Security Tokens Are
Not All Created Equal

A Critique

Blog Article Series
Claus Skaaning: 26-08-2019


Security tokens are tokens with a security property, for example revenue sharing voting rights. In some cases they resemble shares, and in other cases bonds and other familiar security types.

Security tokens were in practice invented by the United States Securities and Exchange Commission (SEC) who was struggling to classify the flood of crypto tokens being issued in 2017 and 2018. The companies creating the tokens hoped that they would be treated as as outside securities regulation as "utility tokens." However, this proved to be a false hope.

Some tokens had classic properties associated with securities such as profit sharing or voting rights while others in more general terms offered "security like" profits over time to investors. Almost all of them were deemed to be securities falling under security regulations. Recently, the SEC has identified a few very obvious cases where tokens were not being sold to raise capital or the tokens were not offering any kind of investment return, etc.). Hence security tokens as a category was created and innovation could proceed in new directions.

The categories of utility tokens and security tokens still exist but are useful in only some jurisdictions. In the US almost all tokens are issued as securities even for quite clear cases of utility tokens but in many European and Asian jurisdictions it is still possible to issue well-designed utility tokens to offer potential investment profits in the future while evading securities regulations.

Innovation is going in many directions. While some are focused on developing optimal representations of old-fashioned types of securities like stocks and bond on the blockchain, others are inventing new types of securities that may either be more limited or more complex. The fact that securities can now in many countries be fully issued and managed with software increases the design scope for securities enormously and suddenly makes it possible for a broader range of people from outside the financial world to have influence on the design of securities.

DigiShares is focused on porting traditional securities to the blockchain because these securities have been developed over hundreds of years and their properties are very well understood by both issuers and investors. These traditional securities have the same investor protections as non-blockchain ones. Our innovation is primarily focused on automating procedures relating to issuance, management and trading of tokenized shares, bonds, assets and debt-instruments.

Other companies are focused on designing new types of securities that are designed to specific applications, such as the production of films or the financing of real estate projects. These securities can be designed so they precisely match the life time and the money flows of the underlying asset. For instance, a real estate security token can handle the regular payout of rent to investors, and a film production security token could take into account the life time value of the film where most of the value is produced in connection with the release. Such tokens create value since they more closely reflect the nature of the specific application. This makes them easier to understand and evaluate than more generic types of securities.

Where innovation goes wrong is where the new design scope of security tokens is abused to create more simplified and issuer-friendly tokens. When issuing tokens to raise capital, it is extremely easy and tempting to design the token so the issuer's rights are increased and the investors' rights are decreased.

We have seen many examples of this in the recent wave of STOs. Indeed it seems a large proportion of current STOs sell a security to investors that is more limited than a standard share or bond. While many STOs could easily issue standard tokenized shares with full voting rights, dividends, pre-emptive rights, buy-back rights, or piggybacking rights they have chosen to issue much simpler tokenized securities as a "revenue sharing right" or a "profit sharing right" and nothing else. In some cases that we have reviewed, the issuer management even withholds the right to distribute these "dividends" so the "shareholders" have no guarantees of seeing a profit in the future. Utility tokens disguised as security tokens may be even worse, as they masquerade as securities while offering no governance rights at all.

We hope that regulators will catch up and start looking at security token design to uphold consumer and minority shareholder protections. We also hope that industry players such as forthcoming security token exchanges will make it easy for consumers to determine the qualitative differences between tokens with different degrees of rights. A starting point could be to classify tokens as shares, bonds, or other traditional security types, or more limited simplified tokens with only revenue share or profit share, so that the difference is clear to investors.

Hopefully the market itself will build into the price of traded securities whether they are securities with full rights or handicapped versions such that issuers are incentivized to act in the best interest of consumers and shareholders.


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