operate legally and compliantly while providing investors with a clear and transparent investment environment.

The Innovation of Security Tokens and Programmable Finance

At the forefront of fintech, security tokens powered by blockchain technology have given birth to a new concept called "programmable finance." This innovation enables traditional financial assets to be expressed, traded, and managed in digital form, not only reducing market friction but also greatly enhancing efficiency and transparency.


In the past, financial markets were limited by centralized database systems, resulting in cumbersome and time-consuming settlement processes, poor data compatibility between institutions, and high operational costs due to the lack of unified standards. On the other hand, blockchain functions as a decentralized shared database that allows all participants to interact directly on a ledger maintained collectively, thus enabling seamless integration.


By tokenizing securities, these assets can be embedded into a globally interconnected network, allowing for real-time settlement and significantly shortening the delivery cycle. Furthermore, smart contracts can automatically execute many complex operations, such as investor identity verification (KYC) and anti-money laundering (AML) compliance procedures, investment lock-up period management, and more, ensuring precise rule execution while minimizing potential risks associated with human intervention.

Security Token Offerings and Compliance Requirements

Ensuring compliance is crucial when issuing security tokens. Since security tokens represent some form of investment contract or equity, they are subject to rigorous scrutiny and regulation by financial authorities worldwide. For instance, in the United States, according to the SEC (Securities and Exchange Commission), any token that meets the Howey Test is considered a security and must be registered or exempted under federal securities laws.

The process of issuing security tokens typically involves several key steps:

1. Legal Consultation and Framework Development: Issuers first need to seek professional legal advice to determine whether their token falls within the securities category and design a compliant issuance structure accordingly, such as through exemptions like Reg D, Reg A+, or Reg S.


2. Disclosure and Transparency: Similar to traditional securities offerings, security tokens also require detailed disclosure documents, such as whitepapers, prospectuses, etc., to clearly present investors with the project's business model, financial status, risk factors, and intended use of funds raised.


3. KYC/AML Verification: To comply with anti-money laundering and know-your-customer requirements, issuers must verify the identity and background of individuals or entities participating in the investment.


4. Trading Platform Selection: Only exchanges with the appropriate licenses can trade security tokens; thus, issuers need to find platforms that have obtained the necessary permits and comply with relevant regulations for collaboration.


5. Ongoing Reporting and Compliance Obligations: After issuing security tokens, issuers must also submit regular reports to regulatory agencies, promptly updating project progress and financial status, and fulfilling other potential ongoing compliance obligations.

Conclusion

In summary, security tokens, as a product of the intersection between blockchain innovation and the financial world, achieve the digitization of asset ownership, transaction transparency, and improved management efficiency by mapping traditional securities rights to a distributed ledger. This emerging field challenges the existing structure of financial markets while also presenting the possibility of reshaping securities issuance and management models. Looking ahead, as global regulatory frameworks gradually adapt and embrace this innovative form, security tokens are poised to further drive the development of programmable finance and broaden investors' access to the market under compliance.