Security Tokens and Regulation: A Global Perspective

Security tokens are digital representations of ownership in an asset, stored securely on a blockchain. Security tokens serve as programmable vehicles for investment in any asset that already has value, like real estate, a car, or corporate stock.

While the European Crypto Regulation (MiCAR) focuses on other types of crypto assets, security tokens often fall under existing securities regulations.

What is the relationship between crypto money and security token?

Cryptocurrencies and security tokens are both digital assets, but they have key differences in purpose, regulation, and underlying value. Here's a breakdown of their relationship:

Similarities:

• Digital Assets: Both exist on a blockchain, a digital ledger that records transactions securely.
• Tradable: Both can be bought and sold on exchanges.

Differences:

• Purpose: Cryptocurrency: Primarily functions as a medium of exchange (like digital money) or a store of value (like an investment). Examples: Bitcoin, Ethereum. Security Token: Represents ownership in a real-world asset, similar to a stock or bond. Examples: Security token representing shares in a company, ownership of a piece of real estate.
• Regulation: Cryptocurrency: Regulations are still evolving, but generally less strict than security tokens. Security Token: Often falls under existing securities regulations, similar to stocks and bonds. This means they may be subject to stricter regulations regarding investor protection and disclosure.
• Underlying Value: Cryptocurrency: Value is based on factors like supply, demand, and network adoption. Doesn't represent ownership in any physical asset. Security Token: Derives value from the underlying asset it represents (e.g., company shares, real estate).

Here's an analogy: Think of a safety deposit box.

• Cryptocurrency: A digital safe holding your digital money (crypto coins).
• Security Token: A document in the safe representing ownership of something valuable outside the safe (like a stock certificate for a company).

Howey Test

The U.S. Securities and Exchange Commission (SEC) uses the so-called Howey Test to determine if a digital asset qualifies as a security, which falls under existing securities regulations.

SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”). See also United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“Forman”); Tcherepnin v. Knight, 389 U.S. 332 (1967) (“Tcherepnin”); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943) (“Joiner”).

This test focuses on "investment contracts," and according to the SEC's framework, a digital asset is considered a security if it meets two key criteria:

1. Investment of Money: Investors contribute funds to the project.
2. Expectation of Profits from the Efforts of Others: Investors rely on the efforts of a third party (promoter or team) to generate profits.

The Howey Test is broad and applies to "any contract, scheme, or transaction," regardless of traditional security characteristics.

Decentralization and the Howey Test

William Hinman, the SEC's Director of the Division of Corporate Finance, clarified the application of the Howey Test to decentralized networks. He stated that if a token operates on a sufficiently decentralized network, where investors no longer rely on a specific group for management, the asset may not be considered a security.

Centralization and Regulatory Risk

This interpretation highlights the link between a crypto project's level of centralization and its regulatory risk. A highly centralized community with a strong leadership team managing the project increases the likelihood that the SEC would classify its token as a security, subjecting it to stricter regulations.

In short:

• Cryptocurrency is a new form of digital money or investment asset.
• Security Token is a digital representation of a traditional investment like a stock or bond, leveraging blockchain technology.

Digitization of Securities Paves the Way for Security Tokens

Countries that embrace the digitization of traditional assets, such as digital share certificates, are more likely to support security tokens. This is because the tokenization process is seen as a technological advancement within existing securities laws.

Global Support for Security Tokens

Several countries, including Singapore, Austria, Australia, the UK, Denmark, Norway, Malaysia, Germany, France, Canada, Hong Kong, Korea, and the US, have shown support for security tokens. This suggests a global trend towards regulatory acceptance.

The Future: Security Tokens as the Preferred Choice

Regulators seem to favour security tokens, aiming for all tokens to be classified as securities or subject to similar governance, investor protection, and compliance rules. This fosters a more regulated and transparent environment for digital assets.

Europe: A Patchwork Evolving Towards Harmony

While European securities regulations remain a work in progress, a trend towards harmonization is emerging. This means some countries, like Germany, the UK, France, Denmark, Switzerland, and Austria, fully embrace security tokens within their existing legal frameworks. Others, such as Sweden and Spain, are still solidifying their approach.

Despite this patchwork, the European Union aims to be a global leader in blockchain innovation. The recently approved MiCA regulation signifies a significant step in this direction. This regulation aims to create a more unified approach to crypto-assets across Europe, potentially including security tokens.

The US: A Clear Framework for Security Tokens

The United States stands out for its clear and well-established regulatory framework surrounding security tokens. Legal professionals have a strong understanding of how tokenized securities are treated, making the landscape predictable for businesses. This clarity aligns with the SEC's apparent preference for most digital assets to be classified as securities.

The SEC has established a framework to help assess whether a digital asset qualifies as a security. Importantly, they haven't issued any regulations or statements suggesting an intention to ban, restrict, or limit security tokens. This suggests a supportive environment for their development and use.

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