Blockchain For Beginners Part 5: Security Tokens

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In this Smart Money Club Blockchain Basics lesson, we continue to expand your knowledge, introducing you to Security Tokens.  Security tokens are the finance industry’s future, and they offer new opportunities for investment that were not previously possible.  Security tokens are made up of both Fungible and Non-Fungible Tokens.  We’re taking you to the Power of X, explaining why security tokens are only possible with distributed ledgers and what novel options they bring.  Let’s begin!!!!

The Basics

Security tokens are digital contracts for nearly any type of asset; this includes real-world assets.  Cryptocurrencies and NFTs are both types of security tokens.  However, security tokens can be for almost anything (a car, stock, real estate, or a celebrity’s future income), and once in token form, security tokens can also be subdivided into fractions of the asset, as small as the code written when the token is created allows.  An advantage of security tokens on a blockchain is that the owner knows that their ownership is immutable until they sell the token, and all information is saved on the blockchain’s ledger and can be publicly verified.  These capabilities add value to assets that were once illiquid and unavailable to many retail investors.

An example helps:

Say you have a home worth $1,000,000 and you also have the opportunity for another investment that requires $100,000; rather than take out a mortgage on the house or sell the home outright, you create security tokens for your home, a total of 1 million of them, and you sell 100,000, enough for the new investment, and you can remain in your home.  If an investor buys all 1 million tokens, they are the home’s new owner. 

Two types of security tokens

Fungible

These are any tokens that can be interchanged, like bitcoin, one fungible token is worth the same as every other.  If a company has security tokens for its shares, each token will all be equal in value.  Fungible security tokens can also be subdivided into fractions, like some online broker’s offering of stocks, or the smallest denomination of a Bitcoin (1/1000000th) a Satoshi, you can buy fractional parts of a fungible token.  This fractionalization capability opens opportunities to purchase part of a share in a Private Equity fund, multifamily syndication,  or 1/500,000th of a work of fine art, the kinds of investments that were previously unavailable to retail investors.

Non Fungible

These are non-interchangeable, nondivisible, and unique assets.  NFTs are the classic example of this kind of security token. 

What can be tokenized?

The possibilities are endless because tokenization creates both fractional ownership and proof of ownership but fall into a few categories:

Assets– any item of value that can be converted to cash, including personal (cash/property) or business assets (on a balance sheet).

Services-future goods and services can be offered by a company or individual to raise money.  Investors can use the tokens to purchase the goods like a redeemable anytime (or defined time) futures contract.

Equity- Shares can be tokenized and stored in an online wallet but easily traded on an exchange. 

Funds- Funds can have assets that tokenized, representing shares of the fund that can be subdivided and sold.

Security Token Advantages

Liquidity and Prices- When there are fractional shares, the liquidity of assets is increased; you can now buy part of a home that would normally not be available, which means that prices also become fairer.  

Reduced costs– Third-party intermediaries (lawyers/banks) are no longer needed because the transfer is on the blockchain, reducing costs. 

Transparent process– being on the blockchain, the history of an asset is known, and a seller is unable to make it look better than reality.

Identity confirmed- Token requirements and the digital signatures of public and private key pairs can ensure that Know Your Customer (KYC), and Anti Money Laundering (AML) processes have been fulfilled.

The Future of Security Tokens

Tokenization is transforming finance.  Being new, the quick expansion is faster than the legal and regulatory framework around it.  The view from the investor will remain mostly the same; a platform will have various investment options it provides.  What happens behind the scenes with offerings, ease, and prices that democratize market access and ensure fairness and security, will be drastically different.  Every new type of security token will require a new regulatory framework.  E-sports trading cards have entirely different hurdles compared to a fractionalized investment in real estate or a human’s future earnings.  The creation of a legal bridge between an asset and a blockchain’s distributed ledger needs the cooperation of legal and tax professionals to solve cross-jurisdictional issues.  The process will likely take longer than expected, but new solutions will be coming to the market as these issues are resolved, changing our lives for years to come.

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