The short version
- Security tokens are the blockchain equivalent of stocks or pre-IPO shares, representing ownership in a company or project.
- Any stock that trades on the stock market can be converted into a security token (called a tokenized stock), but where security tokens can be especially helpful is for investing in companies before their IPO.
- Pre-IPO security tokens can be very risky as they combine features of startup investments with cryptocurrencies.
What is a security token?
A security token is a digital currency asset representing ownership of an underlying company or project. Each token is stored on a digital wallet using blockchain technology, similar to cryptocurrencies and NFTs. In fact, they often use the same software as existing blockchain projects.
While cryptocurrencies such as Bitcoin and Ethereum act more like fiat money in that you use them to buy and sell other assets, security tokens represent a portion of an asset's ownership, making them more like a stock.
Any stock that trades on the stock market can be converted into a tokenized stock. In fact, there are already tokenized stocks for many popular companies such Tesla and Amazon. However, where security tokens can be especially helpful is for investing in companies pre-IPO.
Access to pre-IPO shares has traditionally been restricted to venture capital firms. But security tokens make it easy for anyone to invest in a company before its IPO. Still, investing in security tokens carries many of the same risks as investing in pre-IPO stocks. You could see your investment grow by 10x or more. But your investment could also crater if the project falls through or goes bankrupt.
While you could earn huge returns, you may also lose everything. With the risks and potential benefits in mind, you should tread carefully when investing in pre-IPO security tokens.
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How do security tokens work?
Security tokens are blockchain assets tracked using a public ledger known as a blockchain. If you’re not familiar, blockchains are distributed databases. Many computers worldwide, called “miners,” either work together or compete against each other to process and validate new transactions. This leads to a trusted, undisputed source for the history of ownership of all assets on that blockchain.
Like cryptocurrencies, security tokens are held using digital wallets. Each digital wallet consists of a public address and a private key used to send and receive transactions. If you own a cryptocurrency wallet that’s compatible with the desired token, you can buy it, likely with cryptocurrency, and can keep proving ownership of that asset by controlling your digital wallet.
When tokens are first sold to the public, the seller gets to keep all of the proceeds from that sale. Like when a company goes public with an IPO, these funds are often used to help invest in and grow the project. However, the cryptocurrency industry is ripe with scammers.
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After all, something is only worth what someone else will pay for it. If the cryptocurrency security token you buy turns out to be a scam, you could lose your entire investment.
Stay safe out there: How to avoid cryptocurrency scams
Examples of recent security token launches
In April 2022, makeup company ODDITY announced the launch of its security token that runs on the Ethereum blockchain. If Oddity goes public, the token shares will convert into regular shares at a 20% discount to the IPO price. But until then, they won't be tradeable.
In June 2022, the blockchain-based investing private equity company Realio revealed that it would allow secondary trading of the Realio Security Token (RST) on the tZERO ATS alternative trading platform. The company says that RST is the “world's first DeFi hybrid equity token.”
Are security tokens legal?
Because security tokens represent ownership in securities, they must follow the same laws as stocks and are regulated by the Securities and Exchange Commission (SEC). For a token to be legal, it must register with the Securities and Exchange Commission and follow all SEC guidelines and other applicable government regulations.
Some cryptocurrencies have been accused of going afoul of these regulations. Most notably, perhaps, is Ripple. Also known as XRP, Ripple has been accused of acting as an unregistered securities provider. This is why it’s so hard for new buyers to find Ripple listed in exchanges targeting users in the United States.
To summarize, security tokens can be legal, but they're not always legal. If you’re considering investing in one, doing plenty of due diligence is critical to ensure the investment is legitimate. That includes operating within the confines of the law.
Pros and cons of security tokens
- Security tokens offer an innovative method to release shares of ownership in a company to the general public.
- Security tokens democratize access to initial offerings for new projects and companies that stock brokerages may otherwise reserve for wealthy investors.
- Thanks to the blockchain, security tokens maintain a strong record of ownership history, and there should be no dispute about who currently owns the assets.
- There's an elevated risk of scams, fraud, and losses in the securities token industry.
- Digital assets require some technical knowledge and computer skills to use.
- This newer investment class is subject to fewer regulations and oversight.
The bottom line
Many security token offerings have been for small projects that are unsuitable for most investors. But a few blockchain-related companies have taken steps to offer security tokens for their businesses or tokenize other stocks for users to buy and sell as tokens.
With security tokens, you could send your friend or family member a share of stock with the same ease as sending an NFT or bitcoin. As technology and regulations develop, this is an exciting development for the stock market's future.