Security tokens are the first area where the regulation of major financial markets meets crypto innovation, and the union can provide a safer space for further crypto adoption.

The crypto space today is still under-regulated and the mainstream views it as too risky for adoption. This is slowly changing as misguided projects are filtered out and true disruptors emerge. At the same time, the U.S. Securities and Exchanges Commission (SEC) is making up its mind about how to regulate and include crypto and tokenized assets in mainstream financial markets. To aid this, a new token standard is emerging: security tokens.

There are two main issues with regulation in the crypto space which security tokens are aiming to solve: one facing investors, and one facing projects and regulators.

Token sale investors generally have very few assurances and almost never legal security for being repaid, even if the project is a fraud.

At the same time, because crypto markets are global and digital assets difficult to trace, Know-Your-Customer (KYC) requirements and other regulation must do their best to prevent rogue actors from buying and using tokens for criminal intent.

Making token investments reliable

Tokens represent uncertain returns for investors, because they are, in many cases, designed as a tool for buying products or services that the company launching the token sale is still developing. They are high risk but potentially high reward bets on disruptive technologies. Many fail. When projects fail before creating a usable token, the line to fraud is thin and this becomes a legal issue.

The promise for security tokens is that regulations that prevent fraud can be encoded into the smart contracts that underlie the token itself. This hardwired regulation should create more investor trust in the financing process of blockchain projects. The first steps for this we can already see in the form of KYC encoded in the ERC20 token standard, the most common one used today.

New projects can encode regulation that satisfies SEC requirements for a security into the smart contracts that govern how and by whom a token may be transferred. The SEC uses the ‘Howey rule’ to consider whether an asset is a security, and therefore lies under its strict regulation:

1) Is it being sold as an investment promising financial returns?

2) Is there a central person or group of people upon whom investors rely for the development of the value of the investment?

Token projects usually try to work around being classified as a security to avoid a stricter regulatory regime. Many claim not to meet the first condition because the tokens serve as vehicles for the purchase of a service. Nevertheless, many investors buy tokens in the hope of price appreciation, not simply to use the token for products, and this satisfies the condition.

Meanwhile, cryptocurrencies like Bitcoin or Ethereum can claim to be sufficiently decentralized in their developer communities to not meet the second condition, but again, most projects creating tokens have central developer teams and often companies behind them, which makes them a security.

Encoding regulation

There are several ways to encode regulation and make sure that crypto assets follow legal frameworks for investment.

The simplest is writing certain rules into the security token of a company or network itself, like KYC rules that make sure that only whitelisted and approved addresses can send and receive tokens. This can be extended to combat fraudulent projects or the fraudulent or improper use of tokens.

Regulators can further create ‘shell’ tokens that enforce specific types of country- or industry-specific regulations onto transactions of general tradable tokens. Legal advisors or auditors could also create smart contract-based regulatory add-ons that automatically check for certain conditions needed for the satisfaction of legal frameworks or certificates, for example, environmental protection provisions.

Furthermore, security tokens will only be able to be bought and sold on exchanges with a license for security trading. These can encode the legal requirements for their functioning into their smart contracts running the transactions on their platforms. This is a crucial place to attempt to curb fraud from the investor side because exchanges are often the entry-point into the crypto financial system.

All three forms of programmable regulation promise a clear upgrade on current best practice: they prevent rather than punish unlawful actions. Today, legal protection ensures that the law will punish wrongdoing after it has happened. However, if funds are locked in smart contracts that have regulations encoded, they cannot be transferred or used for fraudulent purposes in the first place.

Tokenization brings many benefits to markets: tokens enable more varied asset classes to gain liquidity and create trustless financial markets. With security tokens, we can now see a rise of encoded regulation that pushes the use of tokens into a safer investment space and, hopefully, more widespread adoption.