It's been all over the cryptocurrency news. The US government's Securities & Exchange Commission (SEC) is going after cryptocurrencies by claiming they are securities. This has caused a bit of Fear, Uncertainty, and Doubt (FUD) among crypto investors and enthusiasts. This hasn't been limited to residents of the United States: any action taken by the SEC will affect crypto prices worldwide.
But there are some cryptocurrencies that have taken it upon themselves to declare themselves (sorry about the anthropomorphism, it just sounds better) securities. This removes some of the FUD but does create some limitations for these cryptocurrencies, which are called security tokens.
First, how does the SEC define a security? A security passes what is called the Howey test, named after a US Supreme Court case that determined if a transaction was an investment contract. If the transaction was for an investment contract, then the investment was a security.
The Howey test has four parts, all of which must be met in order for a transaction to be considered a security:
- An investment of money (money being the original term, now it is more flexible)
- In a common enterprise
- With a reasonable expectation of profit
- Derived from the efforts of others
Looking at these four criteria, it is clear that Bitcoin (BTC) is not a security, failing the second and third tests (no common enterprise, no expectation of profit).
Most Initial Coin Offerings (ICOs) would meet all four parts of the Howey test. Usually, it comes down to the expectation of profits and the efforts of others. If a token does not pass all four parts of the Howey test, it is classified as a utility token. Utility tokens give their owners some special access to products or services, instead of profits.
Tokens that pass all four parts of the Howey test are security tokens. Most, if not all, security tokens are backed by an asset. Being classed as a security brings restrictions in the United States. Among these restrictions are being limited to accredited investors and SEC-approved investment firms.
Given these restrictions, why would a token voluntarily choose to be a security token? Security tokens, being asset-backed and regulated by the SEC, provide a lower-risk investment in the blockchain world. This makes them suitable for many investors who want stability and increased security, including large investment funds.
The downsides of being a security token are not being available to the general public and only being available through an SEC-registered broker-dealer.
However, these downsides may not deter companies from issuing security tokens, instead of traditional shares of stock. Security tokens can improve liquidity with 24/7 trading, raise capital more easily, and can provide for fractional ownership.
Security tokens may offer innovative means of investing. Imagine a piece of real estate backing 1,000 security tokens. Depending on the token, an investor can buy a tiny fraction of that real estate, maybe only 0.000001 of a token, instead of a more substantial piece if the real estate was put into a partnership. An investor could diversify more easily by buying lots of small pieces instead of just a few larger pieces.
Given the SEC's threats against cryptocurrencies, we may see more security tokens being offered in the future.
It shouldn't need to be said, but here it is: This is neither financial nor legal advice. Do Your Own Research (DYOR). Stay safe out there, fight the good fight, and keep on stacking!
